Believe it or not, it might have been. But the Budget released by Finance Minister Morneau on February 27th nevertheless levied a heavy blow to successful businesspeople across this country.
The Small Business Deduction: are its days numbered ?
The small business deduction (“s.b.d.”) sets the low rate of tax for active business profits earned by private corporations – in BC, that rate is currently 13% – admittedly, a very low rate.
Now, thanks to this Budget, it will drop even further: to 12%, and then 11% in 2019 (these rates factor in current BC tax, as well).
All that looks very good. But then: what can you do with the earnings retained inside the corporation ? The Government wants you to spend that money on things that will generate even more active business income. And if you do – no problem. But if you don’t want to do that, or if such a level of investment is not needed or appropriate in your circumstances, you have little choice but to accumulate the earnings, for long-term investment. Certainly, that’s nothing to be ashamed of, given the relatively poor opportunities for retirement savings that entrepreneurs have (RRSPs being the principal tool here). That’s a big contrast to the kinds of pensions that highly paid employees or Government employees – particularly cabinet ministers – get to enjoy.
And do not forget that the taxes levied to individuals on the eventual extraction of those accumulated profits has been increasing dramatically in the past few years – such extractions will generate taxes that the Government will rake in at a top rate of tax of either 49.8%, or 43.73% for ineligible dividends, 34.2% for eligible. That’s a big rake !
The new rules will also change the long-established method of dealing with corporate refundable tax (“RDTOH”), by making things much more complicated. In future, it will be necessary to specify whether dividends are intended to be paid out of “eligible RDTOH” or “ineligible RDTOH”. A new ordering rule will require companies to pay out ineligible dividends beforeeligible dividends. Since taxes are much higher on ineligible dividends, the Government wins again.
The plan has always been to structure extraction of funds at a pace that avoids, if possible, those high rates. And, to some extent, those opportunities will remain. However, recent developments in income tax disclosure, which includes the mandatory provision of asset holdings has provided the minions at the Department of Finance with a wonderful array of statistics as to the accumulating wealth of successful Canadians. And while the prospects of seeing these funds eventually pass out of these corporations encourages them, it seems they have grown impatient with the wait.
So, they have invented a new way to raise taxes on these funds in the meantime. The small business deduction for all private corporations will be eroded, starting for fiscal years that begin after December 31, 2018, by the income earned on the investment wealth inside the corporation, or by associated corporations (such as holding companies) under common control. No erosion of s.b.d. will occur until “adjusted aggregate investment income (aaii)” (a new term) exceeds $50,000 per year (recall some press recently that this presumes a 5% return on an investment portfolio of $1 million). Whatever – what counts is what investment income is actually realized. But once the $50,000 threshold is exceeded, the small business deduction shrinks at the rate of $5.00 for every dollar of investment income higher than that. So the s.b.d. completely disappears at passive income levels of $150,000, or more.
Obviously, the quantum of a corporation’s a.a.i.i. will be essential information. And it will, of course, add to the cost of calculating and filing tax returns.
Since no “grandfathering” has been offered (despite being promised by the Government in recent months), all those with investment portfolios that exceed, perhaps, $2 million or so at this time (again, the s.b.d. “grind” will be determined by actual, realized investment income) will no longer get the small business deduction.
The tax rate differential between the small business rate and the general business rate will be 15% in B.C. in 2018. This means a corporate tax increase of $75,000 per year to those successful corporations who are suddenly caught by this rule. Ouch !
Of course, there are also some traps in these rules, just to keep things interesting. One particularly sneaky trap is the inclusion of income from savings in a “non-exempt” life insurance policy in the definition of a.a.i.i. This type of information has, until now, seldom been needed by accountants in determining corporate taxes. No longer. Insurance companies and agents will have to be far more communicative and proactive than they have been in the past in order to assist in the preparation of annual corporate tax returns. Thankfully, most insurance policies sold these days are generally ‘exempt’.
Also, the passive income grind will be based on actual investment income realized and taxed in the year. So, if you have invested in various low-yielding assets, such as real estate or low-risk debt instruments, you may be able to keep your actual income fairly low, and perhaps under the limit. Investments in companies that do not pay dividends, but rely on capital growth, may become more desirable – or perhaps we will see more offerings of “dividend deferral” schemes in the investment market.
A useful exclusion from the “investment income” definition is for dividends received from connected corporations, which, thankfully, means that holding companies can still be put to their useful purpose of storing the money, in a place where it is hoped to be more or less safe from general business liability concerns.
Consider also what may happen in a year when you may have “re-balanced” your investment portfolio (perhaps on the suggestion of your investment advisor) and, just for one year, spiked up your investment income because of realized taxable capital gains ? Well, in the next year you could very well lose your s.b.d. If your money goes “quiet” in the next year, the s.b.d. could be reinstated, however.
And how will we manage the issue of “working capital”, and corporate savings for future business asset acquisitions ? Generally, until now, the Canada Revenue Agency has considered the interest earned on the deposit of monies kept for these purposes as active, not passive income. Since so much will hang on this determination in the future, suddenly a whole new level of uncertainty has crept into the management of taxes for corporations.
All of this, will, of course, play havoc with tax payment deadlines, as because those are directly affected by whether or not a corporation is entitled to the s.b.d. Prepare for a future in which unintended interest charges are levied by CRA at random times, and due to random events.
The whole process of Budget making has been under scrutiny for several months, since last summer’s rash and disturbing release of much more draconian measures. Thankfully, at least most of these have been scrapped. But a total lack of sympathy for the concerns of small business is strongly evident in the current Government’s proposals, its statements, and its proposed legislation.
Hidden away in the commentary were questions raised as to the need for the small business deduction, at all. So could this be the beginning of the end of the small business deduction ? Don’t count that out – there has to be something for future Budgets to tax !