Small Business Tax pain continues…

Small Business Tax Pain Continues

But it’s not as bad as we first thought.

Last July, the federal government announced plans to introduce some significant changes to Canada’s Income Tax Act (ITA). In January of this year, the government introduced the first phase of those changes by limiting its ability to distribute dividends to family members. I wrote an article about income splitting or sprinkling in January.

In this year’s budget, the finance minister introduced limits on a small corporation’s ability to benefit from passive income.

2018 Budget – Restrictions on Passive Income

Before I explain how the government plans to restrict a shareholder’s ability to benefit from passive income, I will provide some context. In the world of tax, definitions are important. Accordingly, I must explain some key concepts on definitions.

Passive v. Active Income

If you own a business selling widgets, then your business’s income from the sale of those widgets is defined as Active Income. If you provide services instead of products, then the income you generate from providing those services is also called Active Income. When you’re accumulating a bunch of cash in your corporation and invest, then the interest or growth generated from those investments is considered Passive Income. If your corporation owns real property and receives rents, then you are generating Passive Income.

Why Is This Important?

Under the ITA, the government taxes Active Income and Passive Income differently, with Active Income receiving less taxation. The government wants to encourage Active Business because companies that generate Active Income add more value to the economy. Think of SkipTheDishes or Stella’s Restaurant. They hire staff and spend money on services and products to grow. The government likes this and wants to encourage growth, especially for small businesses just starting.

So, a long time ago, the government decided to provide tax breaks to those small businesses that generate Active Income in the hope that those businesses would reinvest that money in growth. So, if you incorporate and your income is $500,000.00 or less, you receive a generous corporate tax deduction. Currently, that tax rate is 10 per cent (the ITA defines this group of corporations as Canadian Controlled Private Corporations or CCPC). This rate will go down to 9 per cent in 2019. (The actual federal general tax rate for business is 38 per cent. But there are several different tax breaks available for business, so I’m not sure how many businesses pay that much.)

Passive income does not contribute to the economy in the same way. If you own a bunch of apartment blocks and you hire a management company to manage the headaches, you can sit on a beach and enjoy the constant, predictable income. The government won’t prevent you from working on your tan, but it certainly won’t let you do that while enjoying tax breaks.

How We Got Here

These small businesses or CCPCs would generate Active Income and receive beneficial tax treatment over the years. The owner or controlling shareholder would leave the corporation’s profits, treating them as a retirement fund. As with RRSPs, personal income taxes are deferred. With RRSPs, you pay taxes when you cash them in. With a CCPC, an owner pays personal income taxes when the funds are taken out of the corporation. So while the cash sits in the CCPC, over time, it will generate interest. A CCPC will also likely invest those funds in mutual funds, stocks or even property. Therefore a CCPC can generate Passive Income in addition to Active Income.

Now, I am not an accountant, so I can’t provide specifics. However, for this article’s purposes, most of that Passive Income continued to receive beneficial tax breaks.

Changes

As of 2019, that beneficial treatment will change. Fortunately, it won’t be completely eliminated, and the government won’t introduce complicated tax rules in doing so. But changes are coming.

The government will not change anything on the first $50,000.00 of earned Passive Income. For every dollar earned above $50,000.00, the government will reduce the income threshold of $500,000.00 by $5.00. As discussed above, if your CCPC earns less than $500,000.00, it benefits from the best tax breaks available (with a corporate tax rate of 10 per cent this year and nine per cent tax next year). For example, if you earn $50,001.00 in Passive Income, that threshold of income you can earn from both Active Income and Passive Income and still pay 10% corporate tax goes down to $499,995.00. If you earn $75,000.00, then your threshold goes down to $375,000.00. If you earn $150,000 of Passive Income, then you cannot benefit from the preferential tax rate at all (even if you generate Active Income).

Manitoba Corporate Tax

All of the above applies to federal taxes only. Each province also assesses corporate taxes which are not affected by these changes. To my surprise, when I first looked into provincial corporate taxes, Manitoba offered the lowest. Manitoba does not collect any provincial corporate tax from CCPCs that earn $450,000.00 or less, with this threshold amount going up to $500,000.00 in this year’s provincial budget. It is the only province that offers a tax break of this magnitude—all other provinces tax CCPCs anywhere from two per cent to four-and-a-half per cent.

Conclusion

According to the federal government, these changes will bring in anywhere from 600-900 million dollars. However, I look at these predictions with caution. According to the Parliamentary Budget Office (PBO), the changes to income sprinkling will bring almost double as much as the government predicted when it announced the measures. This suggests that the number of small business owners affected is also twice as high as predicted. These changes were not supposed to affect small businesses, but only those “rich people” who took advantage of the rules. While some may have benefited, overall, small businesses are paying a significant price.

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Disclaimer – Legalese

This article is presented for informational purposes only. The content does not constitute legal advice or solicitation and does not create a solicitor-client relationship (this means that I am not your lawyer until we both agree that I am). If you are seeking advice on specific matters, please contact Philippe Richer at 204.925.1900. We cannot consider any unsolicited information sent to the author as solicitor-client privileged (this means confidential).

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