Federal budget’s simpler plan to tax passive income likely to calm small business outcry

OTTAWA — The small business tax revolt that rocked Canadian politics for much of last year has resulted in a simpler and scaled-back proposal for taxing passive investment , and it appears likely to calm the concerns from tax experts.

Budget 2018 unveils an entirely new approach that will bring in less money for the federal government, but relieve businesses of the accounting requirements that the would have imposed.

In short, the new rules mean that once a builds up a multi-million dollar war chest of passive investment assets, its business income will no qualify for the federal small business tax rate (which is being lowered to 9 per cent), and instead be taxed at the regular corporate tax rate (which is 15 per cent).

The new rules would kick in for tax years starting after 2018.

But the simplicity comes at a cost in federal revenues. The Parliamentary Budget Officer had estimated the original proposal would at first bring in around $1 billion for the treasury, rising over a decade to as much as $6 billion annually (though that came with the huge caveat that assumed no behaviour change).

The budget estimates this new proposal would raise $305 million in 2019/20, rising to $705 million in 2022/23.

“I think it’s a big improvement,” said Bruce Ball, vice president for taxation with the Chartered Professional Accountants of . “It’s better directed at the root issues.”

The Canadian Federation of Independent Business was more cautious, saying it welcomed the new approach but the impact on passive assets, which would no longer be grandfathered in under rules.

“The new rules appear to be simpler and may improve things for some business owners from , but others will lose the benefit of the lower small business rate due to past investments,” said the federation’s Dan Kelly.

Don Carson, a tax partner with MNP, said the initial proposal “would have created an incredibly complex system.”

He said Budget 2018’s proposal is much easier to understand and does a better job of ensuring tax integration — the principle that income is taxed fairly regardless of whether funds are kept inside or outside a private corporation.

“Most of the negative have been removed,” he said. “The concept of integration generally is being maintained through these modified proposals, whereas the earlier proposals would have represented a departure away from a system that had been in place for 45 years.”

Passive income results from corporate investments made in areas other than active business operations. The government says it wants to prevent the wealthy from gaming the tax system by exploiting the small business tax rate to start an investment portfolio, but its first proposal generated massive backlash over its complexity and unintended consequences.

The Canadian Federation of Independent Business was more cautious, saying it welcomed the new approach but was worried about the impact on existing passive assets.

Under that initial proposal released last July, the withdrawal of passive income from a private corporation would trigger an array of tax manoeuvres meant to eliminate the initial tax advantage from years earlier.

The new proposal comes at the problem from a different direction. Under these rules, the amount of business income that qualifies for the small business tax rate would be reduced depending on how much annual passive income is declared above $50,000 — and eliminated completely once passive income rises above $150,000. The thresholds are not indexed to inflation.

Furthermore, capital gains realized from the sale of active investments would not be counted under the threshold, a measure meant to protect venture capital investors — particularly in the technology and innovation sector.

The original proposals had come under attack not only for their increased tax burden, but also their enormous complexity. Because existing assets would be grandfathered in under the old rules, it meant business owners would have to meticulously track different streams of passive income each tax year. The new rules simply look at the total amount of passive income being declared and adjust the small business tax rate accordingly.

“During the period of consultation, the government heard that its proposals could be very complex and add significant burdens on businesses,” says the 2018 budget document.

“The new approach will be much simpler to comply with, will not require the tracking of new and legacy pools of passive investments, and will target only private with more than $50,000 in passive investment income per year.”

Assuming a five per cent return, $50,000 in passive income would require $1 million in investment assets. The $150,000 upper threshold would require $3 million in assets. The government estimates about 50,000 private corporations — or less than 3 per cent of the total — will be affected.

Including the government’s earlier proposal to crack down on income sprinkling, the budget estimates the tax changes on private corporations will bring in $925 million annually by 2022-23.

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