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Small businesses with large passive investment income to be taxed more

Finance Minister Bill Morneau is congratulated by Prime Minister Justin Trudeau after delivering the federal budget in the House of Commons in Ottawa on Tuesday, Feb.27, 2018.

Sean Kilpatrick/THE CANADIAN PRESS

The federal government is overhauling the way it taxes investment income generated inside small businesses - changes that will eventually raise almost $1-billion a year in additional tax revenue.

But the budget tabled Tuesday backs off a controversial plan to heavily tax so-called passive investment income - money made by investing in shares, bonds or other sources unrelated to their main businesses - that sparked outrage among doctors, farmers and other small-business owners when it was proposed last year.

The new approach is designed to discourage wealthy Canadians from using small-business structures to pay less tax by accumulating so-called passive investment income inside their companies, according to Finance Minister Bill Morneau.

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"The wealthiest Canadians should not be able to use private corporations to pay less tax than the middle class," Mr. Morneau said in his budget speech in the House of Commons.

Small Canadian-owned companies with annual income of as much as $500,000 a year enjoy a special, lower tax rate than larger companies. The small-business rate is slated to fall to 9 per cent in 2019, down from 10.5 per cent in 2017 and 10 per cent this year. The rate for larger companies is 15 per cent. And both rates are significantly lower than what individuals pay.

Under the changes announced Tuesday, small businesses will pay the lower small-business rate on the first $500,000 of active business income annually provided its passive investment income is below $50,000 in that year. Once passive income exceeds $50,000, the amount of income subject to the small business rate will be reduced by $5 for each $1 of passive income from $50,000 to $150,000, at which point the small business limit would be fully eroded. Any active income not subject to the small business rate is taxed at the general corporate rate.

Ottawa had earlier proposed heavily taxing passive investment income when business owners tried to withdraw that income from their companies. Business groups had complained of facing combined tax rates of as much as 70 per cent - well above the top personal income tax rates.

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Small-business groups say the changes in the budget are better than the original plan but will still take money out of the hands of entrepreneurs – money they would otherwise reinvest in their companies or save for retirement.

"It's a less bad way of approaching this," said Dan Kelly, president of the Canadian Federation of Independent Business. "But this will still take $1-billion out of the hands of business owners."

Combined with reforms announced last year that limit the ability of small-business owners to distribute, or "sprinkle" income, to family members, the changes will raise an extra $925-million a year by 2022-2023, according to the budget documents.

Mr. Kelly said the changes are generally easier to understand and will make it simpler for businesses to file their taxes than what Ottawa had initially proposed.

But he and the government disagree on how many small-business owners are affected. The government says it's about 3 per cent of small companies, while Mr. Kelly says it could be 10 per cent or more.

"The government is vastly underestimating who's affected," he warned.

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There are roughly 1.8 million Canadian-controlled small companies in Canada. The Finance Department estimates that roughly 350,000 of them report passive investment income.

Mr. Kelly warned that the changes are retroactive and will apply to investments that many small-business owners have already built up inside their companies.

Tax experts generally applauded the government for making a distinction between active business income and passive investment income.

"It's a totally different concept," said Bruce Ball, vice-president of taxation at the Chartered Professional Accountants. "Once you accumulate too much [passive] income, you'll see your tax rate go up," Mr. Ball said.

Meanwhile, the budget does nothing to address a growing tax gap between Canada and the U.S. The recent U.S. tax-reform package has turned what was a roughly eight-percentage-point Canadian advantage in the marginal effective tax rate on new investment into a handicap. Business groups have complained that with uncertainty hanging over the North American free-trade agreement, Canada can't afford to lose any more ground.

Mr. Morneau acknowledged those concerns in his budget speech and has directed the Finance Department to study their impact on Canada. He insisted Ottawa would proceed with any further tax changes in a "responsible and careful way, letting evidence and not emotion guide our decisions."

Editor’s Note: An earlier version of this article was not clear in stating that for small businesses, the amount of income subject to the higher rate grows where there is more passive investment.
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