Incentive Effects of the New SBD Clawback

The Department of Finance has proposed a new regime to address the deferral advantage that corporations can enjoy by reinvesting, outside the business, after-tax income that was subject to tax at the small business deduction (SBD) rate. The new approach is a clawback, which, although a defensible policy, creates fiscal hazards. For example, an extra $1,000 of rental income creates $1,307 of immediate tax in Alberta, as well as cash flow issues in certain situations. Changes in investment portfolios may be appropriate.

Legislation released on March 22, 2018 amends subsection 125(5.1) for taxation years after 2018 by reducing the business limit of a corporation by the greater of the normal amount (relating to taxable capital) and a new amount—the clawback. The clawback depends on the adjusted aggregate investment income (AAII) (subsection 125(7)) of the corporation and any associated corporations as follows:
  1. $0 to $50,000—no impact;

  2. $50,000 to $150,000—for every dollar of AAII earned, a $5 reduction in the business limit; and

  3. beyond $150,000—no impact (because the business limit has already been reduced to nil).

Furthermore, RDTOH is now divided into two separate accounts:
  1. an account for AAII that creates GRIP, such as portfolio dividends (eligible RDTOH); and

  2. AAII that does not create GRIP, such as interest or rents (non-eligible RDTOH).

For further details, see "2018 Budget Simplifies Passive Investment Rules," Tax for the Owner-Manager, April 2018.

The Department of Finance's rationale is that the SBD is intended to encourage reinvestment in business activities. If a corporation has significant AAII, and therefore significant investment assets, then it is unlikely that business reinvestment is occurring; thus, the SBD may no longer be justified. However, just about any attempt to create categories in the tax law creates incentive effects around the borders, and these changes are no exception: this can have a significant impact on the cash flow of a corporation earning AAII and generating non-eligible RDTOH.

Consider X Co, a corporation that
  • is not associated with any other corporation,

  • has no SBD reduction from taxable capital,

  • has $200,000 of active business income (ABI), and

  • has $110,000 of rental income.

X Co's business limit is $200,000 ($500,000 − ($60,000 × 5)), and all of the corporation's income qualifies for the SBD. If X Co earns another $1,000 of rental income in 2019, its business limit will fall by $5,000, to $195,000. In Alberta, going from the SBD rate to the general corporate rate on $5,000 of ABI results in $800 more tax ($5,000 × 16% differential). Further, the combined federal and Alberta corporate income tax on the AAII is $507 ($1,000 × 50.7%). Thus, there is a total cost of $1,307 on the extra $1,000 of income in Alberta.

The $1,307 is the immediate cost. This amount is reduced, at some time in the future when dividends are paid, by the $357 ($5,000 × 72% ×  (41.6% − 31.7%)) benefit to a top-bracket owner of having increased GRIP, and by a $307 ($1,000 × 30.7%) refund of non-eligible RDTOH. However, owing to the new bifurcated RDTOH regime, a corporation will have to find money to pay two dividends: (1) an eligible dividend (to realize the benefit of GRIP) and (2) a non-eligible dividend (to recover non-eligible RDTOH). Recovering the GRIP would require an eligible dividend of $3,600 ($5,000 × 72%), and recovering the non-eligible RDTOH would require a non-eligible dividend of $800 ($307/38.3%). Clearly, an additional source of funds beyond the after-tax amount left from the original income amount of $1,000 will be required.

Of course, this sky-high tax cost is in some respects a special circumstance. Many corporations do not need all of their business limit or do not have between $50,000 and $150,000 of AAII.

Taxpayers will have to examine their investment structures to discern how best to address amended subsection 125(5.1). For many corporations, a simple fix may be an adjustment to their investment portfolio, either by (1) switching to more conservative investments that are more secure and pay less income or (2) switching to growth assets to provide flexibility to the corporation in how and when it will realize AAII in the form of capital gains. In the latter situation, a corporation might consider the "big bath" approach of realizing all of its capital gains in one year. To the extent that this pushes AAII above $150,000 in that year, it will reduce the amount of AAII that would otherwise reduce the business limit in other taxation years.

Jason Pisesky
Felesky Flynn LLP, Edmonton
[email protected]

Canadian Tax Focus
Volume 8, Number 2, May 2018
©2018, Canadian Tax Foundation