Federal Budget 2018: Taxation of Passive Investment Income

By: Michael Warner, MD, FRCPC, MBA.

President, AdvisoryMD

Minister Morneau presented the 2018 Federal Budget on February 27.

Read the full document here.

A 5-page backgrounder on the treatment of passive investment income is here.

1. Punitive taxation of passive investment income above $50,000/year has been abandoned.

• The taxation of passive investment income will not be changing
• There will be no need to to track new and legacy pools of passive investments 
• Compliance and accounting costs should not materially increase 

2. Access to the small business deduction limit of $500,000 will be reduced if passive investment income is > $50,000 in a given year

• Currently, the small business deduction limit allows up to $500,000 of active business income to be subject to a lower small business tax rate (13.5% vs normal active business income rate of 26.5% in Ontario)
• The small business deduction limit will be reduced by $5 for every $1 in investment income above the $50,000 threshold.
• Example 1: Dr. Smith has a corporate investment portfolio of $500,000 which earns $45,000 of investment income in 2019. He has active business income of $475,000 the same year. Since the investment income does not exceed $50,000, his active business income will continue to be subject to the lower small business tax rate of 13.5%. 
• Example 2: Dr. Jones has a corporate investment portfolio of $2 million which earns $100,000 in investment income in 2019. The same year she earns $400,000 in active business income.  Since her investment income exceeds the $50,000 threshold by $50,000, her small business deduction limit will be reduced by $5 x $50,000 = $250,000 to $250,000. Therefore, the first $250,000 of her active business income will be subject to 13.5 % tax. The remaining $150,000 will be subject to a tax rate of 26.5%. This will cost her an extra $19,500 in tax.

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3. Grandfathering clause has been removed

• The Oct 18, 2017 proposal emphasized that existing corporate investments were to be protected from the new tax treatment when implemented. In this proposal, investment income will no longer be subject to punitive taxes but passive income earned on pre-existing corporate investments will be included in the annual threshold calculation. 

• Interest on short-term deposits held for operational purposes is to be excluded 
• It is unclear if short-term deposits held in an interest bearing account to pay for future taxes, would be subject to this preferential treatment as well

Overall, I feel this plan is an improvement upon the Oct 18, 2017 proposal but still has a negative impact on physician retirement planning compared to the status quo.

• Since new and legacy pools of investments will not have to be tracked, compliance costs should not increase
• There is no need to hoard cash in the corporation as the grandfathering clause has been removed
• The proposed punitive tax treatment of corporate investment income has been completely rescinded but the removal of the grandfathering clause will be costly to physicians with significant existing corporate investments and active business income >$500,000
• Physicians earning >$50,000 annually in passive investment income will not be able to realize the full benefit of the $500,000 small business deduction limit. However, to earn this amount of income, a physician will be holding a significant corporate investment portfolio. These  physicians are more likely to be mid to late career and may not be earning as much active business income as they did in the past. Therefore, the impact of the reduction in the small business deduction limit may not be as significant.

Michael Warner is the President of AdvisoryMD and provides personal finance education, billing training and career counselling to physicians.