New tax rules were implemented in 2019 by the Government of Canada regarding investment income taxation earned from Canadian controlled private corporations (CCPCs).
Passive Investment Income
The passive investment includes items such as dividends, interest, royalties, and capital gains. Surplus cash of Canadian organizations is typically invested in passive investments, such as stocks, bonds, real estate, and mutual funds. This is done to earn an acceptable return rate on the capital. The new tax rules implemented in 2019 affect the taxation of this type of income.
On investment income, Canadian controlled private corporations are generally subject to hefty tax rates as high as 50%. For each type of investment income, there is an associated tax rate. Certain streams of investment income have lower tax rates associated with it. Under current tax legislation, only half of any capital gains are subject to tax (also known as the capital gains inclusion rate). As such, capital gains are effectively taxed at half the corporate tax rate on investment income or approximately 25%. Although the specific tax rates have not been altered, modifications were made to the tax rate on corporate earnings from daily business activities by a Canadian controlled private corporation where profits are being reinvested into passive investments.
Generally speaking, the new rules leave the income tax rate on passive investment income unchanged at 50%. However, the tax rate on the corporation’s ordinary business income increases if your passive investment income crosses a certain threshold, currently $50,000. In summary, there is a disincentive for Canadian controlled private corporations to invest excess corporate earnings into passive investments, if the earnings on those passive investments will result in more than $50,000 of investment income a year. The intention is that corporate earnings are used to invest in growing businesses and earn more business income, while also discouraging the use of specific corporate structures to earn significant investment income.
On the more technical side, there is a small business deduction that Canadian controlled private corporations can claim on the business’ earnings up to $ 500,000, reducing the tax rate on these earnings to 12.2% in Ontario at the time of publishing this article. Once a corporation crosses $50,000 in investment income, the deduction for a small business is reduced by $5 for each dollar generated from passive investment income by a Canadian controlled private corporation above $50,000. At the point when the passive investment income accumulates to $150,000, the deduction for a small business is decreased to $0, and the corporation has to pay the higher corporate tax rate of 26.5% in Ontario.
To make this concept clearer, let’s apply it to an example. Assume Company X is a Canadian controlled private corporation with a single owner. Company X has generated a net income of $400,000 from its daily business activities during the current year. Furthermore, Company X has invested the business’s cash savings of $1,000,000 in a passive investment, which is stated to make an interest income of 9% or $90,000 this year.
The tax rate for the passive investment income previously was 50% and remains at 50% after the new rules. However, the tax rate on the business activities, which was once 12.2% will now increase given the entity currently has less access to the small business tax rate. Earning more than $50,000 in passive investment income will result in a reduction of the maximum amount of earnings that can be subject to the lower small business rate. Thus the entity will pay a higher tax rate on the part of its earnings.
As passive income increases by $1 over $50,000, the small business deduction decreases by $5. Company X earned $90,000 in passive investment income during the year, which is $40,000 greater than the limit of $50,000. Furthermore, this results in a reduction in the small business deduction of $200,000. As a result of the reduction, the small business deduction limit goes from $500,000 to $300,000.
The impact on Company X’s business taxes begins with the amount of $300,000 earnings of business profit within the small business deduction limit remaining being taxed at the lower tax rate of 12.2%. Following, the remaining $100,000 earnings of business profit from Company X will be subjected to a tax rate of 26.5%. This results in a total tax liability on the business income of $63,100 ($300,000 x 12.2% + $100,000 x 26.5%), an increase from $48,800 ($400,000 x 12.2%) under the old tax rules.
This article aims to provide you with general information and a summary of the topic. This is not a substitute for professional advice from an accountant or financial professional. As this area can be complicated and confusing, it is advised to consult with a professional to provide you with a tailored solution to your specific situation. If you have any questions or would like to connect with an Accountant at SRJ Chartered Accountants, please feel free to contact our offices at email@example.com or by phone at 647-725-2537.
1. How are capital gains taxed in a corporation in Canada?
Capital gains can be defined as profits by selling capital or passive assets, including businesses, stock or shares, goodwill, land, etc. Typically, capital gains tend to be included in the taxable income of a corporation. However, they are usually subject to more favourable tax treatment because only half a capital gain needs to be included in income.
2. Do corporations pay capital gains tax?
Yes, corporations do pay capital gains tax on capital gains earned. Corporations also can use capital losses to outweigh capital gains. Speak with your SRJ accountant about potentially utilizing past losses against capital gains earned in a particular year.
3. What is the capital gain rate for 2020?
The capital gains inclusion rate, which is the percentage of how much of your capital gains must be included in your taxable income, remains unchanged at 50%.