Canadian business owners are facing recent tax changes that may have a significant impact on them: restrictions on income splitting, and the small business deduction grind in relation to passive investment income. These changes mean that income distributed by Canadian businesses, and investments made by them, could be taxed at a higher effective rate. Despite the complexity of the new provisions and the confusion caused by them, a little preparation now can go a long way towards mitigating the financial headwinds.
A team of our practitioners has considered each measure for its potential impact and has come up with some practical steps you can take to get your business prepared.
Income splitting has been limited, but can still be effective for many
Income splitting is a tool that has been used frequently by small and medium-sized business owners to lessen the financial risks associated with running the business and to generate savings that can be used for expansion and innovation. Despite the new restrictions on the practice, income-splitting might still be available and advantageous for your business.
The key question is whether your income distribution framework fits within the available exceptions to the new restrictions. How family members participate in the business – whether through ownership, employment or assumption of risk – is important.
If a person directly owns at least 10% of the voting shares in the business, for instance, income splitting may still be available, so business owners may want to review their corporate structure by year-end to assess how such shares could be distributed. Other contributions may also qualify for exempted status – perhaps the family member meets the threshold for substantial employment within the business or has taken on certain financial risks – so it may be beneficial to also review these elements of your operations. In all of these cases, it is important to have the proper supporting documentation that shows how the family member is actively involved in the business, has assumed the relevant risks, etc.
There are a few special circumstances to keep in mind. For example, recipients of a dividend must be over the age of 25 to qualify for some of the exemptions noted above, so if a person under that age works to only a limited degree in the business it may be best to pay them a reasonable salary as opposed to a dividend. On the other hand, if you are approaching the age of 65, it could be more strategic in certain circumstances to defer payments to a spouse for a year or two, as there are more income splitting opportunities available at this age.
Some of the rules are more restrictive to service corporations and professional corporations, which means that it’s essential to understand how your business will be classified under the new rules. Defining what a service corporation is can be a complex – and occasionally subjective – process for any business that bills for services or labour, and your qualified tax advisor can help provide clarity here. At a minimum, business owners should review their invoicing practices and consider if they should be unbundled, to clearly separate materials from labour.
Family trusts will also be subject to the new requirements on income-splitting, and understandably some trustees will be concerned. It is essential to look at the complete picture, however, because family trusts can provide other advantages beyond income splitting, and their overall impact may therefore still be positive. Trustees should avoid making any hasty decisions solely on the basis of the new tax legislation, and instead take the time to closely review the full scope of the trust, including any future benefits it may provide.
Passive income cap may affect investment strategies
Income earned from investments outside of the immediate business (or passive income) has been an important means of mitigating the risk of sudden downturns or cyclical pressures for many Canadian businesses. The most significant change to the rules on passive income is the implementation of $50,000 yearly cap, after which every investment dollar earned leads to a loss of five dollars in the small business deduction. After $150,000 in passive income, this deduction is no longer available.
When planning your company’s investment strategy, it is essential to remember the calculation of passive income is based on the previous year. Because of this, small business owners should monitor their investment income and their capital gains today in preparation for 2019 and beyond. How can business owners prepare? It may be possible to control the timing of capital gains, especially if your investments have performed better than expected. In other cases, it might be possible to offset the capital gains with losses taken in the same year.
Another key factor is the nature of the passive income – specifically, how capital is invested and what types of returns it produces. It makes a difference for the purposes of calculating your income for the new $50,000 cap whether your investments yield dividends or capital gains and whether the capital gains have been realized. Other types of assets, such as tax-exempt life insurance policies, may also be considered more closely as investment alternatives since they do not provide passive income that would otherwise impact the small business deduction.
One final note is the manner in which the tax changes will affect the Refundable Dividend Tax on Hand (RDTOH) account. This is an account that attempts to ensure that tax payable on investment income is the same, whether earned in a corporation and distributed to shareholders or earned personally by shareholders. Generally speaking, RDTOH refunds have now been made more complex by tying into the type of investment income received and the types of dividends declared by the corporation. Consultation with your tax advisor is now even more important in determining the proper mix for year-end dividend planning.
Prepare your business
Business owners can prepare for these changes today by carefully reviewing their corporate structures. Of course, any changes to the corporate structure should be made carefully and in compliance with the new anti‑avoidance rules. This review, in combination with remuneration planning and revisiting investment and distribution strategies, will allow owners to be set up for future success.
Grant Thornton works with businesses like yours to manage challenges and realize opportunities – to help business owners navigate through these tax measures in this new environment. To learn more, contact us.