Private Corporations: Understanding the Proposed Tax Changes on Passive Investments

November 15, 2017 Angela Campbell

Blog image

When it comes to the federal government’s proposed tax changes, the one on passive investments is promising to be the most complex.

On July 18, the government introduced a proposed new framework for the taxation of passive income held inside private corporations. The outcome of it, if enacted, would effectively be a significant increase in the passive tax rate. At that time, no legislation was introduced; instead, the community at large was asked to provide feedback.

On October 18, the government announced that it would be pursuing a new framework that includes an annual passive income threshold of $50,000 before any proposed tax changes would take effect. There remains, however, a great deal of uncertainty about how these proposed tax changes would be administered or their effective date.

Here are things we know, and things we don’t know.  

Why does the federal government want to make tax changes on passive investments?

The government is concerned with the number of private corporations that are using their surplus earnings to passively invest in their corporations versus distributing the profits to shareholders (where your personal tax would be paid under current tax rules) or are reinvesting the profits in their businesses to grow their business ventures.

Here’s a simple example. Conceptually, an incorporated physician pays income tax at the small business tax rate of approximately 15%, whereas a physician who has not incorporated his or her practice can pay personal income tax at rates of 50% or more annually. It is this difference in tax rates that creates a deferral of about 35% in tax on the medical practice income. Because this 35% in tax doesn’t need to be paid until a future date, the money is left in the corporation and, when invested, can compound on a tax-deferred basis.

The government believes this tax deferral benefit puts owners of private corporations at a significant advantage compared with employees and self-employed individuals who are fully taxed on income when it is earned.

What is the government proposing to change about passive investments?

When the government first announced the proposed tax changes in July, it wanted to change the way passive income earned on investments in a private corporation would be taxed: effectively, the proposed changes would eliminate the tax deferral advantage.

The government’s mid-October announcement of a new annual passive income threshold of $50,000 for passive investments held in private corporations, however, suggests that private corporations will be allowed to maintain passive investments of about $1 million before being subjected to any new tax rules. (The announcement assumed a 5% return on investment, hence the $50,000 threshold in annual passive income.)

 

When are the proposed changes on passive investments expected to take effect?

Unlike for the income sprinkling proposal, which included reference to an effective date of January 1, 2018, the government did not address precise timing for the passive investment proposal. There was a suggestion, though, that it would appear in the 2018 federal budget, which can be expected in the spring.

What is the government proposing to change about passive investments?

In the October 18 announcement, the government recommitted to “grandfathering” existing passive investments. This means that passive investments currently held in private corporations, and future income streams from these assets, will be protected and that any new tax measures will apply only on a “go-forward” basis.

However, the government did not clarify the effective date for these proposed changes, so it is still not clear what date will be used for a “go-forward” basis.

Until the draft legislation is released, there remains significant uncertainty as to how these proposed measures will apply. You should remain cautious about undertaking any drastic changes in your corporation (i.e., winding it up or selling all passive investments) as you could accelerate the payment of tax or reduce your pool of capital available to be grandfathered.

What will the financial impact be if the tax deferral advantage is restricted?

At this time, it is difficult to provide any certainty as to the financial impact. It will likely vary for incorporated physicians, depending on their career stage. There is no draft legislation to work with and the government has commented on these proposed changes only in general terms.

  • Newly incorporated physicians may still have the opportunity to build a level of passive investments before any proposed changes would take effect.

  • Incorporated physicians who have already accumulated considerable passive investments should be protected on their current assets with the expected grandfathering rules—subject to the go-forward date, when established. Their future passive investment assets may be impacted if they exceed the proposed new passive income threshold.

  • Incorporated physicians who have retired or are close to retirement should be impacted the least due to the proposed grandfathering. 

 

Is there anything physicians could or should be doing now?

For now, most physicians can continue with their current corporate investment strategies.

The federal government has not commented on an effective date for these proposed changes. Thanks to the proposed grandfathering and $50,000 passive income threshold, the consequences of any changes to tax legislation may now be less immediate, allowing time for tax planning. 

That said, if the proposed legislation becomes effective, the framework outlined in the July 18 announcement from the Department of Finance suggests that the outcome would be a tax rate on capital gains of around 60%; on interest income, it could be more than 70%.

You may want to learn more about other options for savings and estate planning now because they may become attractive strategies for investing your corporate cash in the future. The two main ones are individual pension plans and whole life or universal life insurance plans. Getting familiar with these now could make it easier for you to implement them in the future, if necessary.  

As MD Financial Management continues to monitor the situation, we encourage you to remain in touch with your MD Advisor and tax advisor, who can help you understand the potential consequences of these changes on your financial plan. 

 

 

About the Author

Angela Campbell

Angela Campbell, CPA, CA, is Assistant Vice President with the Taxation Services Team at MD Financial Management. She and her team of tax professionals provide tax solutions, tax planning and tax compliance for the MD Group of Companies.

More Content by Angela Campbell
Previous Article
Samsung: It’s About Big Profits, Not Big News
Samsung: It’s About Big Profits, Not Big News

Samsung produces more smartphones than any other company, including one model last year that spontaneously ...

Next Article
Getting paid for patience (not patients)
Getting paid for patience (not patients)

Private asset classes make patience attractive for investors who can put a portion of their money in illiqu...

×

Subscribe to our Newsletter

Thank you!
Error - something went wrong!