Will the 2018 Proposed Legislation on Passive Investment Assets held by Canadian Controlled Private Corporations (CCPC’s) Affect My Business or Me Personally?
The impact of the 2018 Federal Budget is still not fully understood. When meeting with physicians or other incorporated professionals, we are often asked to explain the changes and how they impact their individual situations.
To answer these questions, we have spent time working through different scenarios which we will share later in this article.
Before we discuss how these changes may impact different individual situations, let’s review the changes themselves. We will not be discussing the income sprinkling rules announced in Dec of 2017 as we have previously done so in our article: A Recap of Income Sprinkling Rules in 2018 with a Specific Look at Medicine Professional Corporations.
We will focus this article on the draft legislation regarding Passive Investment Assets tabled on Feb 27, 2018 by Federal Finance Minister Bill Morneau.
The changes impact the Small Business Deduction (SBD). When a CCPC (such as a Medicine Professional Corporation) has active business income (ABI), it pays a lower tax rate on the first $500,000 of its ABI. In Ontario, that lower rate is 13.5% in 2018 (it was 15.0% in 2017). For ABI over $500,000, an Ontario corporation pays taxes of 26.5%. Many accountants will work with their clients to ensure their ABI does not exceed $500,000 – paying salaries or bonuses to keep it below that threshold. For a medical professional active business income often refers to medical billings; it does not include investment income received from passive investments in the corporation. The larger a physician’s savings are in a corporation, the larger they can expect their passive investment income to be. This investment income is taxed at a higher rate than ABI.
The government has targeted corporations that have significant passive investments by restricting the amount of Adjusted Aggregate Investment Income (AAII) that a corporation can have without being penalized. For passive investment income exceeding $50,000, the government announced in the budget that it would restrict access to the lower small business deduction (SBD) tax rate for taxation years that start in 2019. To be specific, any dollar past $50,000 in passive investment income will decrease the $500,000 SBD allowance by $5.
Let’s work through a short example below.
| Category | Amount ($) |
|---|---|
| Billings | $550,000 |
| Salary | $50,000 |
| Taxable Active Business Income | $500,000 |
| Passive Investment Income (interest) | $120,000 |
| Passive Investment Income over $50,000 | $70,000 |
| SBD Limit Reduction: $5 for every $1 > $50,000 | $350,000 ($70,000 x 5) |
| Amount Taxed at Small Business Rate (12.5%) | $150,000 ($500,000 – $350,000) |
| Amount Taxed at General Business Rate (26.5%) | $350,000 ($500,000 – $150,000) |
As you can see above, since passive investment income exceeded the $50,000 threshold by $70,000, the amount that was eligible for the small business tax rate decreased by $350,000 ($70,000 x $5). This left only $150,000 eligible for the lower, small business rate and the rest of taxable active business income at the higher, general tax rate.
As before, passive investment income received through investments inside your corporation are still taxed depending on what type of specific income it is, shown below.
| Source | Tax Rate (%) |
|---|---|
| Interest Income | 50.17% |
| Dividend Income | 38.33% |
| Capital Gains | 25.09% |
Tax can be complicated and that is why we have narrowed down the implications of the new federal budget to three different corporate client situations.
- Newly practicing Physician, billing $300,000 with passive investment income less than $50,000
- No immediate affect, the entire amount of active business income under $500,000 will likely remain taxed at the lower, small business tax rate
- Mid-career Physician, billing $900,000 with passive investment income greater than $50,000
- Will likely be affected, the amount of active business income taxed at the small business rate will be reduced by $5 for every $1 of passive investment income greater than $50,000
- Retired Physician, no billings but with significant passive investment income
- No affect, since the Physician is not billing, there is no income being taxed at the small business tax rate to begin with
As you can see, Physicians with significant billings and passive investment income greater than $50,000 will be affected. Below you will find a detailed breakdown of the continuation of the impacted case.
| Category | Before Budget Change ($) 2018 | After Budget Change ($) 2019 |
|---|---|---|
| Billings | $900,000 | $900,000 |
| Salary | $100,000 | $100,000 |
| Active Business Income | $800,000 | $800,000 |
| Amount of Investments | $2,500,000 | $2,500,000 |
| Passive Investment Income Received | $125,000 | $125,000 |
| Passive Investment Income Exceeding Threshold | N/A | $54,167 |
| Reduction to Small Business Tax Deduction | N/A | $270,837 ($54,167 x $5) |
| Total Income Included For Small Business Deduction | $500,000 | $229,163 ($500,000 – $270,837) |
| Tax on Included Income (13.5%/12.5%)* | $67,500 ($500,000 x 0.135) | $28,646 ($229,163 x 0.125) |
| Total Income Excluded From Small Business Tax Deduction | $300,000 ($800,000-$500,000) | $570,837 ($800,000 – $229,163) |
| Tax On Excluded Income (26.5%)** | $79,500 ($300,000 x 0.265) | $151,271 ($570,837 x 0.265) |
| Tax on Passive Investment Income*** | $47,326 | $47,326 |
| Total Tax Paid | $194,326 | $227,243 |
| Net Income Retained In Corporation | $730,674 | $697,757 |
| Impact of Change | N/A | $32,917 |
*Small business rate for Ontario, varies by province
**General business rate for Ontario, varies by province
***Mix of interest Income, dividend income and capital gains
From above, you can see there is a $32,917 impact in this example. The impact is calculated as the amount of the reduction to the small business deduction multiplied by the difference in the small business tax rate and the general business tax rate ($375,000 *(26.5% – 13.5%)). The largest impact the change can have is entire small business reduction amount, $500,000 multiplied by the difference in tax rates shown above. The maximum impact for a corporation in this situation would total $65,000.
Although a portion of active business income will be unable to qualify for the lower tax rate, there is still a significant tax deferral opportunity for incorporated physicians. The difference between their personal tax rate of say, 47% (top Ontario rate is 53.53%) and 26.5% for the general business tax rate.
There are still ways to mitigate or eliminate the proposed changes. For more information on strategies to optimize your wealth plan, please speak with your Tall Oak Raymond James advisor.
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