The Impact of New Passive Income Rules for Canadian Private Corporations

The new passive income measures for Canadian Controlled Private Corporations eliminate five dollars of the small business limit for each dollar of passive income over $50,000 earned by a corporation or its connected corporations. The reduction to the small business limit will occur on a straight line basis as passive income increases, to a maximum passive income level of $150,000 at which point the small business limit will be gone ($5 * $100,000 = $500,000). These measures apply to years that begin after 2018.

Within the small business limit, qualifying active business income will be taxed at a rate of 9% in 2019. This is compared to the higher 15% federal tax rate on general business income. Provincially in Ontario, the small business tax rate on active business income is 3.5%, compared to 11.5% on general business income; the difference is meaningful at both the federal and provincial levels.

Passive income for the purpose of grinding down the small business limit is defined with a new concept called Adjusted Aggregate Investment Income (AAII). This is a modification of Aggregate Investment Income which has been around for a while.

Aggregate Investment Income (the old concept) includes the following:

Taxable capital gains net of current year losses and losses carried back or forward from previous years.
Total income from Canadian and foreign property excluding non-connected Canadian dividends.
Income that is incidental to active business, such as interest on an operational bank account, is excluded.

The adjustments to arrive at AAII are as follows:

Taxable capital gains are excluded if they are the result of
- a disposition of property used to carry on active business in Canada by the corporation or a related corporation, (think selling a piece of equipment used in the business), or
- a disposition of shares of a connected corporation that primarily uses its assets to carry on active business in Canada.
Net capital loss carry over from other years is excluded. This is an important change – losses from other years cannot be used to offset current-year capital gains for the calculation of passive income.
Dividends from non-connected corporations will be added – again, this is a substantial difference resulting in dividends from Canadian stocks in a corporate investment account being included in the calculation.
Income from a non-exempt insurance policy is added to the extent that it is not otherwise included in Aggregate Investment Income. A Whole Life insurance policy that has been properly structured as an exempt policy remains a viable way to shelter investment income, keeping in mind the additional costs and restrictions.

Let’s look at the implications of these changes in the context of holding a diversified portfolio in a corporate investment account.

A $3m globally diversified portfolio consisting of 40% bonds, and 20% each Canadian, US, and International stocks might have an expected long-term return of 4.84% broken down as follows:

INCOME CHARACTERISTIC	EXPECTED RETURN	ADJUSTED AGGREGATE INVESTMENT INCOME
Interest & foreign dividends	1.70%	51,000
Canadian dividends	0.48%	14,400
Realized capital gains	1.33%	19,950
Unrealized capital gains	1.33%	0
Total	4.84%	85,350

Based on these assumptions, AAII exceeds the passive income limit by $35,350. With $35,350 of income over the limit, there will be a $176,750 of reduction to the small business limit. If we assume that this corporation already has $500,000 of active business income, then each dollar of passive income will result in tax on five dollars of active business income at the general corporate rate as opposed to the small business rate. In Ontario, the combined 2019 federal and provincial small business rate is expected to be 12.5%, and the combined general rate is 26.5%. In this case, passive income above the $50,000 exemption results in additional taxes owing on active business income of $24,745.

The chart below shows the decreasing small business limit and increasing taxes owing on $500,000 of active business income against AAII in Ontario.

We can see from the chart that at $150,000 of AAII, the small business limit is $0, and additional taxes owing on the first $500,000 of active business relative to the old rules is $70,000 in Ontario.

What we have not yet considered is that active business income retained in the corporation and taxed at the higher general corporate tax rate will be added to the General Rate Income Pool (GRIP). The GRIP can be paid out to a shareholder as an eligible dividend, taxed at a lower rate than an ineligible dividend. We have also assumed that the entity takes no action to reduce active business income, when in reality salaries might be adjusted to reduce the corporation’s taxable profit. I will go into more detail on these topics in another post.

Benjamin Felix
Portfolio Manager, Head of Research, MBA, CFA, CFP, CIM

Benjamin Felix is the Head of Research at PWL Capital, a Canadian wealth management firm known for its publicly available thought leadership. PWL creates resources for Canadian investors including white papers, model portfolios, and research content. Benjamin co-hosts a podcast, the Rational Reminder, and is the host of a YouTube channel which together reach hundreds of thousands of people in Canada and around the world. Benjamin joined PWL Capital in 2013 after completing a degree in mechanical engineering and an MBA in financial management. He is a CFA charterholder and a CFP professional.

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