Businesses have the potential to earn revenue through diverse channels, typically categorized into two main types — active income and passive income. Active income is the result of physical participation and material contribution to business pursuits. On the other hand, passive income pertains to earnings derived from owning capital assets that generate income without requiring substantial effort from the owner. It’s important to note that passive income is often subject to taxation in Canada.
Here are some things you need to know about the tax implications associated with passive income earned within a Canadian-controlled private corporation (CCPC).
Understanding Passive Income Tax in Canada
The term “passive income” has recently been used very loosely. It has been used informally to describe recurring income requiring little to no work from the recipient. It includes self-charged interest, rental properties, and businesses where the recipient of income isn’t actively involved.
There are several ways for a corporation to earn passive income, such as:
Investments can be low risk, like Guaranteed Investment Certificates (GICs) and savings accounts, which yield passive income in small amounts as interest. They can also be a bit riskier, like owning shares in another company. In Canada, all passive incomes you earn by investment are subject to taxes.
However, registered plans like Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs) can offer some tax advantages. TFSAs allow investors to earn without paying taxes as long as they don’t exceed their contribution limit. On the other hand, RRSPs generate taxable passive income, but the money you contribute to your RRSP can be deducted from your taxable income for the year. The contributions and the interest they’ve earned are taxed at the regular income tax rate when withdrawn.
- Rental Properties
In Canada, the income you make from renting is subject to taxes, but you can reduce the amount you owe by deducting various expenses related to earning that rental income. These deductions may cover most repair costs, energy expenses, and even the interest part of your mortgage payment.
- Non-material Participation in a Business
Suppose you invest $500,000 in a candy store under an arrangement where the owners agree to pay you a portion of the profits. This income falls under the category of passive income, provided you refrain from actively engaging in the business’s day-to-day operations beyond your initial investment. However, if you actively assist in managing the company alongside the owners, your income may be classified as active, as your involvement constitutes “material participation.
The Complexity of Passive Income Taxation in Canada
In the past, the Small Business Deduction (SBD) applied mainly to active incomes, and the eligibility criteria were less restrictive, allowing more Canadian-controlled private corporations (CCPCs) to benefit from it. However, the government grew concerned about multiple claims for this tax break.
Previously, CCPCs generating passive income were not seen as exceeding the small business income limits. This meant that an owner of one CCPC who started two additional branch companies could save taxes on three income sources, costing the federal government a significant amount in lost tax revenue. This concern prompted the introduction of stricter regulations.
- Corporate Taxation
In Canada, when a CCPC (Canadian Controlled Private Corporation) earns passive income, it’s typically taxed at a rate of about 50% nationwide. Here’s how it works:
(a) The first $500,000 of business income is subject to a lower small business tax rate.
(b) Any income over $500,000 is subject to a higher general tax rate.
Starting in 2019, if the CCPC and any connected corporations make more than $15 million, they can’t claim the Small Business Deduction. It’s essential to note that any investment income earned in a connected holding company will be considered when calculating passive income. In fact, if you make more than $50,000 from these sources, you might have to pay a higher tax rate, up to 26% on your income.
- Investment Income Taxation
When a corporation pays taxes on its investment earnings and later distributes those earnings to shareholders as dividends, it can get some of its taxes back. For example, if you pay $2.61 in taxable dividends, the corporation can get a $1 refund of its taxes. This is often referred to as Refundable Dividends Tax on Hand (RDTOH).
- Refundable Dividends Tax on Hand
RDTOH is a theoretical account that grows when a CCPC pays corporate tax on its investment earnings, like taxable capital gains, interest, rents, and dividends from unrelated Canadian corporations. Specifically, 30.67% of the investment income and the Part IV tax owed by the corporation receiving dividend income are added to this RDTOH account. Since 2019, RDTOH is divided into eligible and non-eligible portions and is refundable depending on the type of dividends distributed by the CCPC.
Essentially, RDTOH is an advance payment of an estimated personal tax amount at the corporate level. It’s designed to prevent tax deferral opportunities for investment income and to ensure that when the money is eventually received by the shareholder personally, the tax system remains integrated.
- Capital Dividend Account (CDA)
When a corporation earns money from selling investments (capital gains), only half of that money is subject to tax. The other half, which is not taxed, is added to a special account called the CDA (Capital Dividend Account), which keeps track of non-taxable earnings.
Life insurance payouts (after subtracting the initial cost) can also be added to the CDA. These amounts can then be paid out to shareholders as tax-free capital dividends. To do this, the corporation must file a request with the Canada Revenue Agency.
Investing in capital assets is tax-efficient because the growth isn’t taxed until you sell the asset. When you sell, the profit goes into the CDA, and you can distribute it to shareholders without paying additional taxes. This makes the CDA a valuable tool for estate tax planning among shareholders of Canadian Controlled Private Corporations.
- Personal Tax on Dividends
When a company distributes dividends to its shareholders, those shareholders are also responsible for paying personal taxes on the dividends they receive. The specific personal tax rates applied to dividends from a Canadian corporation depend on two factors: (a) the total taxable income of the shareholder and (b) whether the income originates from the corporation’s general rate income pool or other sources. The general rate income pool, or GRIP, consists of corporate business income taxed at the standard corporate rate. Dividends paid from this pool are categorized as eligible dividends. Dividends that do not come from the GRIP pool are taxed as non-eligible dividends.
Benefits of Hiring a Canadian Passive Income Taxation Consultant
- Expertise in Passive Income Rules
A specialized consultant is well-versed in the intricate rules and regulations surrounding the corporate tax rate on passive income in Canada. They can offer invaluable insights and assistance to ensure you navigate this complex landscape effectively.
- Tax Optimization
These consultants are skilled at optimizing your tax strategies to minimize tax liability while maximizing your passive income. They can identify opportunities for deductions, credits, and exemptions that you might overlook.
- Customized Advice
Consultants can tailor their advice to your specific financial situation. They assess your unique passive income sources and financial goals to create a personalized tax plan that suits your needs.
- Compliance and Reporting
Staying compliant with tax laws is crucial. A consultant ensures that your passive income reporting is accurate and adheres to all legal requirements, helping you avoid costly penalties and audits.
- Tax Management Efficiency
Passive income taxation can be time-consuming and stressful. Hiring a consultant frees up your time and reduces the stress of managing your tax affairs, allowing you to focus on your investments and other priorities.
How to Choose the Right Consultant
- Define Your Needs
Before searching for a consultant, clearly define your specific needs and objectives. Whether improving a business process, enhancing your marketing strategy, or addressing a particular challenge, knowing what you require will guide your consultant selection process.
- Expertise and Experience
Look for consultants with proficiency and track record in your industry or the specific area you need assistance with. Ask for references and case studies to gauge their experience and success in similar projects.
- Compatibility and Communication
Effective communication and a good working relationship are crucial. Ensure that you and the consultant can collaborate effectively. They should understand your business culture, values, and goals, as this will contribute to a smoother consulting experience.
- Cost and Value
Discuss the consultant’s fees and pricing structure upfront. Assess not only the cost but also the value they bring to your project. A more expensive consultant who delivers results may be a better investment than a cheaper one with limited capabilities.
- Reputation and Credentials:
Research the consultant’s reputation by checking online reviews, testimonials, and any industry recognition or certifications they may have. A consultant with a solid reputation is more likely to deliver quality services.
At Smith & West, we specialize in corporate tax preparation services in Ottawa. Our experienced team is here to optimize your tax strategy, ensuring compliance and maximizing your savings. Call us today at (613) 425-8871.
FAQs About Passive Income Tax Rates in Canada
- Is passive income taxed in Canada?
Yes, passive income is taxed in Canada. However, the tax rate on passive income can vary depending on the type of income and your overall income tax bracket.
- What are the roles of Canadian passive income tax consultants?
Canadian passive income taxation consultants assist individuals and businesses with managing passive income taxation complexities. Their responsibilities include crafting tax-efficient strategies, ensuring compliance with tax regulations, and staying abreast of evolving tax laws. They also offer customized solutions aligned with client’s financial objectives, advise on tax-efficient investment decisions, and provide support during tax audits.
- What to expect when working with tax consultants in Canada?
Working with a tax consultant provides valuable guidance and peace of mind in navigating the Canadian tax system. When engaging a tax consultant in Canada, you can expect expert advice specific to your needs, ensuring compliance with tax laws and regulations. They will assist in strategic tax planning, informing you about relevant updates, and optimizing your financial situation for individuals and businesses.
- Are there penalties for not reporting passive income?
If you fail to report your passive income, you may be subject to penalties and interest. The penalties can be significant, so you must accurately report all your income on your tax return.
Hire the services of Smith & West Chartered Professional Accountants for on-time and compliant tax preparation and filing.