The provisions include additional taxes that apply to passive investment income the year it is earned (a “refundable tax”), that is
fully or partially refundable to the corporation as it pays out taxable dividends to its shareholders. The additional refundable tax
bridges the gap between the corporate and personal income tax rates, such that the tax payable by corporations on passive
investment income approximates what an individual in the top tax bracket would pay on the same income.
The current rules do not, however, consider the source of earnings used to fund passive investments through private corporations.
That is, there are no provisions to align the corporate earnings available to fund the passive investment with the after-tax amount
that would be available to an individual. As noted earlier, corporations are generally taxed at lower rates than individuals on active
business income. A private corporation earning this income may have more capital to invest in passive investments, which in turn
may generate higher returns on such investments, in comparison to the returns that can be achieved by an employed individual
investing with his or her after-tax dollars. The government views this as an inequitable result, stating the lower tax rates available
to private corporations was not intended to allow shareholders to realize greater personal savings.
3. Proposed Changes
To address the perceived inequity under the current tax rules as described above, the federal government is considering a regime
that would maintain tax rates on the passive investment income of private corporations equal to top personal tax rates. It would
remove the refundability of passive investment taxes where earnings used to fund passive investments were taxed at low
corporate tax rates. In addition, the new system would align the tax treatment of passive income distributed to shareholders as
dividends with that of the earnings used to fund the passive investments. The earnings could either be subject to the small
business rate or the general rate, but could also be funds taxed at the personal level and contributed by shareholders.
In the current tax system, a shareholder can receive one of three types of dividends:
i. Eligible dividends – paid from corporate earnings that have been subject to regular corporate tax rates;
ii. Regular, or “non-eligible” dividends – paid from corporate earnings that have been subject to reduced corporate tax
rates and are therefore subject to a higher personal tax rate than eligible dividends; and
iii. Capital dividends – tax-free amounts paid from a corporation’s capital dividend account, which generally consists of
the non-taxable portion of a corporation’s capital gains.
To properly align the tax treatment of distributed passive income to the tax treatment of the underlying corporate earnings used to
fund the passive investments, the type of dividends paid to shareholders would need to follow the tax treatment of the income that
is used to fund the passive investment, rather than the nature of the passive income itself.
Consider the example of a passive investment funded with active small business income. As the underlying corporate income was
taxed at a preferential tax rate, it is implied all income generated by that passive investment would be treated as a “non-eligible
dividend” upon distribution to shareholders, and accordingly:
• Dividend income from publicly-traded stocks would no longer be treated as eligible dividends, as is currently the case, but
would be treated as non-eligible dividends (consistent with the tax treatment of small business income that is distributed to
• The non-taxable portion of capital gains would not be attributed to the capital dividend account in this example.
The government has introduced two possible approaches to the new regime, an apportionment method and an elective method.
This method would involve an apportionment of corporate passive investment income into three categories, or “pools” that will be
tracked from year to year:
i. Income taxed at the small business tax rate;
ii. Income taxed at the general corporate tax rate; and
iii. Income comprised of amounts contributed by shareholders from income taxed at personal tax rates.
This would translate into three possible tax treatments for passive investment income when distributed to shareholders as
dividends - eligible dividends, non-eligible dividends, or dividends that would be received tax-free.
The Apportionment Method would generally work as follows:
1) The balance of the three pools at the end of each year would be used to calculate their respective proportion of the
total undistributed income pool.
2) The passive income earned during the year would be attributed to each of the pools using the proportions calculated
in Step 1.