Investment income in a corporation: avoid the small business deduction reduction

Investment Insight

In Canada, the active business income (ABI) of a Canadian-controlled private corporation (CCPC) is eligible for the preferential small business tax rate, up to the small business deduction (SBD). When ABI exceeds the SBD, currently $500,000 ($600,000 in Saskatchewan), ABI is taxed at a higher corporate tax rate.

Investment or passive income, earned by a corporation would be taxed at a much higher rate than ABI above or below the SBD. In addition, that passive income can lower a corporation’s SBD. This reduction begins when a corporation (or a group of associated corporations) earns $50,000 of passive income in a year. The SBD will be fully eliminated when passive income reaches $150,000. For each dollar of passive income over $50,000, the SBD will be reduced by $5. In this context, passive income is referred to as adjusted aggregate investment income (AAII).

To maximize the SBD, corporations will want to avoid its reduction. Let’s look at how corporations can do that and benefit their bottom lines.

Strategies to consider

Strategies can fall into one of three buckets. Here are some tips.

Reduce active business income

If your current year’s passive income can be reasonably forecast, then so can your small business deduction (SBD). As a result, if your ABI can be reduced to or below your anticipated SBD, then you can avoid the higher general corporate tax rate. Here are some ideas for doing so:

  • Revisit your compensation mix. Salaries and bonuses are employment income reported on a T4. They’re also deducted from ABI.
  • Pay salaries to your spouse and children. If the salary is reasonable for the job, this income-splitting strategy is still viable.

Reduce passive income

Directly reducing passive income or passive investment assets within a corporation can also reduce their impact on the SBD. There are several ways to do this:

  • Realize capital losses in the current year. Capital loss carry-forward amounts won’t help, as any used are added back as part of the AAII calculation for determining passive income levels. That said, capital losses realized in the current year can offset capital gains also realized in the current year. This can be beneficial if you’re rebalancing current passive assets to reduce passive income in future years.
  • Invest in low taxable income and low-distribution assets. Investments that generate little or no taxable income, such as corporate class mutual funds, will result in less passive income now and possibly in future years. Some mutual fund trusts also follow investment strategies that minimize taxable distributions.
  • Consider Series T mutual funds. Series T mutual funds provide an income stream consisting primarily of return of capital (ROC), which isn’t taxable. Using passive assets within the corporation, in conjunction with series T to provide liquidity, can be tax efficient and won’t impact passive income for AAII purposes.
  • Don’t forget expenses. Expenses incurred to generate passive income, such as interest expenses or investment counsel fees, can be used to reduce passive income.
  • Repay shareholder loans. Using passive assets to repay outstanding shareholder loans can reduce passive investment income.
  • Pay dividends from the capital dividend account (CDA). Funding capital dividends with funds from passive assets can reduce such balances, which in turn can reduce passive income. The shareholders receive the capital dividends tax free, which doesn’t impact their personal tax position.
  • Combine multiple-year transactions. When considering rebalancing passive assets, funding dividends to corporate shareholders with passive assets, or expanding operations, you can combine multiple years’ transactions into one. This may allow the negative impact of realized capital gains on the SBD to occur only once.
  • Purchase corporate-owned life insurance. Investments in life insurance policies are generally tax sheltered. This can reduce passive investment asset balances while addressing a planning need for you and your corporation.

A combination of both

There may be opportunities to combine items from the lists above to lower ABI and passive income. There are also these options:

  • Review investment options outside your corporation. Investment plans such as registered retirement savings plans (RRSPs), individual pension plans, or retirement compensation arrangements can create a deduction against ABI for employer contributions. If such contributions come from passive assets, they’ll be reduced. If they’re earmarked for future personal use, it may be beneficial to hold them outside your corporation, especially when your personal marginal tax rate is lower than your corporate tax rate on investments.
  • Make a corporate donation. A corporate donation creates a deduction against income and may reduce passive investments, as it’s funded with corporate money. Further, in-kind donations of publicly traded securities attract a 0% capital gains inclusion rate and, therefore, don’t increase the current year’s passive income. Finally, since 100% of the capital gain is tax free, the entire gain is added to the CDA, which could be paid to the shareholders tax-free.

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MK33567E 05/23

Tax, Retirement & Estate Planning Services Team

Tax, Retirement & Estate Planning Services Team

Manulife Investment Management

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