Holding Investments in your Corporation and the Passive Income Claw back

Traditional tax plans have hit a snag since the 2018 federal budget when it comes to holding investments in your corporation, if that corporation uses the small business deduction.  However, there are strategies that continue to allow for this.

Dividends in Alberta are taxed depending on the tax rate paid by the corporation issuing the dividend.  If you have a small business that qualifies for the small business deduction (SBD), that corporation would be subject to 11% tax in Alberta on the first $500,000 of taxable active business income earned.  A dividend issued to an individual from that corporation would be subject to 15.86% to 42.31% tax in 2023 (15.86% to 42.31% tax in 2022).  This is considered an other than eligible dividend.

The 2018 federal budget has limited access to the SBD for corporations holding earning passive income.  Passive income includes rents, royalties, dividends, and interest – or more specifically income that is not active business income.  While $50,000 in passive income is permitted without penalty – each dollar above that mark will decrease access to the SBD by $5.  As such, a corporation that earns $150,000 is have their entire SBD clawed back and be subject to the general corporate tax rate. 

It is important to note that the first $50,000 in passive income can be earned without penalty – and then the $500,000 limit starts to get clawed back.  If you are not utilizing the full $500,000 limit, an annual calculation may be all that is needed to be aware of you standing.      

Corporations that do not qualify for the small business deduction are subject to the general corporate tax rate of 23% in Alberta.  A dividend issued to an individual from that corporation would be subject to 2.57% to 34.31% tax in 2023 (2.57% to 34.31% tax in 2022).  This is considered an eligible dividend.

The integration of these rates varies between tax brackets.  Two examples, the first assuming the highest personal tax bracket and the second assuming a marginal tax bracket as this being the only income earned by the investor illustrates the overall relatively minor variances in overall tax paid.

Using Highest Personal Rate	SBD	General Rate
Revenue	200,000	200,000
Expenses	100,000	100,000
Net Income Before Tax	100,000	100,000
Tax Rate	11%	23%
Corporate Tax	11,000	23,000
Net Income	89,000	77,000
Available to Dividend	(89,000)	(77,000)
Personal Tax Rate	42.31%	34.31%
Personal Tax	37,656	26,419
Total Tax Paid	48,656	49,419
Using Marginal Personal Rate	SBD	General Rate
Revenue	200,000	200,000
Expenses	100,000	100,000
Net Income Before Tax	100,000	100,000
Tax Rate	11%	23%
Corporate Tax	11,000	23,000
Net Income	89,000	77,000
Available to Dividend	(89,000)	(77,000)
Personal Tax Rate	marginal	marginal
Personal Tax	17,213	6,008
Total Tax Paid	28,213	29,008

The traditional strategy resulted in active business income being retained in the corporation to earn passive income via large cap stock or rental investments that earned passive income.  As those investments were subject to the high rate of tax – the dividend once distributed at the personal level would be an eligible dividend and result in an overall tax savings with an incentive to save within the corporation.  This strategy continues to be relevant with the first $50,000 in passive income earned within the active business or up to the clawed back SBD limit being utilized by that business.

Where additional passive income is anticipated, the utilization of a whole life policy with high cash surrender values should be considered.  These somewhat sophisticated plans may also be beneficial where the $50,000 in passive income has not yet been achieved. 

Shajani CPA would be happy to consult on an appropriate plan.          

This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. ©2023 Shajani CPA.

Shajani CPA is a CPA Calgary, Edmonton and Red Deer firm and provides Accountant, Bookkeeping, Tax Advice and Tax Planning services.