Following numerous announcements and months of consultations, the tax reform begun in 2017 by federal Finance Minister Bill Morneau finally became official in 2018. The main components will now be in force for all tax years after 2018.

If you are an entrepreneur, the new rules that apply to your passive income should catch your attention. Here are three questions that tell you why.

  1. What is passive income?
    As a business grows, so does its cash reserves, only some of which are needed to carry on day-to-day operations. The remaining cash is usually invested by the business owners to generate some returns. A company’s passive income is specifically that part of its income generated by these investments, whether in the form of interest, dividends or capital gains. So passive income is income not directly associated with the company’s business operations.
  2. Why is this difference important?
    From a fiscal standpoint, passive income is treated differently than active business income. SMBs actually benefit from a lower tax rate on the part of their operating income below a certain threshold, currently $500,000. This is known as the Small Business Deduction, or SBD. Passive income, on the other hand, is taxed at the higher general corporate income tax rate.
  3. What has changed?
    While retaining this differential tax treatment, the tax reform of 2018 established a connection between the amount of passive income and the amount of active income that qualifies for the Small Business Deduction. In other words, the higher a company’s passive income, the less it is deemed to be a small business. Here’s how the calculation works:
    • with $50,000 or less in passive income, the entrepreneur retains the entire business limit of $500,000, i.e. the amount eligible for the Small Business Deduction;
    • however, for each dollar of passive income above $50,000, the business limit eligible for the SBD is reduced by $5, as shown in the following diagram.

    Graph showing the relationship between passive income, on the X-axis, and the small business limit eligible for the Small Business Deduction, on the Y-axis. The limit remains at $500,000 as long as passive income is below $50,000. Then it drops sharply, reaching $0 when passive income exceeds $150,000.
     

As we can see, these new provisions have little impact on business owners with low investment income, or with operating income that is well below the $500,000 small business limit. 

However, for established entrepreneurs who have both strong operating income and solid investment income, this new tax situation could translate into a difference of thousands of dollars in their after-tax income.

The following sources were used to prepare this article:

BDO Canada, “Passive Investment Income and its Impact on the Small Business Deduction,” April 2018.
Osler, “Federal Budget Briefing 2018,” February 2018.
QuickBooks, “Understanding the New Federal Passive Income Rules for Small Businesses.”
The Globe and Mail, “Federal budget highlights: Twelve things you need to know,” February 2018.