Since summer 2017, much has been written about the Morneau reform, especially because of the many tax changes that incorporated professionals are faced with.
Among the measures that provoked the strongest reactions are the changes related to the tax on split income. Other major changes related namely to passive income earned by a Canadian-controlled private corporation (CCPC) came into effect on January 1, 2019 for corporations whose fiscal year-end is December 31.
Repercussions of the new rule
A corporation is normally taxed at lower rates on the first $500,000 of net professional income. For the fiscal year beginning January 1, 2019 and the years following, the business limit will be gradually reduced when the investment income of the corporation (and of its associated corporations) exceeds $50,000. According to the circumstances, the corporation’s tax rate could therefore increase.
The reduction of the business limit will be $5 for each dollar of investment income above $50,000. This limit will therefore be completely eliminated when the investment income reaches $150,000 (($150,000 – $50,000) X $5 = $500,000).
Which type of income will be included in a corporation’s total adjusted investment income?
- Interest income
- Dividend income
- The taxable portion of capital gains
- Net rental income
What can you deduct from this total adjusted investment income?
- Investment expenses
- Net capital losses of other years
- Gains from property used in the business
Know that certain investment income will not be treated according to the new rules. This is the case for gains arising from the sale of the assets of a practice, when the professional decides to sell these assets.
 The business limit is the amount of income eligible for the SBD.
An example to illustrate the rule
Two incorporated professionals each have annual professional income of $400,000 and a fiscal year ending December 31.
- The first professional has annual investment income of $30,000 and the second, $150,000. Since each of their corporations has fewer than 5,000 hours worked by its employees, neither is entitled to the Québec SBD.
|Professionnal 1||Professionnal 2|
|Business income (ABI)||$400,000||$400,000|
|Tax payable on the business income (ABI)||$82,400||$106,400|
For an incorporated professional without employees, this new measure therefore represents an additional 6% tax on the income that was eligible for the SBD, according to the tax rates in effect in 2019.
- In the case where the $500,000 business limit is completely lost, the increase in the tax charge could therefore reach $30,000 ($500,000 X 6%) per year.
- For a professional eligible for the SBD at both levels of government (his or her employees work more than 5,500 hours per year), the additional tax could reach $58,000 ($500,000 X11.6%) per year.
Strategies to consider
If a professional has investment income of between $50,000 and $150,000, it is possible to review his or her investment portfolio or compensation in order to reduce the impact of the new measures.
- An investment portfolio focused on growth which generates capital gains rather than interest income would be advisable.
- Another strategy could be to realize losses in order to reduce the investment income for the year.
- As for compensation, paying a salary rather than a dividend could prove beneficial, since a salary is an expense that is deductible from business income.
The integration principle
Despite these strategies, an additional tax charge may be inevitable for certain incorporated professionals. The situation is then less advantageous from an incorporation standpoint since the corporation has a tax deferral on a smaller amount. It is not dramatic, however, because of the integration principle, which stipulates that a company must pay as much tax as an individual, once the tax on business income and the tax on dividends from the distribution of income have been paid.
To respect this balance, a corporation that has a higher tax rate on non-SBD-eligible income can pay eligible dividends, which will be taxed at a lower rate than regular dividends.
Is incorporation still beneficial?
Considering this additional tax charge, is incorporation still a beneficial option for a young professional?
Here is an example:
- A 28-year-old professional in early practice, with no debts and no savings.
- His annual professional income is currently $400,000, indexed at 2% each year.
- He intends to retire at age 65.
- His yearly cost of living is $75,000, also indexed at 2% annually.
- For his investment income, we will assume a rate of return of 4%.
In this example, it would be to the young professional’s advantage to incorporate, despite the new rules on passive income.
- At age 65, his wealth net of tax will be approximately $12.7 million, versus $12 million without incorporation, i.e. a not insignificant difference of approximately $700,000.
- At age 85, this difference would come to $2.7 million.
Despite their complexity, the tax measures affecting private corporations will not have a negative impact on all incorporated professionals. To obtain a total adjusted investment income of more than $50,000, you will have to have a substantial investment portfolio.
- Young incorporated professionals whose investment portfolio has not reached that size will not be affected by this measure.
- When the $50,000 level is reached, there may be no financial impact, if the professional’s net income is below $500,000.
- A retired professional who no longer earns income from his or her business and who has high investment income would not be affected by these measures.
In all cases, discuss your situation with a tax specialist, who can analyze your situation and recommend the most effective solutions to give you peace of mind. At the Financial, your wealth management advisor works with a team of tax specialists who are accessible and who know the financial issues of your profession. Feel free to ask him all your questions.
Benoit Chaurette, M.Fisc., F. Pl.
Manager, Professional Practice