New Tax Rules Related to Passive Income and the Small Business Deduction

17 Feb 2020

Leslie Du - Accounting Associate

The new tax rules related to the passive income grind of the small business deduction ("SBD") apply to corporations with a taxation year that begins on or after January 1, 2019. Under the new rules, passive investment income earned by a Canadian controlled private corporation ("CCPC") can have a negative impact on the corporation's ability to claim the SBD.

For every $1 of passive income earned over a new $50,000 threshold by an associated group of companies, the SBD limit will be reduced by $5. Once passive investment income earned by the associated group exceeds $150,000, the ability to claim SBD is eliminated for the entire group. The application of these new rules would result in an increase to the amount of corporate tax paid by the business.

For the purpose of determining the reduction of the $500,000 small business limit of a CCPC, passive income will be measured by a new concept called "adjusted aggregate investment income" (AAII), which is "aggregate investment income" (AII) with a few adjustments.

"AII" consists of the following:

  • Interest
  • Taxable Capital Gains, net of allowable capital losses
  • Passive rental income
  • Passive foreign income 
  • Losses from property

"AAII" is AII plus the following adjustments:

Exclusions:

  • Capital gains and losses from the disposition of active assets.
  • The corporation cannot deduct any net capital losses from other taxation years.
  • No deduction for charitable donations.
  • No deduction for foreign accrual taxes.

Inclusions:

  • Dividends are included (except for dividends received from connected corporations).
  • All income from a "specified investment business" is included
  • Income from savings in a life insurance policy that is not an exempt policy is included

Going forward, it is crucial for associated corporate groups to monitor their levels of passive income from year to year, and plan ahead with regard to which years to realize capital gains and losses for example. It is the prior year's passive income level which impacts the current year business limit grind. The result in most cases in Ontario is corporate tax applied at a rate of 26.5% versus 12.5% to the first $500,000 of active business income, which can make a huge impact on many small businesses.

If you have any questions regarding this matter, please do not hesitate to contact us.