The Liberal Government of Canada recently introduced new tax rules, which come into effect in 2019, for the taxation of investment income earned by Canadian controlled private corporations (CCPCs). If you are a Canadian business owner that invests through your company, then keep reading to learn more.
What is passive investment income?
Passive investment income includes dividends, interest, capital gains, and royalties. Canadian companies often invest their surplus cash in passive investments, such as real estate, stocks, bonds, and mutual funds, to earn a decent rate of return on their capital. The government of Canada has enacted new rules applicable to 2019 that impact the taxation of this income.
The Old Rules
Canadian controlled private corporations already pay a high rate of tax on investment income, i.e. 50%. Some types of investment income are taxed at a lower rate, such as capital gains, which have a tax rate of 25%. These tax rates have not changed. What has changed is the tax rate applied to corporate business profits generated from day-to-day operations by a CCPC, where the business profits are re-invested in passive investments.
The New Rules
To understand the new rules for Canadian corporate taxation of investment income, let’s look at an example. Pineapple Express Inc. is a CCPC, with a single owner, Sethy Rogan. Pineapple Express Inc. invested $1,000,000 of its savings into a passive investment making interest income of 9% or $90,000 for the 2019 year. In addition, Pineapple Express Inc. also made profits from its main business of $300,000 for the 2019 year.
The tax rate on the passive investment income is 50%, which is the same under the old and new rules. BUT, the tax rate on the business income made has gone up from 13.5% under the old rules, to 21.8% under the new rules. Why is this case?
The reason is the Liberal Government of Canada passed a tax law, effective 2019, that imposes a higher rate of tax on business income of a CCPC, where the corporation is earning more than $50,000 of passive investment income in the year. They are penalizing CCPCs for saving lots of cash and investing that cash in passive investments. Let me explain further.
CCPCs can claim the small business deduction on business profits of up to $500,000, which reduces the tax rate to 13.5% on those profits. However, for every dollar of passive investment income earned by a Canadian private corporation over $50,000, the small business deduction is reduced by $5. Once the passive investment income reaches $150,000, the small business deduction is reduced to $0.
Let’s apply these rules to Pineapple Express Inc. Pineapple Express Inc. earned $90,000 of passive investment income, which is $40,000 over the threshold of $50,000. As a result, the small business deduction limit will be reduced by $200,000. After the reduction the small business deduction limit becomes $100,000 from $300,000.
The business taxes of Pineapple Express Inc. are impacted as follows:
• The first $100,000 of business profit earned by Pineapple Express Inc. will be taxed at 13.5%, which is the same under the old and new rules.
• The next $200,000 of business profit earned by Pineapple Express Inc. will be taxed at 26% under the new rules, compared to 13.5% under the old rules
• When you add up the total taxes paid by Pineapple Express Inc on its business profits of $300,000, the tax rate comes to 21.8% under the new rules compared to 13.5% under the old rules.
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