The Canadian tax system is built on the concept of tax integration. Based on the view of principles of fairness and neutrality, tax integration aims to ensure that an individual is indifferent between earning income through a corporation or directly as the after tax results should be the same.
Currently corporate tax rates are lower than personal tax rates; however, when after tax profits earned in a corporation flow out to an individual the net result is comparable to the net result had the individual earned it directly. The difference occurs when a corporation’s after tax profits are saved inside the corporation as a passive investment to be flowed out to the individual at a later date.
A corporate owner has the advantage of investing a higher principal inside the corporation as the profits have not yet been subjected to personal tax rates. This higher principal results in a realization of returns that exceeds what an individual can achieve. If an individual had $100,000 of extra income to invest passively the after tax earnings to invest would be approximately $50,000. If a corporate owner had $100,000 of extra income to invest passively and held the investment inside their private corporation, the after tax earnings to invest would be approximately $85,000. If the corporate owner were to continue this investment strategy over a 30 year period, they could achieve higher returns than individual (we consider).
The government is considering options to remove this advantage by replacing the current refundable taxes on passive investment income with a non-refundable passive investment income tax rate equivalent to the top personal tax rate, changing how passive income is categorized and changing how passive income is taxed when distributed as dividends. The new system would consider how the income was taxed prior to investing in order to appropriately offset the tax advantage on which the returns were generated. The goal is to have the after tax distributions of the investment to be equal whether invested inside the corporation or personally. The proposed system includes combined taxes of over 70%.
Have a question? Contact Grant Gilmour. Your comments are always welcome!
Grant has been in the CA business since 1988, starting his own practice in 1994. His tax expertise encompasses tax planning, international tax issues, and Scientific Research and Development tax credits. He is a graduate of the CICA In-Depth Tax Course and in 2012, Grant received the CA Community Service Award and the Scout Leader Medal.
1 comment on “Passive Investment Income Proposed Tax Changes”
Thanks for this – very interesting.
The “advantage” to shareholders of Canadian Controlled Private Corporations arises because of the low corporate tax rate on active business income. Wouldn’t it be smarter to simply eliminate the low tax rate that CCPCs pay on active business income?
In any event, small business owners beware. Both the United States and Canada are becoming increasingly hostile to passive income earned inside corporations.
Assuming that the changes are made to the tax treatment of Canadian Controlled Private Corporations, there will be fewer reasons to incorporate at all. This will remove one headache for Canadian residents who have U.S. citizenship.
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