Our 2018 budget came in like a lamb, not the lion we feared from pre-budget consultation. Changes to personal finance and investment taxation were far less noteworthy than originally threatened with the Canadian small business remaining the target for change. Largely at issue are corporations holding real estate, stocks and bonds (passive investments) intended not for reinvestment within the corporation, but for the benefit of its shareholders.
Changes to the Small Business Environment
Moving forward on its plan to change the small business tax regime, this budget began what could be considered a phase-out of the preferential treatment small businesses get in Canada. It is worth noting that the USA does not have a similar “small business environment” and many G20 countries are also phasing out tax advantages to small corporations. Here are the changes in summary:
Federal Tax Rates. The Federal small business tax rate is going down to 10% in 2018 and 9% in 2019 leading to combined Federal/Alberta Small Business (SBD) income tax rates of 12% and 11% respectively. They were 14% leading into 2018.
Passive Income Rules. Starting in January 2019, corporations earning $50,000 or greater passive income will see a reduction in their Small Business Deduction ($5 for every $1 of passive income). This means at $150,000 of passive income, the SBD will be lost. Passive income generally includes rental income and/or income from an investment portfolio (interest, dividends and/or capital gains). This means that a corporate investment portfolio starting at approximately $2,000,000 could begin to reduce or eliminate the SBD. Mathematical modeling still indicates that corporate held investment portfolios are preferential in the stewardship of corporate surplus even when using the higher general income tax rates. Therefore, the new passive income rules should not change the planning for most small business owners in reference to their investment management.
Refundable Dividend Tax on Hand (RDTOH). RDTOH is a refundable tax intended to encourage the extraction of passive investments from a corporation in the form of a declared dividend. Starting in 2019, RDTOH balances need to be tracked and matched against the General Rate Income (GRIP) or Low Rate Income (LRIP) they were generated from. Any RDTOH on the balance sheet heading into 2019 will be broken into GRIP or LRIP pools using a formula supplied by CRA. This was also introduced to offset creative tax planning done with RDTOH in previous years and should not change the investment plans for most small business owners.
Tax On Split Income (TOSI). Effective January 2018, TOSI rules have been introduced and are best understood as an extension of the “Kiddie Tax” rules already in place. These are severe for many family businesses. Here, income paid to a spouse (or other family member) will be re-characterized at the highest marginal rate without access to personal tax credits unless the spouse or family member is “exempt” from TOSI. This will effectively end the use of a family trust for income splitting (but leaves them intact for splitting capital gains) as family trusts are not exempt from TOSI. Income received in the form of dividends, interest and/or shareholder benefits is subject to TOSI. Exempt from TOSI are those employed on a regular, continuous and substantial basis (20 hours per week) and those over age 65. Remuneration subject to TOSI must be justified as reasonable (similar to salary), but the definition of reasonable is left for case by case analysis by CRA.
Trust Reporting Requirements. To combat what was considered aggressive tax planning, what are referred to as “express trusts” will be required to file an information return (T3) annually with CRA starting in 2021. These include EPSP, Spousal, Alter-Ego and Family Trusts with an associated penalty for failure to file. The information return will include identification of the trustees, beneficiaries and settlors. Exempt from these new requirements are Graduated Rate Estate Trusts (GRE) and trusts that have been in existence for less than 3 months or hold less than $50,000 in assets throughout the year.