The 2022 federal Budget announced a new measure that targets “substantive” Canadian-controlled private corporations (“CCPCs”). Essentially, the federal government was concerned that taxpayers are intentionally undertaking transactions to remove the CCPC status from their corporations in order to avoid the higher rate of tax on investment income that normally applies to CCPCs. On August 9, 2022, the government published draft legislation that included the proposed substantive CCPC rules, upon which this commentary is based.
Our income tax system is designed to ensure that income earned through a corporation is taxed more or less the same as income that is earned directly by a Canadian resident individual—this is referred to as integration. Income from a business earned by a corporation is generally subject to a low rate of tax and only when the income is paid to individual shareholders is the full tax bill paid. Thus, retaining income in a corporation provides a tax deferral advantage. However, additional refundable taxes apply to investment income earned by a CCPC. These taxes are intended to eliminate any tax deferral that could have been enjoyed by earning investment income through a CCPC.
Apparently, some taxpayers were manipulating CCPC status in order to avoid the additional taxes on investment income. And this is what brought about the proposed amendments for substantive CCPCs. Basically, a non-CCPC corporation that is a “substantive CCPC” under the rules will be subject to the additional taxes on investment income that a CCPC would be subject to, while continuing to be prohibited from accessing the beneficial aspects of CCPC status (e.g., the small business deduction).
Currently, the substantive CCPC rules are proposed by draft legislation dated August 9, 2022.
Substantive CCPC Defined
The proposed definition of a substantive CCPC would be added to subsection 248(1). A corporation will be a substantive CCPC if it is a private corporation (other than a Canadian-controlled private corporation) that
- is controlled, directly or indirectly in any manner whatever, by one or more Canadian resident individuals, or
- would, if each share of the capital stock of a corporation that is owned by a Canadian resident individual were owned by a particular individual, be controlled by the particular individual.
Consequences of Substantive CCPC Status
Where a corporation is a substantive CCPC, the following tax consequences will occur:
- The 102/3% additional refundable tax under section 123.3 will apply to the corporation’s aggregative investment income;
- The corporation’s aggregate investment income cannot benefit from the 13% general rate reduction under section 123.4;
- 302/3% of the corporation’s aggregative investment income will be added to its “non-eligible dividend tax on hand account”; this can be refunded later by paying a dividend;
- The after-tax aggregate investment income of the substantive CCPC will be added to the low-rate income pool (“LRIP”), which is defined under subsection 89(1). As a result, the investment income will not qualify to be paid out as a tax-preferred eligible dividend; and
- Despite substantive CCPC status, the corporation will not be eligible for certain beneficial tax provisions that require CCPC status (e.g., the small business deduction and enhanced SR&ED investment tax credit).
The legislation also includes proposed subsection 248(43), which is an anti-avoidance rule that would apply where a corporation or its shareholders intentionally cause a corporation not to be a CCPC, or a substantive CCPC. Basically, this rule would catch tax planning to avoid the additional refundable tax under section 123.3 that is not otherwise caught by the substantive CCPC definition. If it is reasonable to consider that one of the purposes of any transaction or series of transactions is to cause a corporation that is resident in Canada to avoid tax payable under section 123.3, subsection 248(43) deems the corporation to be a substantive CCPC.
Timing of Application
The definition of a substantive CCPC will apply to taxation years that end on or after April 7, 2022. However, a transitional rule will be provided for genuine commercial transactions entered into before April 7, 2022.
Small Business Deduction
The federal small business deduction allows a CCPC to benefit from a reduced federal tax rate on up to $500,000 of income from an active business. However, this $500,000 limit must be shared among associated corporations and is subject to various reductions and restrictions.
One of those reductions is where the corporation (plus any associated corporations) have taxable capital exceeding $10 million. Where taxable capital exceeds $10 million, the business limit is gradually reduced. The amount of the reduction is equal to 10 cents of every dollar by which taxable capital exceeds $10 million. Thus, when the taxable capital reaches $15 million (i.e., the excess amount is $5 million), the $500,000 small business limit is completely eliminated ($5,000,000 x 10% = $500,000).
However, Bill C-32 proposes to increase the upper limit of taxable capital employed in Canada for purposes of calculating the reduction to the business limit. The amount at which the limit is fully eliminated would be increased substantially from $15 million to $50 million. The reduction of the business limit would continue to apply on a straight-line basis, and the reduction rate would be a much lower rate of 1.25 cents per dollar of capital in excess of $10 million. For example, a CCPC with $30 million in taxable capital would be subject to a 50% reduction in the business limit, with access to a business limit of $250,000 (where previously it would be ineligible entirely). Also, a CCPC with $40 million in taxable capital would be subject to a 75% reduction in the business limit, with access to a business limit of $125,000. This change will apply to taxation years that begin on or after April 7, 2022.
First published in Tax Topics, Report No. 2648, December 6, 2022