It was with a sigh of relief that I read the federal budget papers back in February, as the anticipated changes, especially to corporate tax rules, were not as onerous as we had thought they might be. Here’s a summary of the key corporate tax measures introduced in the federal budget.
Passive income rules
In my previous articles on the proposed changes affecting private companies, the last word from the Department of Finance was that the 2018 budget would contain legislation on how the passive income rule changes would be applied. These changes, which you’ll recall caused quite a backlash in the small business sector, were aimed at the tax deferral advantages of accumulating passive assets in a private corporation and being able to take advantage of lower corporate tax rates. The proposals, made back in July 2017, suggested applying the top corporate tax rate (50.17% in Ontario) on passive income, subject to the following modifications:
1. Any past and current investments (and future income earned on them) in a corporation as at the date the new rules are announced (i.e., budget date) will be grandfathered, and so will not be subject to the new rules.
2. The first $50,000 of passive income will not be taxed at the top rates.
3. The rules will allow for contingency funds or reserves to allow for the purchase of equipment, business expansion, or hiring and training of staff.
4. Incentives will be in place for venture capital and angel investors to continue investing in Canadian start-ups.
It all sounded like typical government overkill. Happily, the 2018 budget substantially scaled back those proposed measures, so much so that they seemed to be completely new rules. Essentially, the budget proposed a clawback of the small business deduction instead of the application of the top tax rate.
Specifically, the budget proposed that the small business deduction (SBD) limit for Canadian-controlled private corporations (CCPCs) and associated corporations be reduced on a straight-line basis for CCPCs that have between $50,000 and $150,000 of investment income. The budget reduces the SBD by $5.00 for every $1.00 of investment income over the $50,000 threshold (the safe-harbor amount previously announced in October 2017). Therefore, the SBD would be eliminated once a corporation reaches $150,000 a year.
The new rules will work in tandem with the taxable capital rules (where the SBD is reduced and eventually eliminated for companies that have taxable capital between $10 million and $15 million). Therefore, the reduction in a corporation’s SBD limit will be the greater of the reduction under the new passive income rules and the existing taxable capital-reduction rules.
As part of these new rules, the concept of “adjusted aggregate investment income” (AAII) was introduced to measure investment income. Generally speaking, the AAII will exclude taxable capital gains (and net capital losses) from the sale of active investments and investment income that is incidental to the business (this is meant to appease venture capital and angel investors). However, dividends from non-connected corporations will be added to AAII.
So, the key takeaway from these rules is that a CCPC might lose its SBD, but any investment income will still be taxed at the general corporate rate (26.5% in Ontario) rather than at the top corporate rate. In the end, these proposals are definitely a welcome change.
Refundable Dividend Tax on Hand (RDTOH)
For CCPCs, the access to RDTOH on the payment of taxable dividends to its shareholders is a true cornerstone of tax integration for corporations and their shareholders. Currently, a CCPC will receive RDTOH refunds when paying a dividend, whether eligible dividends (which are taxed in the hands of the recipient at lower dividend rates and are generally a result of high corporate tax being paid by the CCPC) or ineligible dividends (which are taxed in the hands of the recipient at higher dividend rates, and which are generally a result of low corporate tax being paid by the CCPC).
The budget introduced “eligible” and “non-eligible” RDTOH accounts. Under this new two-tiered system, if a corporation pays an eligible dividend, it can only access the RDTOH refund to the extent of its eligible RDTOH account. If a corporation pays a non-eligible dividend, it must first recoup the non-eligible RDTOH. Once that is exhausted, it will then get access to the eligible RDTOH.
The eligible RDTOH account will only include Part IV tax paid on the receipt of eligible dividends from non-connected corporations, and Part IV tax paid on dividends received from a connected corporation, to the extent of its proportionate share of the connected corporation’s dividend refund arising from its eligible RDTOH account. The current RDTOH account will be redefined as the non-eligible RDTOH and will track Part I refundable taxes.
Transitional rules were also announced for existing RDTOH balances: the lesser of the existing RDTOH balance and 38 1/3% of the GRIP balance will be allocated to the eligible RDTOH for CCPCs.
Corporate tax rates
Although there were no new changes proposed to the corporate tax rates, the budget confirmed the previously announced reduction in the federal SBD: a reduction to 10% for 2018, and a further reduction to 9% for 2019.
Miscellaneous business measures
The budget clarified that the at-risk rules for limited partnerships would apply at each level of a tiered-partnership structure. The current at-risk rules provide that a limited partner may deduct their share of a partnership’s losses only to the extent of their at-risk amount (being their invested capital that is at risk in the partnership).
Legislation was also introduced to clarify certain aspects of the synthetic equity arrangement rules and the securities lending arrangement rules to prevent taxpayers from realizing artificial tax losses through the use of equity-based financial arrangements.
The budget also amended the dividend stop-loss rule to decrease the tax loss on a repurchase of shares held as mark-to-market property, where it receives a tax deductible intercorporate deemed dividend on the repurchase.
The Health and Welfare Trust tax regime (which has been based on an administrative position published by the CRA) will be discontinued. Transitional rules have been announced to facilitate the conversion of such trusts into Employee Life and Health Trusts, which are governed by specific rules under the Income Tax Actso as to provide for one set of rules.
International tax measures
Cross-border surplus stripping.Currently, there are cross-border anti-surplus stripping rules that seek to prevent non-residents from obtaining a tax benefit through a transfer of the shares of one Canadian corporation to another Canadian corporation that does not deal at arm’s length with the non-resident, in exchange for shares of the purchasing Canadian corporation. The budget included some comprehensive look-through rules where taxpayers attempt to use partnerships as an intermediary as part of the transfer, such that the assets, liabilities, and transactions of a partnership and trust will be allocated to its members or beneficiaries based on the relative fair market value of their interests.
Controlled foreign affiliate status.Currently, passive income of a foreign company controlled by a Canadian (a “controlled foreign affiliate”), referred to as FAPI, will be included in the income of the Canadian taxpayer on an accrual basis. The budget proposed to deem a foreign affiliate to be a controlled foreign affiliate where there is a tracking arrangement in place allowing a taxpayer to retain control over its assets and any returns on them. Such arrangements have been used to avoid the controlled affiliate status.
Foreign affiliate – investment business.The budget proposes to curtail the ability of taxpayers to make use of the more-than-five-full-time employee exception to the FAPI rules where they enter into a tracking arrangement to pool their investment activities into one common foreign affiliate. The budget proposed treating each of the activities carried out by foreign affiliate in such tracking arrangements as separate businesses, with each business having to meet its own separate test as it relates to the more than five full-time employees.
Foreign affiliate reporting.Information returns for foreign affiliates (Form Tl134) must now be filed within six months of a taxpayer’s year-end (shortened from 15 months). This measure will apply for the taxation years beginning after 2019. So sharpen your pencils! Better yet, consult a corporate tax specialist.
Courtesy Fundata Canada Inc. ©2018. Samantha Prasad, LL.B. is Tax Partner with Toronto law firm Minden Gross LLP. Portions of this article appeared in The TaxLetter, published by MPL Communications Ltd. Used with permission.