It’s time to get back to business.
In July 2017, the Department of Finance (“Finance”) released a discussion paper and draft legislation which would have, if fully enacted, changed the whole tax landscape for private corporations. Since then, the government has abandoned, modified or changed direction on many of its proposals. One of the biggest proposed changes involved passive investments inside Canadian controlled private corporations. Many business owners have deferred making decisions about insurance purchases because of the uncertainty.
Originally, Finance did not release draft legislation to address the treatment of passive investments inside a corporation. It floated possible approaches that it could take and sought input and feedback on these approaches. The idea was to replace the current system of refundable taxes with a non-refundable tax (generally equivalent to the top personal tax rate). For interest income, this would have meant that combined corporate and personal tax, once the income was distributed to a shareholder as a dividend, would have been in the 72 per cent range. Finance stated that existing investments would be “grandfathered.”
In October 2017, the government announced that it would fine-tune the passive investment proposals and talked of a go-forward $50,000 annual threshold for passive investment income within private corporations that would not be affected by any new regime. It also reiterated the idea of grandfathering and the possibility that income from grandfathered passive investments might also be grandfathered.
While this softening sounded better, there were still a lot of unanswered questions. How would the new system work? What was to be grandfathered – passive investment assets, the income from them, or both? Would corporate-owned life insurance be affected? If so, how? How would businesses keep track of all of this?
Where we are now
The big news from the 2018 Federal Budget was the change in direction concerning the proposals for passive investments inside Canadian controlled private corporations (CCPCs). Rather than removing access to the refundable taxes, as proposed in July 2017, the government is now proposing a different way to limit deferral advantages from holding passive investments in a private corporation.
For taxation years that begin after 2018, the government proposes to limit the ability of businesses with significant passive investment income to benefit from the small business tax rate. The current small business limit allows for up to $500,000 of active business income to be subject to the lower small business tax rate (which the government has proposed to reduce from 10.5 per cent for 2017 to 10 per cent for 2018 and to 9 per cent for 2019), versus the general business tax rate, which is currently 15 per cent federally.
Under the proposal, if a corporation (and its associated corporations) earns more than $50,000 of passive investment income in a given year, the amount of active business income eligible for the small business tax rate would be gradually reduced. It is proposed that the small business limit be reduced by $5 for every $1 of passive investment income above the $50,000 threshold, such that the small business limit would be reduced to zero at $150,000 of passive investment income.
For example, if a CCPC has $100,000 of passive investment income, its small business limit will be reduced to $250,000 ($500,000 – (excess $50,000 x $5)). If the corporation has $200,000 of active business income, this reduced small business limit will not affect it. The full $200,000 will be taxed at the small business tax rate. However, if the corporation has $325,000 of active business income, it will benefit from the small business tax rate only on the first $250,000 of that income. The other $75,000 ($325,000 – $250,000) will be taxed at the higher general corporate tax rate.
For a purely investment holding company that is not associated with an active business, there is no change to the taxation of passive investments and the distribution of this income. This is a significant and welcome departure from the original proposals. And, even where there is an impact, it affects only the tax rate applied to the active business income. No tracking, no pools, no grandfathering of existing assets – but that’s a good thing!
Investment income will be measured by a new concept: “adjusted aggregate investment income.” This includes everything that is currently considered passive investment income when calculating a corporation’s refundable taxes (including interest, dividends and capital gains). The new concept will not include capital gains from the sale of property used in an active business or the sale of shares of an active business that is connected with the corporation, nor will it include investment income that is incidental to the active business. Adjusted aggregate investment income will include dividends from non-connected corporations and income from savings in a non-exempt life insurance policy. Gains arising from the disposition of an exempt policy and income from annuities held by private corporations are also included, but again, nothing about the taxation of these amounts is changing; the change is that this income may reduce a corporation’s small business limit.
Implications and opportunities for insurance
What does this mean for insurance? In general, this is positive news. Exempt life insurance does not produce passive investment income unless there is a disposition of the policy. Repositioning a portion of a corporation’s passive investment assets into a life insurance policy could provide a shelter that would limit the erosion of the small business limit. Ultimately, corporate-owned life insurance may enable the transfer of wealth to the next generation through strategies such as the Corporate Estate Bond concept. Life insurance may also provide additional retirement funding using the Corporate Insured Retirement Program. All this without affecting the corporation’s small business limit and to some degree reducing what might count towards erode it.
Corporate-held critical illness insurance with return of premium under which the corporation is the beneficiary of the critical illness and ROP benefits does not produce passive investment income to the corporation.
Now that there is some certainty about the direction of the passive investment proposals, let’s get back to business and start talking about corporate insurance solutions again.