The Government of Canada implemented major changes to the rules for passive income and the Small Business Deduction Limit for Canadian Controlled Private Corporations (CCPCs) in Canada. The changes were introduced in 2018 and came into effect for 2019 income.
Small Business Deduction
The Small Business Deduction is essentially a reduction in corporate tax for Canadian Controlled Private Corporations that gives corporations the benefit of a lower tax rate. Effective for 2019 the first $500,000 active business income is taxed between, 9% to 15% depending on the province (keeping in mind Saskatchewan has an extra $100,000 incentive). On the other hand, business income that does not qualify or is over and above the $500,000 is taxed between 26% and 31%, once again depending on the province. Obviously, this is a big difference and well worth some planning.
Many businesses choose to retain earnings within the corporation rather than paying it all out in the form of salaries or dividends. Typically, these assets are then invested in hopes of earning income, usually in either financial vehicles or real estate. The income produced by these “passive” investments is taxed at a much higher rate than active business income (50.2% - 54.7%) Even though a portion of that can be recovered through the Refundable Dividend Tax Credit when dividends are eventually paid out.
𝗡𝗲𝘄 𝗣𝗮𝘀𝘀𝗶𝘃𝗲 𝗜𝗻𝗰𝗼𝗺𝗲 𝗥𝘂𝗹𝗲𝘀
CRA introduced new rules that penalize corporations generating large amounts of passive income. Under the new regulations, any corporation earning over $50,000 in passive income for the year will have some of their Small Business Deduction clawed back. So instead of paying tax at a low rate, your corporation would be subject to the higher general rate. In fact, for every dollar over $50,000, the SBD will be reduced by $5. However, if you tend to run a bit closer to the threshold - or are well above $50,000 in passive income - you could find some of your business income taxed 16-17% higher than before. Not a pleasant thought.
An easy example of this is a company with $70,000 of passive income. Since they are $20,000 over the claw back threshold, they will lose $100,000 ($20,000 x $5) of their SBD, leaving them with $400,000. A company with $150,000 or more of passive income will have their entire Small Business Deduction 100% clawed back.
Canadian business owners don’t simply have to sit idly by hoping that the numbers work out in their favour at the end of the year. There are many options available, from improving the tax-efficiency of your corporate investments to funnelling assets out of the corporation to be invested personally. With many of our clients finding themselves in this very situation, we have developed 5 Ways to Avoid the Small Business Deduction Claw back in order to solve this very problem.
Just because you have passive income doesn’t mean you should be passive when it comes to tax planning. Don’t hesitate to consult with an expert on the subject before it’s too late.