The recent federal tax changes have been a hot topic in the investment community lately. The new rules are incredibly complex and a source  of confusion for many advisors. To shed more light on the rapidly changing tax landscape, CFA Society Toronto’s Private Wealth Management Committee invited John Campbell, partner at Hilborn LLP, to discuss the new tax rules. The event, Corporate Tax Changes: The Facts, the Myths and the Remaining Uncertainty, was held in April at the CFA Society Toronto offices.

A Little Context

The federal government initially introduced the proposed tax changes on July 18, 2017. Finance Minister Bill Morneau’s letter accompanying the proposed legislation stated that the objective was to “…close loopholes and deal with tax planning strategies that involve the use of private corporations.” However, many financial pundits argued that the tax changes don’t merely close loopholes; rather, they would result in a fundamental shift in the way private corporations are taxed. As a result, the government revised its initial proposals and presented the updated version of the tax rules in the Department of Finance Release (Dec. 13, 2017) and the 2018 Federal Budget (Feb. 27). With this background, let’s now focus on the two major topics discussed at the April event: tax on split income (TOSI) and taxation of passive investment income (TOPII).

Tax on Split Income

The purpose behind the TOSI rules was to curb a common tax-planning technique called income sprinkling. This technique would enable a shareholder to divert some of the income that would otherwise be subject to a high tax rate to his or her family members. This technique is based on utilizing the lower marginal rates and personal tax credits of family members, and would usually result in a significant reduction of the family’s overall tax bill. The government viewed this tax-planning technique as unfair and introduced the TOSI rules.

TOSI results in the application of the highest marginal tax rate to the individual income recipient. The tax impact can be significant, given that, in Ontario, the top marginal rate on regular income is 53.53 per cent and 46.84 per cent on ineligible dividends. The new TOSI rules also extend the application of the existing “kiddie tax” rules, which previously applied only to minors, to adults. These new rules would result in the highest marginal tax rates being applied to certain income received by a minor.

The new TOSI rules apply differently to the following three age categories of adults: those aged 18 to 24, those 25 and over, and individuals whose spouse is age 65 or over. Each category has different exceptions from the TOSI rules (which are incredibly complex, but a technical discussion is unfortunately beyond this article’s scope). However, it’s probably safe to assume that, in most cases, a payment made to a family member who is not actively involved in the business would result in the application of TOSI. Given the multiple exceptions available to different age categories, one could imagine driving on a “TOSI highway” and looking for an appropriate exit ramp/exception. These rules effectively apply as of Jan. 1, 2018.

Taxation of Passive Investment Income

The initial problem that the government set out to correct with the July 18 tax proposals was the ability of corporations to build up larger pools of investable assets as compared to individuals. This is possible because private corporations are subject to a lower tax rate compared to individuals: for example, the corporate tax rate on income eligible for the small business deduction is 15 per cent (2017), compared } to the individual top marginal tax rate of  53.53 per cent (in Ontario). Given this disparity  in tax rates, a private corporation would have  a larger investable base compared to an  individual earning the same pre-tax income. The government considered this result to be unfair and introduced several measures to deal with this perceived issue. One of these measures would have resulted in a combined corporate-personal flow-through rate of  73 per cent on certain types of investment income! The business community voiced numerous  concerns regarding these punitive tax measures and argued that a flight of capital from Canada could ensue as a result.

The revised TOPII rules were presented in the 2018 Federal Budget and are applicable for taxation years that begin after 2018. It would appear that the government heeded the public sentiment and abandoned the initial proposals. The TOPII rules outlined in the Budget do not directly result in an increased tax on investment income. Instead, the government introduced measures to limit access to the small business deduction (SBD) and, by extension, to the low rate of tax, for private corporations that earn more than $50,000 of passive investment income in a taxation year. The new rules introduce a mechanism that would reduce the available SBD of a corporation by $5 for every $1 of passive investment income earned by the corporation or any associated corporation, above the $50,000 threshold. In other words, if an Ontario corporation (or an associated corporation) earns $150,000 or more of passive investment income, then all of its active income will be taxed at 26.5 per cent.

Furthermore, the new rules will change the mechanism for obtaining a refund of the Refundable Dividend Tax on Hand (RDTOH). Under the new rules, the RDTOH will be refunded when the corporation pays ineligible dividends. An exception is available in cases when the RDTOH balance arises from receipt of portfolio dividends.

How will these changes affect investment holding companies? First of all, two pools of RDTOH—eligible and ineligible—will need to be tracked. The eligible RDTOH will track the refundable taxes arising from receipt of eligible portfolio dividends, and can be refunded by paying eligible dividends. The ineligible RDTOH will track the refundable taxes arising from all other investment income and can be refunded only by paying ineligible dividends.

Conclusion

While the new tax rules are a welcome change from the July 18 proposals, they’re still very complex. The TOSI rules will severely limit the opportunities to split income with family members. As a result, the utility of a family trust structure may need to be revisited. Moreover, the TOPII rules introduce an additional layer of complexity, which will likely increase the compliance burden on corporations and their shareholders.