Blog  |  Tax

The Liberal Government will be delivering their first Federal budget on March 22, 2016. Much of the coverage so far has been on the expected amount of the planned deficit and the impact of the fallen price of oil.

There are many rumours about potential changes in the income tax system and rates. The main rumours fall into two categories:

1. Potential changes to the capital gains inclusion rate.
2. Potential changes to the small business tax rate.

Capital Gains Inclusion Rate

If the capital gains inclusion rate were to increase, then there would be an incentive to realizing capital gains prior to the date of the increase, but not losses. Consideration should be given to whether it would be beneficial to realize accrued gains now to avoid a potential tax increase.  Possible assets that might bear unrealized gains to consider would be, portfolios of stocks, bonds, mutual fund assets, real estate such as investment properties, cottages, residences not subject to the principal residence exemption, vacant land, shares of a private corporation not eligible for the capital gains exemption, farm and fishing properties not eligible for the capital gains exemption, goodwill, quotas and many other items.

The current capital gains inclusion rate is 50% of the amount of realized capital gain (or loss). Speculation suggests that the 50% rate could be increased.  Prior to 1972 capital gains were not taxable.  Since then the capital gains inclusion rate has varied according to the following chart:

Year	Inclusion Rate
Before 1988	50%
1988 and 1989	66 2/3%
1990 to 1999	75%
Jan 1 to Feb 27, 2000	75%
Feb 28 to Oct 16, 2000	66 2/3%
Oct 17 to Dec 31, 2000	50%
2001 to present	50%

 

It should be noted that in all cases the rate in effect at the time of the realization of a gain has been the rate used to calculate the gain and hence the tax, as opposed to a system where gains would be allocated by year to the rates above.

The non-taxable portion of a capital gain earned through a corporate structure is added to the capital dividend account. A capital dividend is an amount that can be paid out by a corporation tax free to the shareholder.  The result is that the shareholder is put in the same position as if they had earned the capital gain in their personal hands.  An increase in the capital gains inclusion rate, based on historic transitions between rates, would result in a decrease in the amount added to the capital dividend account but not an adjustment to amounts already added to the capital dividend account prior to the change in inclusion rate.  There is always the possibility that the government would break from past precedent.

The following table shows a tax difference of $13,383 ($40,148 – $26,765) crystallizing a $100,000 gain now at the 50% inclusion rate vs. triggering a gain at a hypothetical 75% inclusion rate (assuming only personal tax applies at 2016 rates for simplicity):

	Tax result at 50% Inclusion rate	Tax result at 75% Inclusion rate
Amount	$100,000	$100,000
Taxable amount	50,000	75,000
Income tax at 53.53%	26,765	$40,148
Net after tax	$73,235	$59,852

 

One must also consider the time value of money, so assuming any gain crystallized now would have been deferred into the future at the higher tax rate, the following rates of return are applicable over the following time periods:

Time	Rate (approximate)
1 year	50%
5	8.45%
10	4.14%
15	2.74%
20	2.05%

 

Given the number of previous changes in the inclusion rate over the 44 year history, any analysis of a long term cost/benefit is almost meaningless as any future government could simply lower the inclusion rate again, but could also increase it further.

Small Business Tax Rate

Possible ways to avoid a potential additional tax cost should the Small business deduction become unavailable to your company include operating as a proprietorship or partnership, earning income before a rate change where possible (although in the event of a change it might be that income for the fiscal year would be prorated by the number of days before and after a change), taking advantage of the tax deferral and graduated rates available to an incorporated entity and splitting income with family members at lower tax rates where possible to reduce or eliminate the incremental tax cost.

The current tax rate on the first $500,000 of active business income for a small business is 10.5% for 2016. In combination with the Provincial tax on small business income the overall tax rate on the first $500,000 of active business income is 15% in Ontario for 2016.

Speculation is that access to the Small Business Deduction may be restricted for companies not meeting certain criteria. There are precedents in that the current law does not allow a small business deduction for a specified investment business or a personal service business.  There is also a recent change to the qualification criteria for the Small business deduction in Quebec, the main changes being that for tax purposes in Quebec:

• any corporation that employs more than three full-time employees in its business throughout the year or that would usually have used the services of more than three full-time employees had financial, administrative, maintenance, management or other similar services not been provided to the corporation in the year by a corporation associated with it, and
• any corporation in the primary or manufacturing sector,

are eligible for the Quebec small business deduction.

Should the Federal government adopt a similar set of rules, the changes will apply in Ontario as well.  Ontario has adopted the Federal tax rules in this regard.

The good news is that unless the government were to stray far from the current tax theory that says no matter how you earn a dollar you should pay roughly the same amount of tax on it, a comparison of the possible loss of the Small Business Deductions can be made by comparing the tax rates for income over $500,000 vs. income eligible for the deduction using 2016 rates:

	Small Business Income up to $500,000	Active Business Income over $500,000
General Federal rate after abatement	28%	28%
Small Business Deduction	(17.5)	0.0
Rate reduction	0.0	(13.0)
Net Federal tax rate	10.5	15.0
Ontario	4.5	11.5
Total corporate tax rate	15.0	26.5

 

Example showing incremental tax on $100,000 in Ontario assuming personal income is over $220,000:

	Earned by a Proprietorship	Small Business Income up to $500,000	Active Business Income over $500,000
Taxable income	$100,000	$100,000	$100,000
Corporate income tax	0.0	(15,000)	(26,500)
Net	100,000	85,000	73,500
Personal tax on dividend (45.30%/39.34%)	0.0	(38,505)	(28,915)
Personal tax on income (53.53%)	(53,530)	0.0	0.0
Net after tax dollars at top tax rate	46,470	46,495	44,585

 

If you would like to discuss the above prior to the release of the 2016 Federal budget please contact your trusted advisor at Graham Scott Enns LLP Chartered Professional Accountants.

The Ontario budget contained a number of changes to the Ontario personal and corporate income taxes.  The highlights are summarized below.

Personal Income Tax:

• The tuition and education tax credits will be discontinued beginning in the fall of 2017.
• Residents of Ontario who have unused tuition and education tax credits available for carry-forward on December 31, 2017 will be able to claim them in future tax years.
• Tax filers moving to Ontario from other provinces after December 31, 2017 will not be able to claim accumulated tuition and education tax credits in Ontario.
• The children’s activity tax credit will end as of January 1, 2017.
• The healthy homes renovation tax credit will end as of January 1, 2017.
• Split Income of certain related children will be taxed in a parallel manner to the federal approach.  As a result, the top marginal personal income tax rate will of 20.53% will apply starting January 1, 2016.

Corporate Income Tax:

• Changes will be made to parallel the changes to the gross-up rate for non-eligible dividends as part of the 2015 federal budget.  As a result, the Ontario non-eligible dividend tax credit rate will decline from 4.5% for 2015 to 4.2862% for 2016.  A review is being done of the non-eligible dividend tax credit rate for 2017 and subsequent years.
• For eligible R&D expenditures incurred in tax years that end on or after June 1, 2016, decrease the Ontario Research and Development Tax Credit rate from 4.5% to 3.5% and decrease the Ontario Innovation Tax Credit rate from 10% to 8% (Prorated for year ends straddling June 1, 2016).

These changes apply to the calculation of Ontario Income Tax only.

 

The government has introduced a motion in Parliament to proceed with certain proposed income-tax changes.  They have stated that the changes will take effect in 2016.

The income-tax rate on Canadians earning between $45,282 and $90,563 will be reduced from 22% to 20.5%.

A higher tax rate of 33% will be imposed on those earning more than $200,000 per year.  The current Federal tax rate is 29%.

The increase in the limit for the tax-free savings accounts to $10,000 will be cancelled and hence the contribution limit for 2016 will be $5,500.

In addition to the above changes which have been highly publicized, there are also changes to the taxation of investment income of private corporations including Canadian-controlled private corporations.  The intention of these changes is to prevent creating an additional tax deferral advantage by earning investment income through a corporation.  The changes are as follows:

• An additional 4% refundable tax is imposed on investment income meaning the rate changes from the current refundable rate of 26.67% to 30.67%.  The overall Federal tax rate on investment income before any dividend refund is therefore 38.67% where it was previously 34.67% (both figures plus Provincial tax).
• There is an additional 5% refundable tax on portfolio dividends meaning a changes from the current refundable rate of 33.33% to 38.33%.  Portfolio dividends are not subject to any other corporate tax so 38.33% becomes the Federal and overall corporate tax rate on portfolio dividends before the dividend refund.
• There is an increase in the rate at which dividend refunds are paid out of a private corporation’s refundable dividend tax on hand from 33.33% to 38.33%.  So for every $300 paid out as a dividend, $115 will be refunded to the company paying the taxable dividend rather than the current $100 to the extent the company has a balance of refundable dividend tax on hand.

The change to the tax rates on investment income will also apply beginning in 2016 and will be prorated if the fiscal year end of the company straddles December 31, except that the increase of 5% on portfolio dividends will apply to dividends received in 2016.

As a result of the personal tax rate changes, there is a possibility of paying personal tax on income earned through a corporation in 2015 (or prior) at 2016 and beyond rates by paying the net income of a company after corporate tax to the shareholder(s) in 2016 (or after).  Put another way there may be a tax benefit to paying out dividends to the shareholders in 2015 rather than waiting until 2016 where the taxable income of the individual receiving the dividend has taxable income greater than $200,000.

The overall impact of the changes to the refundable dividend tax are zero to the extent that all of the increase can be recovered in the future, but there may be a true tax cost where all refundable tax cannot be recovered.  Companies earning investment income will have to pay more up front to the extent that all refundable tax is not recovered in the year paid.

To discuss how these changes might impact your unique circumstances please contact us.