How Will the New Passive Income Rules Impact Your Business?

If you own an incorporated small business in Canada, you might pay more in tax. But it may not be as much as you think.

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There are more than one million small businesses in Canada that help drive the economy and provide income for families by selling products and services. Running an incorporated business can also be tax advantageous as any money left inside of a corporation, up to $500,000 of active business income, is taxed at a low small business tax rate.

Just over a year ago, though, the federal government introduced changes to rules on passive income earned – income generated from rents, investments or dividends – that may impact how much money businesses can receive at that preferential tax rate. The new rules take effect this year for corporations whose year-end is on or after January  1, 2019.

“We encourage clients to hold investments in multiple places, not just in their corporations, to reduce passive income.”

Sheryl Troup, director, tax & estate planning with IG Wealth Management, helps clarify who these new rules will impact and how.

  • Will the new rules on corporate investment income affect all small business owners in Canada?

    No. The first question to ask is: Do I operate a corporation with an active business or own a corporation that’s associated with a corporation running an active business? If not, these new rules pose no problem for you. If yes, the next question is: What is my income from that active business, and do I have a large number of passive assets in the company or in an associated company? Then you can determine what impact, if any, the new rules will have on you.
  • Okay, so I have a corporation (or associated corporation) that earns both active and passive income. What do I need to know?

    There is a new limitation on the $500,000 small business deduction, based on a company’s previous year’s passive income. A corporation can have up to $50,000 of investment income in the prior year with no impact to the small business deduction. But for every dollar of passive income over that amount, you lose $5 of the deduction. That means once passive income exceeds $150,000, you lose the small business deduction entirely.
  • What does that look like in practical terms?

    Businesses could pay more in corporate tax upfront on their active business income if they lose some or all of the small business deduction. For example, in Alberta, the general corporate tax rate is 27 percent, compared to the small business deduction rate of 11 percent.
  • Should business owners be doing anything differently in light of these changes?

    It depends. Corporations earning less than $500,000 may not have needed the full small business deduction in the first place, so the impact on them could be less severe. For example, a corporation with $300,000 of active business income could earn up to $90,000 of passive income and not be affected by the new rules. Sometimes doing nothing is the right approach.
  • What about businesses earning more than $500,000 in active income that also have substantial passive income – is there anything they can do to mitigate the potential loss of the small business deduction?

    We encourage clients to hold investments in multiple places, not just in their corporations, to reduce passive income. For example, they should be maximizing their personal registered retirement savings plans (RRSPs) and tax-free savings accounts (TFSAs). They can also design their portfolios to be more tax-efficient by holding fixed-income assets in their tax-deferred RRSPs, and equity-based assets in the corporation. There are many other things business owners can do – such as buying active business assets or repaying corporate debt – to reduce passive income.
  • How big of a deal is this change for small businesses?

    While the potential increase in corporate tax may seem like a lot, this change is not terribly horrific. When the corporation pays more tax on its active business income, the individual pays less tax through the eligible dividend regime. You still get a significant tax deferral by having the income stay within the company, but it’s now just a bit smaller. Assuming your personal tax rate is 48 percent (the top rate in Alberta), your tax deferral goes down to 21 percent. When you look at all corporate and individual taxes you will eventually pay on that income overall, it’s only an increase of about 1.6 percent (in Alberta). Business owners need to be aware of the change, but they don’t have to panic. Good tax planning is key.

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