According to the government of Canada, as of December 2018, 97.9% of businesses were classified as small businesses. Most provinces averaged between 96% and 97% small businesses, but B.C. was one of 4 provinces that had an even higher number of small businesses in the market.
In B.C. 98.2% of businesses are classified as small businesses, with a large number of these in Vancouver and other metropolitan areas. With over a million small businesses, it is important for business owners to understand how they are taxed on different types of income.
More specifically, these small businesses need to know what is classified as passive income and what is classified as active income—and the taxation differences between the two.
Active business income is generally the main and incidental income that businesses will earn. Most often, this is seen in the form of the sale of products or services by a company. Passive investment income, on the other hand, generally consists of corporate earnings not directly related to those core business services and operations. This passive income can include interest, dividends, capital gains, royalties, and some types of rental income.
Simply put, it’s money that comes in with very little effort needed to earn. Most often, passive income is commonly referred to as “investment income”, because investments (whether in real estate, stocks, or other areas) are the most common source of sustainable passive incomes for small businesses.
In today’s markets, and with changes in businesses being brought on by COVID restrictions in Vancouver and B.C., many small businesses in B.C. are focusing on creating passive income streams to help support their businesses. However, there are very different taxation rules for small business passive income.
If Vancouver-based businesses want to maximize how they earn from investment income, it is important to understand how Canadian-controlled private corporation (CCPC) is taxed. A CCPC is a private corporation that is controlled by Canadian residents. It cannot have a non-resident directly or indirectly in control of the business, and it cannot be directly or indirectly controlled by one or more public corporations. It also cannot be controlled by a Canadian resident corporation that lists its shares on a designated stock exchange outside of Canada.
In simpler terms, a CCPC is a private Canadian-owned and controlled business that is not listed on any stock exchange. It is important to know what a CCPC is because most small businesses throughout Canada are CCPC’s. In addition to this, investment income taxation rules across Canada and B.C. are established for CCPCs.
Prior to 2019, passive income was taxed just the same as active income for CCPCs. In other words, small businesses were just taxed on whatever was deemed as income for the business, whether it was passive or active income.
In 2019, however, the legislation changed surrounding the taxation of CCPC passive and investment incomes. These changes effectively increased the amount of taxes being paid by CCPC, resulting in some important pieces of information to cover.
One of the biggest changes to the taxation of investment income is that the small business deduction (SBD) limit is $500,000. The SBD is the maximum value to get a reduction in corporate taxes for CCPCs. With the new rules around passive income over $50,000 starting in 2019 and the effects it has on SBD, small business owners in Vancouver, and throughout the rest of B.C. need to take note of what changes apply to them—and consult their financial professionals with any questions.
In 2019, the corporate tax rate was 38%. After the federal tax abatement of 10%, the tax rate became 28%.
A CCPC, however, receives an additional 19% tax credit or small business deduction on their small business income up to the SBD of $500,000. This means that for up to $500,000, the federal tax rate was 9%. A CCPC’s active business income after that amount is taxed at 15%. Investment income is taxed at 38.7%. This clearly shows that a CCPC would like to maximize this tax credit.
In addition to the federal tax rate, each province (and territory) has its own tax rates for small business income, active business income, and investment incomes. The tax rates for small business income ranged from 0% up to 6%, and for the active business income they ranged from 11.5%-16% and investment income ranged from 11.5% to 16%.
Specifically, in 2019, the rates for BC were 12% for active business income and 2% for CCPCs, up to $500,000. The investment income was also taxed at 12%. These differences in taxation are clearly significant and could provide tax savings up to a maximum of $80,000. It is important to note these rates throughout B.C., because of the large number of CCPCs throughout the province.
Again, because of these tax rates, it’s important is to keep your SBD at a $500,000 maximum. You need to carefully watch your passive income because the SBD can be reduced for CCPCs based on levels of “adjusted aggregate investment income” (AAII). The SBD will be reduced by $5 for each $1 of investment income that is earned, over $50,000 of AAII.
Looking at these tax rates, you can see that it is not profitable to earn passive income from investments that are over $50,000. As stated above, for $1 of passive income that is earned over $50,000, the SBD is reduced by $5. If your passive income were to reach $150,000, your SBD would be reduced to $0. That would be a huge tax hit. CIBC provides a summary of the new taxation limits in Vancouver and Canada in the following figure:
What this table shows is that as soon as your business exceeds $50,000 of passive, investment income, you start to have a lower SBD limit, meaning you may lose profitability in the long run.
As an example, to clarify this, if you had a passive income of $100,000, you would be $50,000 over the allowed threshold of passive income. This additional $50,000, would then be multiplied by $5, equalling $250,000. This $250,000 is now deducted from your SBD of $500,000.
What this means is that the first $250,000 of investment and passive income would be taxed at a reduced rate. Anything earned over the new SBD value of $250,000 would now be taxed at the higher corporate tax rate or active business income. Again, when looking at the difference in tax rates, this is considerable.
Below is a graph to help show you the effects of passive income over the $50,000 threshold.
The key reason for this change in legislation is that the government wanted to make a change to promote more sales and active income driving business growth and reduce the number of businesses that were relying on investments to make money. As well, they recognized that businesses were taking advantage of tax deferrals by investing their active business incomes rather than investing personally.
With every small business being different, CCPCs should review the passive income rules with their financial professional to review their current holdings and look at possible options. Some options are simple, some are more complex. For example, a company could look at how tax-deferred investments can offer a tax-preferred means of earning passive investment income.
This could include deferring capital gains where possible. As well, growth within a corporate-owned (exempt) life insurance policy will not affect the CCPCs passive investment income and the death benefit may be paid out as a tax-free dividend. Another option could be to look into passive income earners that are required to pay a less annual tax, such as real estate. To sum up, different types of passive income can be treated differently when it comes to taxes.
There are a lot of different options with regards to how to deal with passive, or investment income.
This is why it’s so important to not only monitor investment/ passive income but to also make sure you always make sure you know what tax rates apply to your business based on your CCPC investment income and your SBD limit. Always remember to plan ahead and speak with a professional as this can save you at tax time or hurt your bottom line.
Need help from an expert?
If you need clarification on which types of dividends, royalties, and rental income are classified as passive income, let one of our experts at Valley Business Centre help. For over 30 years, Valley Business Centre has been providing comprehensive bookkeeping, payroll, and tax services to our clients in Whistler, Squamish, the Sea to Sky Corridor, and Metro Vancouver BC areas. Valley Business Centre provides reliable and effective services to all clients.
This article is written for informational purposes only. It is current at the date of posting and changes to laws and regulations may result in the information becoming outdated. It is not intended to provide legal, tax, or financial advice. It is recommended that readers get advice from a tax professional before making any final decisions.
In real-estate driven economies like Vancouver, and throughout the rest of British Columbia, there are many questions that need to be addressed, surrounding the purchase of real-estate. One of these questions that business and corporation owners in Vancouver and Canada need to ask is whether or not they should buy real estate with corporations – instead of personally.
The answer to this question starts with asking if you are talking about real estate for personal use or for investing purposes. By personal use we mean your primary residence and possibly a vacation home or cottage. Investing purposes includes purchasing real estate to hold, rent or flip.
When talking about purchasing your principal residence, it may actually make more sense for you to purchase your home outside of your corporation. The reason for this is, is that when you sell your home in the future, there will be a tax benefit.
This tax benefit is that you can claim a principal residence exemption on the property value appreciation. There are some rules in place as to what your principal residence is. This includes that you can only claim one home per family and you need to (typically) live in the home. As well, the purpose of the residence cannot be to earn income and there are some restrictions regarding the size of land.
As always, CRA does have stipulations in place so it is always important to discuss your options with your accounting and tax professionals. So, always make sure to consult with the CRA, and to consult with your accounting professionals.
Nevertheless, if you are looking to use your corporation to buy your home, there are a couple of different options.
1. Corporate loans.
One option to purchase real-estate may be that you choose to have your corporation give you a loan for your home purchase, as an employee of the company. Being an employee of your own company means that you need to be on payroll. So, there may be some difficulties if you operate as a board member or contractor.
You could then get a tax-free loan from your corporation, which would need to be supported by a written agreement. As a homeowner, you would then need to pay a reasonable amount of money in interest payments as well provide a reasonable time frame for the loan to be repaid to the corporation.
If the company needed to take out a mortgage, the home would be used as collateral for the loan. But, this would allow you to purchase a home and repay it back – all while keeping it in the company.
2. Corporation purchase.
A variation on this would be if the corporation itself purchases the home. Doing this would allow you to utilize cash held by the corporation, and if needed, the corporation would take out any additional mortgage. You would then pay rent back to your corporation and they would be able to claim this as income, after deducting all of the expenses.
This may be a simpler way of purchasing real-estate, but still allows you to purchase personal housing through a corporation.
There is a significant distinction between holding companies and operating companies that we talk about in one of our other blogs. If you choose to have your corporation purchase your home, it would be smart to have it held by your holding company.
This way, your home would be a protected asset. If needed, the operating company could make a documented tax-free loan to the holding company that you are also a shareholder of, and the holding company would pay annual interest back to the operating company. As a homeowner, you would pay rent to the holding company for the home and your holding company would pay income tax, less any expenses on this rent, or income.
If you do not already have a company in place, you should consult your tax accountant to see if it even worthwhile to transfer your property to the corporation.
3. Trust agreement.
Another option that you could pursue regarding your personal property is to purchase the property under your name and then set up a trust agreement that states that the corporation is the beneficial owner of the property.
The corporation would then be treated as the owner from a tax perspective and would claim the rental income as well as the expenses related to the residence. Again, consult a professional so that you know if there will be tax implications or capital gains.
When looking at secondary homes or rental property, it is typically better to not own these as an individual due to annual taxes and capital gains. If you are in a higher tax bracket, it would definitely be more beneficial to have the property held by the corporation, which would pay lower tax rates.
Purchasing real-estate, pros and cons
If you are looking specifically at purchasing a secondary home, there may be a disadvantage. You would need to compare the rent that you would need to pay to the corporation and its resulting taxes it would need to pay on the income earned compared to what the tax implications would be if you personally held the property.
Here again is where you need to speak with your tax specialist to determine if the costs and implications of moving the property or properties to a corporation when you already own them may outweigh the benefits.
If you are purchasing properties for the purpose of flipping them, the tax implications regarding the profits will be better in the corporation rather than personally. In this instance, your company could be taxed as low as 9-15%.
Another disadvantage is that it may be harder for the corporation to get financing. Depending on the financial institution, they may charge a higher interest rate for the corporation or require the directors to personally guarantee the loan.
In B.C. and real-estate hubs like Vancouver specifically, the mortgage lender may require that the company be registered in BC and may still ask for a personal guarantee from the principal of the corporation.
Again, each case is different especially and it can become more complex if you are looking at purchasing a second property out of Canada. Different countries have different tax laws and you will need to ensure you understand them before purchasing a property. Always check with your accounting professional to ensure you know the implications before you purchase.
A corporation may choose to purchase real estate, not for the benefit of personal use but for the benefit of the corporation. This could include purchasing the real estate that your company is operating out of, or any other properties that it wants for investment purposes.
If a company is a Canadian Controlled Private Corporation (CCPC), there can be benefits. For example, there is a capital gains deduction when corporate shares are sold or there can be increased number of deductions at tax time.
As well, some additional benefits of corporate owned real estate include profit, as the property appreciates, tax benefits due to expenses and cash flow if you decide to rent out your property.
Some disadvantages for a corporation to buy real estate include potential losses if you rent out your property, either from tenants not paying rent or damages incurred. As well, the corporation needs to consider the cost and time that are involved in not only finding the right real estate, but in the maintenance of the property.
One last thing to take into consideration. If you are planning on leaving the property to your children when you pass away, there may be inheritance tax savings if the property is held within a corporation.
If they are shareholders of the limited company, if and when the property is sold and they receive the proceeds, they may be taxed at a lesser level than inheritance tax. Even though there are no inheritance taxes in Canada at this time, there are rules that apply to properties outside of our borders.
Always remember to plan ahead and speak with a professional as this can save you at tax time or hurt your bottom line. Especially in cities and locations with plenty of international real-estate and corporate ownership of real-estate, it is important to consult with taxation and accounting professionals to figure out what the best option is.
Need help from an expert?
If you need clarification on the pros and cons of buying real estate with your corporation, let one of our experts at Valley Business Centre help. For over 30 years, our team has been providing comprehensive bookkeeping, payroll and tax services to our clients in Whistler, Squamish, the Sea to Sky Corridor and metro Vancouver BC areas. We’ll give you the peace of mind you need to make confident financial decisions.
This article is written for informational purposes only. It is current at the date of posting and changes to laws and regulation may result in the information becoming outdated. It is not intended to provide legal, tax, or financial advice. It is recommended that readers get advice from a tax professional before making any final decisions.