How Aggregate Passive Investment Income Impacts CCPC Business Owners

Background

Canadian-Controlled Private Corporations (CCPCs) benefit from the Small Business Deduction (SBD), which reduces the corporate tax rate on active business income up to $500,000. However, changes in tax regulations which was implemented as part of Canada’s 2018 federal budget and has been in effect since January 1, 2019, have increased the burden on corporations with significant Aggregated Passive Investment Income (APII). APII includes interest, dividends, rental income, and capital gains from investments held within the corporation.

Under current rules at the Federal level and in most provinces, once APII exceeds $50,000, the SBD limit is reduced by $5 for every $1 of APII, and at $150,000 or more, the SBD is eliminated entirely at both the federal and most of provinces level. This means that business income above the reduced SBD limit is taxed at the higher general corporate tax rate instead of the lower small business rate.

Additionally, the new capital gains inclusion rate increase (66.7%) affects CCPCs holding passive investments, increasing their tax liability both during ownership, upon sale, and at death.

The Challenge

For CCPCs with large passive investments, these tax changes present several challenges:

• Higher Corporate Taxes – Losing the SBD increases the federal corporate tax rate on active income from 9% to 15%, while the most of provinces rate further compounds the total tax burden.

• Increased Capital Gains Tax – The inclusion rate change means that 66.7% of capital gains are now taxable.

• Significant Estate Tax Burden – Upon death, deemed dispositions trigger large tax liabilities.

• Double and Triple Taxation Risks – If assets are sold, dividends distributed, and estate taxes applied, tax rates in Ontario can exceed 70% in extreme cases.

• Reduced After-Tax Returns – Passive investments within a CCPC now face higher tax inefficiencies.

Impact of APII on a CCPC: Case Study (Ontario)

Scenario: CCPC Holding $2M in Passive Investments

• A CCPC has $2,000,000 in passive investments earning $120,000 per year in investment income.

• The APII threshold is $50,000, so the excess APII is $70,000.

• The SBD reduction is: $70,000 × 5 = $350,000.

• New SBD limit (Federal) = $500,000 – $350,000 = $150,000.

• Since the SBD is nearly eliminated, active business income over $150,000 is taxed at the higher federal corporate tax rate of 15% instead of 9%, resulting in an additional $21,000 in corporate taxes

Capital Gains Tax Impact During Sale

If the CCPC sells passive investments worth $2,000,000 with an unrealized capital gain of $1,500,000:

• Before the tax change: Taxable capital gain = 50% × $1,500,000 = $750,000.

• After the tax change: Taxable capital gain = 66.7% × $1,500,000 = $1,000,500.

• If taxed at 50% corporate tax rate, the additional tax due = $125,250 more.

Estate Tax Implications Upon Death

Upon death, the passive investments are deemed disposed at fair market value, triggering a significant tax burden:

• Deemed capital gain: $1,500,000.

• Taxable amount (66.7% inclusion): $1,000,500.

• Corporate tax at 50% rate: $500,250.

• If heirs withdraw funds as a dividend, the total tax can exceed 70% due to double or triple taxation.

Key Effects of APII and Capital Gains Tax Changes

• Elimination of the SBD results in higher active business income taxes.

• Reduced corporate tax efficiency for passive investment growth.

• Estate planning becomes crucial to minimize taxation on deemed dispositions.

Strategies to Mitigate APII and Capital Gains Tax

1. Shift Passive Investments to a Holding Company

• Moving investments to a holding company can help reduce APII within the CCPC, preserving the SBD.

2. Use a Corporate-Owned Insurance Policy

• Whole Life or Universal Life Insurance inside the CCPC provides tax-sheltered growth.

• Upon death, insurance proceeds are paid tax-free and credited to the Capital Dividend Account (CDA), allowing tax-free distribution to heirs.

3. Individual Pension Plans (IPP)

• Contributions to an IPP reduce taxable corporate income and help minimize APII.

• IPPs also provide deferred tax benefits and creditor protection.

4. Donate Appreciated Investments to Charity

• Donating securities with capital gains eliminates capital gains tax.

• The CCPC receives a charitable donation tax credit, offsetting tax liabilities.

5. Pay Out Dividends Strategically

• Distribute income to family members in lower tax brackets.

• Use capital dividend account (CDA) to extract tax-free capital dividends.

6. Tax-Efficient Withdrawal Strategies

• Use corporate borrowing against investments instead of liquidating assets.

• Spread capital gains over multiple years to stay below the higher inclusion rate threshold.

Post-Mortem Tax Planning for Passive Investments

1. Loss Carryback

• Capital losses incurred after death can be carried back to offset capital gains from the year of death, reducing estate tax liability.

2. Pipeline Strategy

• This strategy allows heirs to extract corporate assets without triggering double or triple taxation by converting shares into capital gains rather than dividends.

3. Life Insurance to Fund Estate Taxes

• A corporate-owned life insurance policy provides tax-free liquidity to cover estate taxes.

• Insurance proceeds flow into the CDA, allowing tax-efficient transfers to heirs.

4. Estate Freeze

• Transfers future growth to heirs while locking in today’s value for taxation.

• Minimizes the deemed disposition tax at death.

5. Use of a Family Trust

• A trust can distribute income among family members, reducing tax exposure.

• It also protects assets from creditors and facilitates multi-generational wealth planning.

6. Spousal Rollover

• Transfers investments to a surviving spouse on a tax-deferred basis.

• Delays capital gains realization until the spouse’s death.

Final Thoughts

For CCPC owners in Ontario with significant passive investments, APII changes and the capital gains inclusion rate increase create substantial tax challenges. Without proper planning, businesses face higher tax rates, reduced investment efficiency, and significant estate tax burdens.

A combination of strategies, including holding company structuring, life insurance, estate freezes, loss carrybacks, and pipeline planning, can help mitigate these taxes. By proactively planning, business owners can preserve more wealth, optimize tax efficiency, and secure a legacy for future generations.

If you own a CCPC and are concerned about these tax changes, consulting with a financial or estate planner, and tax professional is crucial to developing a strategy tailored to your financial goals.