Commentary: Federal Budget 2018
On February 27, 2018, federal Minister of Finance Honourable Bill Morneau released the 2018 budget, the third budget released by the current liberal government. The budget is titled “Equality + Growth: A Strong Middle Class” as the government continued its focus on improving gender equality and new funding to support innovation in Canada.
Major highlights of the budget included a projected deficit for 2018-19 of $18.1 billion and the widely anticipated introduction of new rules dealing with the taxation of passive income of private corporations in Canada. Some highlights of tax measures announced in the Budget which may be of interest to our client base include:
Tax on Split Income (TOSI)
On July 18, 2017, the Minister of Finance released a discussion paper outlining proposed changes designed to prevent small business owners from “sprinkling” corporate income with family members who were not directly involved in the business with the objective of reducing the overall family tax burden.
The discussion paper provided for a 75-day consultation period for interested parties to provide input on the proposed changes. There were over 21,000 submissions received during this consultation period. Between October 15 – 17, during “Small Business Week”, Minister Morneau announced several changes, which amended and, in some cases, canceled portions of the original proposals, along with a promise of a further update before the end of 2017.
On December 13, 2017, the government released further modifications to and some clarification of the proposed TOSI changes. The effective date of these changes is January 1, 2018. On the same day, the Senate released a paper stating the changes should be scrapped or at least postponed until more consultation is completed. With nothing announced since December, many tax practitioners were hoping that there would be an update in the 2018 Budget. Disappointingly, there were no updates or postponements announced in the Budget around the TOSI rules, and the government is going forward with the changes announced last year as updated in December.
Passive Income Rules
The Department of Finance's July 18, 2017, announcement also proposed changes to how a corporation's income from passive investment activity would be taxed. Detailed rules were not provided at that time but several alternatives were suggested, with one of the proposals taxing passive investment income at a rate approaching 75% on PEI by the time the income was in the personal hands of the shareholders! In response to significant opposition from Canada’s business community, during "Small Business Week" Minister Morneau announced further details that there would be a threshold of $50,000 of passive investment income, and any investment income below that amount would not be affected. However, many questions remained as there were no details on the implications for passive income above $50,000, including how the limit of $50,000 would be handled within corporate groups, and what types of passive income would be impacted.
The private sector certainly had a collective sigh of relief with the significant step back the government chose to take on the passive income changes. While the preference of the business community was to abandon the proposed changes to this area, the changes were not as large as feared.
Budget 2018 addressed some of the questions left unanswered in the fall update by including two new rules dealing with passive investment income earned by a Canadian Controlled Private Corporation (CCPC).
Small Business Limit
A CCPC (or an associated group of CCPCs) is entitled to a small business deduction annually on its first $500,000 of active business income. The small business deduction reduces taxes on this active business income, resulting in an effective corporate tax rate of 14.5% in PEI for a December 31/18 year end. Any business income above $500,000 is taxed at a rate of 31% in PEI.
Budget 2018 proposes that the $500,000 small business limit will be reduced by $5 for every $1 of passive income realized by the CCPC (or the associated group's) above the $50,000 threshold amount. The small business limit would be reduced to zero for that year when passive investment income reaches $150,000 in any year. This rule is in addition to the existing rule where the small business limit is reduced depending on the amount of taxable capital employed in Canada by associated companies. The CCPC's (or the associated group's) small business limit will be the lower of the limits determined under the two rules.
The new reduction of the small business limit will be based on the new term “adjusted aggregate investment income” which is based on “aggregate investment income”.
"Aggregate Investment Income" includes:
- Interest on investments
- Any dividends that are included in taxable income (dividends received from a taxable Canadian corporation are generally excluded from a corporation's taxable income)
- Capital gains that exceed capital losses
- Income from property that does not qualify as an active asset
The adjustments to arrive at the “adjusted aggregate investment income” include:
- Capital gains will be excluded to the extent they arise from the disposition of active business assets of the corporation or shares of an active connected corporation, subject to certain conditions
- Net capital losses carried over from other taxation years will be excluded
- Dividends from non-connected corporations will be added
- Income from savings in a life insurance policy that is not an exempt policy will be added
The new small business limit reduction is effective for tax years that begin after 2018.
Refundability of Taxes on Investment Income
Under current rules, corporations on PEI pay tax at a rate of 54.67% on aggregate investment income. The 54.67% tax rate includes a 30.67% refundable portion, called Refundable Dividend Tax On Hand (RDTOH) that is refunded to the company upon payment of taxable dividends to it shareholders. RDTOH also includes a 38.33% "Part IV" tax on portfolio dividends that are not included in regular taxable income. Under current rules, corporations can pay eligible or non-eligible dividends to recover RDTOH.
Finance expressed a concern that the refund of tax paid on passive income and the payment of dividends sourced by passive income needed to be more closely aligned.
In this regard, Budget 2018 proposes to implement two pools of RDTOH;
- One pool for Eligible RDTOH, which will track Part IV tax paid on eligible dividends
- One pool for Non-Eligible RDTOH to track all other refundable taxes paid on non-eligible dividends and investment income
With these new rules, CCPC’s will only receive a refund from the non-eligible RDTOH pool on the payment of non-eligible dividends. Under the new rules, CCPC’s will receive a refund from the eligible RDTOH pool on the payment of either type of dividend. Refunds based on paying a non-eligible dividend must come from the non-eligible RDTOH pool first. These changes will improve the integration of personal and corporate taxes. These rules are effective for tax years that begin after 2018.
Budget 2018 released new reporting requirements for certain Trusts. The goal of the new reporting requirements is to “determine taxpayers’ tax liabilities and to effectively counter aggressive tax avoidance as well as tax evasion, money laundering and other criminal activities”.
In the past, Trusts that did not earn income and did not make distributions to beneficiaries were not required to file an annual tax return. However, even when a Trust was required to file a return, there were no requirements for the Trust to disclose beneficiary information. Budget 2018 will require certain Trusts to file tax returns on an annual basis even if there is no income or distributions. These new filing requirements will apply to returns that are filed for 2021 and subsequent years.
Under the new reporting requirements, trusts will be required to report the identity of:
- All trustees
- All beneficiaries
- All settlors, and
- Each person who has the ability to exert control over the trustee's decision making
Failure to comply with these new rules will result in a $25/day penalty, with a minimum of $100 and a maximum of $2,500. An additional penalty of five percent of the maximum fair market value of property held during the relevant year by the trust will apply if a failure to file the return was made knowingly, or due to gross negligence.
Exceptions to the additional reporting requirements are:
- Mutual fund trusts
- Trusts governed by registered plans
- Lawyers' general trust accounts
- Graduated rate estates and qualified disability trusts
- Trusts that are non-profit organizations or registered charities, and
- Trusts that have been in existence for less than three months, have less than $50,000 in assets, and have no assets other than deposits, government debt obligations and publicly traded
The medical expense tax credit is a 15 percent non-refundable tax credit. The credit is based on the amount paid for eligible medical expenses that exceed the lessor of $2,302 and three percent of an individual’s income. The list of eligible expenses is reviewed and updated regularly.
Currently, the cost to purchase and care for an animal are eligible medical expenses where the animal was specially trained to assist patients with:
- Profound deafness,
- Severe autism,
- Severe diabetes,
- Severe epilepsy, or
- A severe or prolonged impairment that markedly restricts the use of the person's arms or legs
For the expenses to qualify, the animal has to be acquired from a person or organization whose main purpose is to provide special training to the animal.
Budget 2018 proposes to expand the list of eligible expenses to included expenses for a specially trained animal that is used to assist a patient in coping with a severe mental impairment. The example used in a budget paper is a psychiatric service dog used to assist someone with post-traumatic stress disorder.
The expansion of eligible expenses will apply to an expense incurred after 2017.
Extended Reassessment Period for certain circumstances
Canada Revenue Agency (CRA) may reassess taxpayers within a fixed period of time from when they receive their original assessment. The normal reassessment period ends three or four years after the original assessment.
Under current rules, when a taxpayer contests a CRA request for foreign-based information, the reassessment period is frozen while the matter is before the Federal Court, therefore extending the amount of time CRA has to complete its reassessment. This “stop the clock” rule only applies to CRA requests for foreign-based information.
Budget 2018 is amending parts of the Income Tax Act to implement a “stop the clock” rule for reassessment periods whenever any request for information or compliance order is contested. The clock would stop when an application is made to the Federal Court to review a request for information or when a taxpayer confirms opposition to a compliance order. The clock would remain stopped until the final disposition of the matter, including any appeals that may be made. This new rule extends the reassessment period for taxpayers that try to prolong the reassessment process. The CRA believes this will speed up processes and remove backlogs of work.