Budget 2018: Sensible Measures

From a tax perspective, the headline news is that Budget 2018 completes the Government of Canada's general retreat from the astounding - and, to many in the tax community, largely incoherent - July Proposals to address passive investment income in private corporations.

The revised measures introduced on December 13, 2017, dealing with the expansion of the tax on split income rules, while clearer and more measured, were not without flaws. Some feared that Budget 2018 may reintroduce the rules addressing surplus stripping, which were taken off the table in mid-October. Those fears were unfounded.

Budget 2018 completes the retreat: the proposed rules governing passive investment income earned in private corporations do not bear any resemblance to the measures contained in the July Proposals. The Minister of Finance and his team should be commended for recognizing the serious problems with the July Proposals, and for addressing them effectively.

The remaining tax measures in Budget 2018 are, for the most part, either modest fixes of anti-avoidance rules in several areas, including international taxation, financial instruments and financial markets and charities, or a reworking of social measures to make them more generous and accessible.

On the expenditure side, Budget 2018 presents a broad vision of gender equality, innovation and reconciliation, with a full panoply of programs and expenditures to address these themes.

One senses an election.

PASSIVE INVESTMENTS EARNED IN PRIVATE CORPORATIONS

Corporate income tax rates are significantly lower than the highest marginal income tax rate for individuals. This differential has been justified on the basis that the retained surplus is available to the corporation for reinvestment in the business or as safeguard against risks to the business. The differential further ensures Canada's corporate tax rate remains competitive with tax rates in other countries with which Canada competes for capital. The relatively low general corporate rate ("GCR") and the even lower small business rate ("SBR") have fostered Canada's reputation of welcoming productive business investment.

The July Proposals

The passive investment proposals in the July 18, 2017 Consultation Paper (the "July Proposals" and "July Consultation Paper") sought to address a perceived flaw in Canada's corporate tax rules by providing for a substantial reformulation of the rules governing passive investment income earned in a private corporation. From the perspective of the July Consultation Paper, the flaw - the "deferral advantage" - arises from the fact that an individual who incorporates a business will, after the payment of corporate level taxes at either the GCR or SBR, have more capital to invest pending the ultimate distribution of the corporate surplus by a dividend to the shareholder, as compared to an individual taxpayer who earned the same original amount and paid personal income tax in the year earned.

The July Consultation Paper suggested that the increase in the levels of income being earned in private corporations in recent years results from individual taxpayers incorporating their businesses so as to reduce current taxation on business income to the SBR or to the GCR. It was suggested that taxpayers were using their corporations to accumulate wealth or to "save". The July Proposals viewed the amount of the deferral advantage as equal to the passive income earned on this "incremental capital". Therefore, if all of that income from incremental capital were subject to a 100 per cent tax, half paid by the corporation in the year the passive income is earned and the other half paid on distribution, the deferral advantage would be eliminated.

A New Approach

Budget 2018 considerably scales back the policy objectives of the new rules governing passive investments earned in a private corporation. In fact, the new rules bear little resemblance to the July Proposals. Instead, two new passive investment rules relating to private corporations are proposed.

The first rule reduces eligibility for the small business deduction by a calculation based on corporation's investment income for a particular taxation year. The purpose of this rule is to reduce the funds in the corporation available for investment by subjecting the affected active business income to the GCR, rather than the SBR. The second rule seeks to deny the refund of Refundable Dividend Tax on Hand ("RDTOH") on the payment of eligible dividends that are paid from corporate income taxed at the GCR. Stated otherwise, for investment income to come out of a corporation in an integrated manner, the dividend must be a non-eligible dividend.

Business Limit

The first rule reduces the small business deduction by reducing the business limit for a corporation earning active business income pursuant to a formula which tracks the investment income of the corporation. For the purposes of this formula, investment income is defined as "aggregate investment income" with a number of adjustments. The intention is to eliminate the small business deduction in situations where the corporation is earning excess investment income, as determined by the formula. To the extent the corporation's income becomes subject to the GCR, a component of the deferral advantage is removed.

The reduction of the business limit is effected as follows. The corporation would calculate its adjusted aggregate investment income ("AAII") by adjusting its aggregate investment income as follows:

Capital gains and capital losses realized on the disposition of "active assets" are not included in the calculation. For this purpose, "active assets" includes property that is: used principally in an active business carried on primarily in Canada by the corporation or by a corporation related to it; and shares of the capital stock of another corporation where the other corporation is connected to it and the shares would be qualifying small business corporation shares were they owned by an individual; Net capital losses from previous years are not included; Dividends from a corporation that is not connected to the corporation are included in the calculation; and Income earned in the savings portion of a non-exempt life insurance policy is included. The corporation would reduce its business limit by five times the amount that its AAII exceeds $50,000. Thus, if the AAII is $50,000, there is no reduction of the business limit. However, if the AAII is $100,000, the reduction to the business limit is $250,000. And if the AAII is $150,000, the reduction to the business limit is $500,000, and no small business deduction would remain available.

Under these rules, the total amount of investment income will adjust the SBR and there is no grandfathering of assets held by a corporation prior to Budget Day. Anti-avoidance rules will be put in place to deem corporations to be associated with each other for purposes of the ITA, if they enter into arrangements to avoid the application of these rules.

RDTOH Refund Only on Payment of Non-eligible Dividend

The second rule targets another component of the deferral advantage. Under the current rules, a corporation earning both active business income taxed at the GCR and investment income can pay an eligible (or a non-eligible) dividend using funds sourced from the investment income and be entitled to a refund of the associated RDTOH. The eligibility for the refund of the RDTOH is not tied to whether the dividend is an eligible or ineligible dividend. The proposed new rules would remedy this by denying the refund of the RDTOH, where the dividend is an eligible dividend.

This will be achieved as follows:

There will be 2 RDTOH accounts: one account, the new account ("eligible RDTOH") will track Part IV tax paid on eligible dividends; The other, current RDTOH account ("non-eligible RDTOH") will track refundable taxes paid on non-eligible dividends and on investment income. Any dividend paid from the eligible RDTOH account, subject to an ordering rule, will entitle the corporation to a refund; The corporation will be entitled to a refund in the non-eligible RDTOH account on the payment of non-eligible dividends only; Dividends paid to a connected corporation that give rise to an RDTOH refund in the payor corporation will go into the correct RDTOH account of the payee, depending on the source of the dividend to the payor; and Where a corporation pays a non-eligible dividend, it will be required to take a refund from its non-eligible RDTOH account in priority to its eligible RDTOH account. These rules apply for taxation years that begin after 2018. On a transitional basis, existing RDTOH accounts will be divided into eligible and non-eligible accounts. For a CCPC, the lesser of its existing RDTOH account and 38 1/3 per cent of its general rate income account will be allocated to its eligible RDTOH account. For other private corporations, all of its existing RDTOH will be allocated to its eligible RDTOH account.

Anti-avoidance rules will be put in place to restrict companies from deferring the application of these new rules through the creation of a shortened taxation year.

REPORTING REQUIREMENTS FOR TRUSTS

The Government of Canada has proposed to amend the rules applicable to income tax reporting for certain trusts, with the stated purpose of reducing aggressive tax avoidance, tax evasion, money laundering and other criminal activities perpetrated through the misuses of certain vehicles.

Budget 2018 will require that certain trusts file a return of income (a T3 return), where such a requirement does not currently exist and to report new information. A trust that does not earn income or make distributions in a year is generally not required to file a T3 return. A trust is required to file a T3 return if the trust has tax payable or it distributes all or part of its...