The passive income controversy (cont'd)

Bill Morneau finally brought down his budget last Tuesday. While the flavour du jour is gender-based analysis, you had to dig (as per usual) to find out what Finance is doing to really improve the Income Tax Act, among other laws. They have come up with an interesting resolution to the taxation of passive income in CCPCs that I discussed earlier here and here, as well as doing a needed correction to the handling of refundable dividend taxes on hand. I'll deal with the latter matter in a subsequent post.

The Budget (and the real document)

The public version, which most commentators appear to have focused on, is an interesting PR exercise as usual:




However, to see what is really going on, you always have to read this:

 What they're doing with the Small Business Deduction

Where they start discussing their proposal for limiting the availability of the small business deduction (SBD) to CCPCs (at pp. 17-20 and pp. 53-55), you discover that this is really a multiple-factor calculation. The basic formula is:

 $  ABL = BL - max(A,B)  $

where:

• ABL = adjusted business limit to what can be claimed for the small business deduction
• BL = the business limit otherwise available
• A = limitation with respect to taxable capital employed in Canada (a concept borrowed from the Part I.3 tax on large corporations), which is already in effect as ITA 125(5.1)
• B = limitation with respect to adjusted aggregate investment income (ie, passive income) for the year (being the figure from the T2 Schedule 7 with some adjustments)

The very brief summary of the impact is that:

• if a CCPC's taxable capital is less than CAD 10 million, and its passive income is less than CAD 50,000, it will continue to have full access to its business limit
• if either its taxable capital is greater than CAD 15 million, or its passive income is greater than CAD 150,000, it will have no access to the small business deduction
• there is a transitional phase where the above calculation comes into play; it is effectively a percentage reduction of what the dollar amount would otherwise be

The charts that illustrate the impact (as shown in p. 74 of the Budget and pp. 18-19 of the Tax Measures) are very poorly done, as they fragment the extent of its impact. Some commentators have said that these limitations are straight-line calculations, but they are wrong. Both limitations are curvilinear in nature as shown in the following.

The taxable capital limitation

The limitation with respect to a CCPC's taxable capital employed in Canada is:

$ \left[ \frac{0.00225(C-10,000,000)}{11,250} \right],  10,000,000 \leq C \leq 15,000,000 $

where C is such taxable capital, and the business limit after reduction for this limitation is:

The passive income limitation

The limitation with respect to a CCPC''s passive income for the year is

$ \left[ \frac{BL}{500,000} - 5(E-50,000) \right],  50,000 \leq E \leq 150,000$

where E is the adjusted aggregate investment income for the year.



Further testing proved that these calculations are effectively percentage reductions to what otherwise would be the business limit to which a CCPC would be entitled.

This also begs the question as to what to expect when the two curves intersect - as that could happen - and this is something that the wizards at Finance decided not to try to visualize. I tried to summarize this in a single formula, but that was not a practical solution. Through the tried-and-true "brute force" technique, I compiled a dataset of calculated datapoints and have constructed a chart of my own, which proves to be revealing:


You can see that the curve has a definite peak, either side of which tapers down to eventual ineligibility for the small business deduction. That may be worth investigating further, in order to help out with any necessary tax planning such corporations may need to undertake.

I like this solution, but do object to the way it's being advertised. CPA Canada has described it as being "much simpler than what was originally proposed," but no-one has mentioned its integration with the taxable capital limitation in any detail yet, but it represents a very significant expansion. If this goes through in its proposed form, it will essentially expand this anti-abuse provision, because much of the work that CCPCs and their tax advisers have done over the years in making sure that their taxable income is low enough to fully qualify for the small business deduction will become useless, as it's much more difficult to fudge passive income and capital employed. This is to be welcomed, together with last year's exclusion of personal services business income (as now shown on line 520 of Schedule 7) from the SBD and the new SBD denial rules.

This area is becoming rather exciting now. Let's see what happens next.