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The federal budget tabled on February 28, 2018 finalizes the tax reform concerning small and medium-sized businesses initially unveiled by Finance Minister Bill Morneau on July 18, 2017. Of all the measures included in the budget, these changes are, for most professionals, the ones that were most eagerly awaited. They specifically affect investments held in a corporation as well as a corporation’s RDTOH account, on which the minister gave himself time to reflect.

In the following pages, we’ll present the key fiscal measures affecting incorporated professionals and a brief history of the reform initiated by Minister Morneau.

Incorporated professionals

Taxation of passive income earned by a Canadian controlled private corporation

The 2018 federal budget proposes to change the tax payable by corporations that hold substantial investments. This measure will apply to the taxation years beginning after 2018, which will give incorporated professionals time to adjust their investment strategies before the changes come into effect.

Business limit
Before 2018  After 2018
The business limit is generally $500,000 for private corporations held by professionals.

All business income earned below this threshold is taxed at a reduced tax rate; for example, in Quebec for the year 2018, a corporation generally has a tax rate of 18% for the first $500,000 of business income, provided the corporation has employees working more than 5,500 hours per year

The same corporation will pay a tax of 26.7% on income above the business limit of $500,000.

For the taxation years beginning after 2018, the business limit will be gradually reduced when the investment income of the corporation (and its associated corporations) exceeds $50,000.

The business limit will be reduced by $5 for every dollar of investment income that exceeds the $50,000 threshold.

The business limit will therefore be completely eliminated when the investment income reaches $150,000 (($150,000 – $50,000) x $5 = $500,000).

Note that certain investment income will not be subject to these new rules; for example, when a professional wants to sell the assets of their practice, the profits resulting from this sale will be exempt from these rules.

 

An example to illustrate
  • Alexandra is an incorporated professional earning income from her practice of $400,000 per year, after business expenses.
  • Alexandra also has a substantial investment portfolio totaling $2 million in her corporation; the income generated by the investments comes to $100,000 per year.
  • For the taxation year 2018: Alexandra’s corporation will pay a tax of 18% on the business income of $400,000, i.e. $72,000.
  • Assuming a similar situation in 2019: Alexandra’s business limit will be reduced to $250,000 since the investment income exceeds the $50,000 limit ($500,000 – (($100,000 – $50,000) x $5) = $250,000).
  • Considering the tax rates that will be in effect in 2019, the tax that Alexandra will have to pay on her business income of $400,000 will rise to $82,400, representing an increase of $10,400. The investment income earned in the portfolio will therefore have a decisive impact on the calculation of the tax payable on the business income.
  • In addition, a professional who has high investment income in retirement and who no longer earns business income will not be affected by these measures.

COMPARATIVE CALCULATION OF THE PAYABLE TAXES ON  INVESTMENT INCOME

2018 2019
Business income (ABI) $400,000 $400,000
Investment income $100,000 $100,000
Business limit $500,000 $250,000
Business income qualifying for the low tax rate for small businesses (SBD) $400,000 $250,000
Taxes payable on business income (ABI) $72,000   $82,400 

Know that Professionals’ Financial will adjust the investment strategy of its clients so as to optimize their tax situation, if appropriate, under the new rules for the taxation years beginning after 2018.


The refundable dividend tax on hand (RDTOH) account

The government also reviewed the rules governing the refund of the refundable dividend tax on hand (RDTOH). The budget proposes to create an additional RDTOH account for eligible dividends received by the corporation from a public company.

This new account – called the eligible RDTOH account – is separate from the usual RDTOH account, now called the non-eligible RDTOH account. Payments of eligible dividends by a professional’s corporation, which are taxed at a lower rate than non-eligible dividends, will allow for a RDTOH refund only if there is a balance available in the eligible RDTOH account. To obtain a refund of the remaining RDTOH, non-eligible (regular) dividends will have to be paid.

As a professional, how should you react to these new announcements?
The rules governing incorporation have changed and it is important for each incorporated professional to review their situation with a specialist. In light of the measures proposed since July 2017, many strategies could be reassessed. The compensation of incorporated professionals, as well as the composition of their corporation’s investment portfolio, should be reviewed to align with the latest changes.

If you are not incorporated but are considering incorporating shortly, it is essential to analyze your situation with a specialist to ensure that the benefits of incorporation still justify setting up a corporation.

For an overview of the tax reform measures, read our summary leaflet.

In all cases, don’t hesitate to call upon the expertise of a Professionals’ Financial advisor to help you find the best solutions for your corporation. We’re here to guide you and assist you with all your decisions.

Benoit Chaurette, M. Fisc., F. Pl.
Tax Specialist and Financial Planner

 

The information contained herein has been obtained from sources deemed reliable, but we do not guarantee the accuracy of this information, and it may be incomplete. The opinions expressed are based upon our analysis and interpretation of this information and are not to be construed as a recommendation. The tax strategies mentioned in this article may not apply in all cases. Please consult your Advisor.

History

To put the latest budget developments into perspective, here is an overview of the chronology of events and their repercussions on incorporated professionals since the first announcement of tax reform measures affecting private corporations.

July 18, 2017 – Overhaul of the taxation of small and medium-sized businesses (SMBs)

In July 2017, federal Finance Minister Bill Morneau announced several measures affecting the taxation of small and medium-sized businesses. Other measures were still pending as a 45-day consultation period was launched to get public feedback. The government wanted to reform the taxation of SMBs by targeting three concepts:

  1. Income sprinkling and the multiplication of the capital gains exemption.
  2. Taxation of passive income earned by a Canadian controlled private corporation.
  3. Conversion of income to capital gains.
Week of October 16, 2017 – Review of the rules announced in July

During the week of October 16, 2017, the government backtracked on several principles announced on July 18, 2017.

1 – The government indicated that it would not move forward with measures restricting access to the capital gains exemption. Initially, the federal government wanted to abolish, in several situations, the multiplication of the capital gains exemption with family members when a business is sold.

2 – The government chose not to move forward with certain measures that would prevent the conversion of income to capital gains; for example, following the death of the shareholder of a private corporation, it is possible to wind up the corporation so that the deceased will be taxed on a capital gain and not on a taxable dividend. Other strategies could also have been targeted in the event of an amendment to the law.

December 13, 2017 – Income sprinkling

On December 13, 2017, the federal government remodeled the principles governing the payment of a dividend to a family member. The measures announced last December have been in effect since January 1, 2018.

Generally, a dividend paid to a family member from a professional’s private corporation will be taxed at the maximum tax rate. This rule – tax on split income – already existed for dividends received by a minor child. From now on, the tax on split income can apply to family members who are of adult age. However, the government has provided a number of exceptions to accommodate certain entrepreneurs and incorporated professionals.

Here are the main exceptions where a family member can receive a dividend without being subject to the tax on split income, and therefore pay tax according to graduated tax rates.

  • Family members 25 years of age or older, when the dividend paid to them is reasonable, considering the tasks performed.
  • Family members 18 years of age or older, who work at least 20 hours per week throughout the year.
  • Family members 18 years of age or older, who have worked at least 20 hours per week for at least 5 years, whether or not these years are consecutive.
  • The spouse of an incorporated professional 65 years of age or older, regardless of the tasks that were performed by the spouse.
  • Family members holding at least 10% of the voting and participating shares of a corporation that derives less than 90% of its income from the provision of services and which is not a professional corporation.
  • Family members who have received shares as an inheritance from a professional who was not subject to the tax on split income.

Considering the many changes announced during the past year, we invite all incorporated professionals to contact an advisor from the Financial to review the strategies of their corporation and to effectively protect their wealth and that of their family.

 

The information contained herein has been obtained from sources deemed reliable, but we do not guarantee the accuracy of this information, and it may be incomplete. The opinions expressed are based upon our analysis and interpretation of this information and are not to be construed as a recommendation. The tax strategies mentioned in this article may not apply in all cases. Please consult your Advisor.

For an analysis of your situation,
get in touch with one of our advisors