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Canada To Reform Taxation Of Passive Investments

Wednesday, February 28, 2018

Canada's 2018 Budget has provided the long-awaited details of the Government's proposal to limit the tax benefits that can be derived from the holding of passive investments in a private corporation.

In July 2017, the Government consulted on three proposed changes to the tax planning rules intended to prevent private corporations from gaining undue tax advantages. After a backlash, the Government that autumn dropped plans to prevent the conversion of a private corporation's regular income into capital gains. It did nevertheless introduce legislation to restrict income sprinkling by private corporations, albeit in modified form.

The Government also confirmed last October that it would include in Budget 2018 detailed proposals for limiting the tax benefits of investing passively in private corporations, and that it would in the intervening period examine all deferral benefits arising from passive investment.

It did however announce at the time that it would introduce a passive investment threshold of CAD50,000 (USD39,159) per year for future, go-forward investments, which it said is equivalent to CAD1m in savings, based on a nominal five percent rate of return, and that there would be no tax increase on investment income below this threshold.

Finance Minister Bill Morneau delivered his 2018 Budget on February 27.

According to Budget documentation, the Government will, as promised, move ahead with its plans, but will do so in a "more targeted and simpler manner."

In the first instance, the Government intends to limit the ability of businesses with significant passive savings to benefit from the small business tax rate. Under the current rules, the small business deduction limit allows for up to CAD500,000 of active business income to be subject to the lower small business tax rate.

The Government said that it will phase out access to the lower rate on a "straight-line basis" for associated Canadian-controlled private companies (CCPCs) with between CAD10m and CAD15m of aggregate taxable capital employed in Canada. The Government said that this approach will "reinforce the principle that the small business rate is targeted to support small businesses, which tend to have more difficulty accessing capital, so they can reinvest in their active business, not accumulate a large amount of passive savings."

The Government will seek to introduce an additional eligibility mechanism for the small business deduction, based on the corporation's passive investment income.

If a corporation and its associated corporations earn more than CAD50,000 of passive investment income in a given year, the amount of income eligible for the small business tax rate would be gradually reduced. The small business deduction limit would be reduced by CAD5 for every CAD1 of investment income above the CAD50,000 threshold (equivalent to CAD1m in passive investment assets at a five percent return).

As a result, the business limit would be reduced to zero at CAD150,000 of investment income (equivalent to CAD3m in passive investment assets at a five percent return).

The tax applicable to investment income would remain unchanged, unlike under the original July 2017 proposal. No existing savings would face any additional tax upon withdrawal. Capital gains realized from the sale of active investments or investment income incidental to the business would not be taken into account for the measurement of passive investment income for the purposes of this measure.

The Government said that the new approach would be much simpler to comply with.

The second major reform announced in the Budget will seek to limit the tax advantages that larger CCPCs can obtain by accessing refundable taxes on the distribution of certain dividends. The Government has proposed that CCPCs should no longer be able to obtain refunds of taxes paid on investment income while distributing dividends from income taxed at the general corporate rate. Refunds would continue to be available when investment income is paid out.

The two measures would apply to taxation years that begin after 2018. The Government expects them to raise CAD925m a year.

The Government estimates that less than three percent of CCPCs will be affected by these changes – roughly around 50,000 private corporations. It said that more than 90 percent of the tax revenues from the measures would be generated from corporations whose owners' household income is in the top one percent of the income distribution.

The Budget also contained a number of measures designed to crack down on tax avoidance and tax evasion. The Budget proposed that the Government:

  • Clarify the application of certain rules for limited partnerships in order to prevent taxpayers from obtaining unintended tax advantages through the use of complex partnership structures;
  • Ensure that Canada's international tax rules cannot be avoided through the use of so-called "tracking arrangements," which allow taxpayers to "track" to their specific benefit the return from assets that they contribute to a foreign resident corporation;
  • Prevent unintended, tax-free distributions by Canadian corporations to non-resident shareholders through the use of certain transactions involving partnerships and trusts;
  • Introduce enhanced income tax reporting requirements for certain trusts to provide additional information on an annual basis, applicable for the 2021 and later tax years;
  • Introduce legislative amendments to the Canada Business Corporations Act to strengthen the availability of beneficial ownership information;
  • Adopt new rules in Canada's tax treaties to more effectively address treaty abuse;
  • Enact the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting; and
  • Provide CAD38.7m over five years to the CRA to enable the agency to expand its offshore compliance activities through the use of improved risk-assessment systems and business intelligence and hire additional auditors.