Updated: Sep 5, 2018
What is passive income? it’s basically not active income which means it’s not transactional income. Passive income best described would be something like mutual funds or shares held by the corporation. The change that comes to Canadian Controlled Private Corporations (CCPC) is how the passive income will be taxed. Companies currently earning or projected to earn more than $50,000 of investment income will be affected adversely. It is recommended to speak to your tax advisor/accountant on this.
A typical CCPC corporation earning active business income is taxed at corporate tax rates which are lower than personal income tax rates. The tax savings generated by leaving the money in the corporation allows the small business owners to invest more after tax dollars into their respective corporations. Any income earned on Passive income is taxed at a higher rate than the corporate rate to make the tax payable similar to those who invest personally. When the corporation pays out a taxable dividend to a shareholder a portion of that “extra” investment tax is refundable in the corporation’s RDTOH - refundable dividend on hand account. Think of this account as a claw back account for the taxes paid.
Now that we have gone through some of the history the major change is to the small business deduction which is a preferential tax rate charged on the first $500,000 of taxable income. As a go forward a corporation can earn up to $50,000 of passive income without affecting this small business deduction. For every $1 on top of the $50,000 of passive income the small business limit will be reduced by $5. This means if a corporation earned $51,000 in passive income this would reduce the corporation’s small business limit from $500,000 to $495,000. Once the corporation reaches $150,000 in passive income there will be no small business deduction available.
RDTOH - Refundable Dividend Tax On Hand Account Currently, a dividend refund is available to corporations at roughly 38% of taxable dividends paid to the extent that there is an available balance of RDTOH at the corporation’s year-end. The RDTOH balances are typically increased where a corporation earns passive investment income. Prior to this Budget, a corporation would receive a refund by declaring an eligible dividend which carries better personal tax treatment than ineligible dividends.
The budget proposes to introduce measures that will generally allow the CCPC to recover the RDTOH only on the payment of the non-eligible dividends before it can obtain a dividend refund from its eligible RDTOH. There is a exception arising on the payment of Part IX of the tax on eligible portfolio dividends. Such RDTOH will be recoverable on the payment of the eligible dividends.
TOSI - Tax on Split Income (Income Sprinkling changes)
Prior to the changes TOSI only applied to minors which was taxing certain types of income at the highest marginal tax rates including taxable ineligible dividends. The new rules stipulate that they will apply to any Canadian resident regardless of age. Many types of income can be targeted by this new change including taxable dividends, interest on debt obligations. This means that taxable ‘dividends’ paid to a spouse will now be taxed at the highest marginal tax rate unless one of the following exclusions apply.
TOSI will not apply for payments made to a spouse who is actively involved in the business. This means for the purposes of taxes the individual engaged in the corporation must be on a regular, continuous and substantial basis. This means the TOSI rules will not affect true family owned businesses where everyone is involved. However, the key word here is “regular, continuous and substantial basis”. This interpretation is based on judgement and it is advisable to see your Tax Advisor to discuss on this exclusion further.
TOSI rules will not affect “excluded shares”. To meet this the following conditions must be met
All or substantially all of the corporation’s income cannot be derived from a related business in respect to the individual.
The corporation cannot be a professional corporation. Also a requirement to be a professional corporation.
The corporation must earn less than 90% of its income from services. This one was to discourage Doctors, Lawyers, Accountants and other professionals from splitting between spouse/professional partner.
The individual must own at least 10% of votes and value of the corporation.
Fortunately, TOSI will not impact the arms length sale of QSBC shares that qualify for the lifetime capital gains exemption.
There have been many other changes that the Budget brings but the above 3 affect majority of our clients who are small business owners. If you feel that some of these rules are not clear we can definitely help. Please reach out and book in a meeting with us to discuss any detailed questions you might have!