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After outcry from entrepreneurs, federal budget introduces watered-down passive income rules

After outcry from entrepreneurs, federal budget introduces watered-down passive income rules

 

Owners of small and medium-sized businesses across Canada can finally breathe a sigh of relief. For the most part, they’ve won this round in the ongoing fight with the federal government to halt contentious tax reforms for corporations.

Indeed, the 2018 federal budget will be remembered for what it didn’t do, rather than introducing any dramatic new measures, either beneficial or harmful, to the bottom-line health of Canadian SMEs. That’s good news for business owners who feared that Ottawa would move forward with proposals to curb passive income earned by Canadian-controlled private corporations (CCPCs).

Recall that the government’s original plans were to introduce a punitive tax on passive income that would have seen flow-through taxation rates on some investment income spike to as high as 73 per cent—an absolutely ludicrous amount that instantly drew the ire of SME owners. Amid a fierce backlash, the Trudeau Liberals then suggested a $50,000 exemption on passive investment earnings, as well as a grandfathering of new measures. As noted in a previous blog, even the watered-down proposals would negatively impact everything from an entrepreneur’s ability to fund the growth of their business, to their personal financial well-being (many business owners use passive investment income as a vehicle for retirement savings, for example).

The budget scrapped those plans, instead restricting access to the small business deduction (SBD) for CCPCs that earn more than an aggregate of $50,000 in passive income in a given tax year within its associated group. CCPCs will lose $5 in SBD for every $1 in investment income above $50,000. If a CCPC earns $150,000 in passive investment income, it will be ineligible for the SBD. As the budget notes, “For the limited number of corporations earning that level of passive income or more, their businesses’ active income would be taxed at the general corporate income tax rate.”

It goes without saying that this new proposed measure is a vast improvement on the government’s initial plans, first floated in July, 2017. Taxes on passive income will not be directly affected and both refundable taxes and dividend tax rates will go unchanged. The budget claims that “Less than 3 per cent of corporations will be affected. 90 per cent of the tax impact will be borne by households in the top 1 per cent (i.e. the wealthiest).” The Canadian Federation of Independent Business contends that up to 10 per cent of CCPCs could be negatively impacted by the new measures. Whatever the case, the bad news is that many SME owners who previously relied on passive investment income to help fund the expansion of their businesses will now be paying more to the Canada Revenue Agency than before.

For that reason alone, there are few reasons to applaud this budget. Put simply, the measures to curb passive investment income shouldn’t have been proposed in the first place. This is a highly politicized budget that does little to deal with big-picture issues such as improving Canada’s macroeconomic performance or balancing the budget. But for now, at least, entrepreneurs can go back to focusing on the growth and success of their companies.

Of course, the budget didn’t only propose new passive investment income rules. It also introduced several more benign measures such as new reporting requirements for certain express trusts that will require disclosure of trustees, beneficiaries, settlors and protectors. The budget also proposes to extend the tax return reassessment period in certain cases.

But in one area, the government was noticeably quiet. Despite a major overhaul of the U.S. tax system– the reduction of the corporate tax rate to 21 per cent from 35 per cent being the most significant in a game-changing package of amendments—that has largely eroded Canada’s corporate tax advantage, Finance Minister Bill Morneau said only: “Over the coming months, the Department of Finance will conduct detailed analysis of the U.S. federal tax reforms to assess any potential impacts on Canada.”

Let’s hope that analysis happens sooner than later. The threat to Canada’s economic competitiveness in the wake of the Trump administration’s sweeping tax reforms cannot be overstated. And let’s not forget the threat of a potential NAFTA cancellation and the (at least short-term) pain that would be inflicted across industries by the loss of our most important trade agreement.

Overall, Budget 2018 could have been far worse for entrepreneurs. But it also didn’t do much to improve their lot; in that sense, it was a disappointment. We can only hope that Ottawa focuses less on increasing the already onerous tax burden on Canada’s small and medium-sized businesses, and instead puts more work into helping to create opportunities for our entrepreneurs to succeed at home and abroad.

For the full scope of the budget, please refer to our Budget 2018 Commentary.

Armando Iannuzzi, Partner

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