Our current Liberal government believes that both salaried employees and self-employed individuals (who could run a business through a corporation) should face the same level of tax burden. As a result of this philosophy, a number of changes were introduced into our tax system over the last year or two. One of the most important changes is the treatment of investment income (passive income) earned by a private corporation (i.e., a corporation not listed on a stock exchange).

There’s rationale behind this new tax rule concerning the treatment of corporately earned passive income. A private business’s income, up to a threshold of generally $500,000, is taxed at a preferential rate. That rate is in the neighbourhood of 12 percent, depending on the province. A salaried employee’s employment income, on the other hand, is taxed at a much higher rate, ranging from about 20 percent to more than 50 percent—again, depending on the province. Therefore, the after-tax income available for investments is much higher for a private corporation than for a salaried employee. The government believes this is an unfair advantage and must be eliminated—or at least minimized. This change along with several other changes is applicable for fiscal years that begin on Jan. 1, 2019, and later.

These new rules on passive income will result in two major changes: the ability to claim small business deductions and the ability to claim refunds on taxable dividends paid.

Small Business Deductions

Canadian-controlled private corporations are allowed to claim a small business deduction on their first $500,000 of active business income to reduce their corporate income tax rate to about 12 percent (province dependent). That $500,000 threshold will be reduced by $5 for every $1 of passive income exceeding $50,000 and will be fully eliminated once that passive income exceeds $150,000. This reduction must be applied in conjunction with the small business deduction reduction relating to taxable capital.

Refunds on Taxable Dividends

Private corporations earning passive income are subject to refundable corporate tax, which accumulates in an account called Refundable Dividend Tax on Hand (RDTOH). The amount in RDTOH is refunded when taxable dividends are paid to a corporation’s shareholders. RDTOH balance is refunded at a rate of 38.33 percent per $1 of taxable dividends. This mechanism attempts to reduce the advantage of investing through a corporation because of higher personal tax rates. The refundable tax is a temporary tax attempting to level the playing field between investing through a corporation and investing personally.

When a shareholder receives dividends from a corporation, he or she is taxed at a personal level. To compensate for the corporate tax already paid, the shareholder is entitled to a dividend tax credit to reduce his or her personal tax. The amount of dividend tax credit depends on the type of dividends the shareholder receives: eligible or non-eligible.

Eligible dividends offer more generous dividend tax credits (15.0198 percent of the number of taxable dividends) than non-eligible ones (10.0313 percent). The classification is done by the dividend-paying corporation based on certain tax rules. To eliminate perceived abuse, the government has introduced new rules to reduce the number of situations in which a corporation can classify dividends as eligible dividends. As a result, shareholders will now have to pay higher personal tax on dividends more frequently.

The Tough Part

While it might take some effort to fully understand the mechanics of these new rules (they’re explained only conceptually here), the mechanics actually aren’t the most difficult part about applying the new rules. The most difficult part is how to determine passive income. In the legal sense, passive income isn’t defined clearly, and its determination depends on the facts of each particular situation. For example, passive income to one business could be active income to another. In fact, passive income to one business in a particular year could be active income for that same business in another year.

While the federal government has implemented all of the rules regarding passive income, Ontario has indicated that it won’t implement some of them. (Typically, Ontario doesn’t have a separate tax system; it uses the federal one. Sometimes the province decides not to enforce some federal rules or decides to enforce some of the rules differently.)

The good news is, private corporations under Ontario jurisdiction will be exempt from some of these federal measures for their provincial corporate tax. However, this means that the tax system will just be a bit more complicated than usual.