2018-0754581E5 Specified investment business

Principal Issues: The taxpayer's questions relate to the incorporation of a private corporation the purpose of which is to provide commercial loans to small businesses, and to the possible impact, if any, of the proposed rules relating to the taxation of “passive income”.

Position: The taxpayer essentially requests tax advice in respect of the taxpayer's proposed business. As a result, we have determined that our response must be limited to general comments only.

Reasons: Based on the provisions of the Act and CRA publications.

Author: Snell, Sandra
Section: 9(1); 123(1); 123.3; 123.4(2); 125(1); 125(7)

XXXXXXXXXX                                                                                                           2018-075458
                                                                                                                                   S. Snell
                                                                                                                                   (613) 670-9011
April 26, 2018

Dear XXXXXXXXXX:

RE: Treatment of a corporation making commercial loans

We are writing in response to your correspondence dated February 18, 2018 to the office of the Minister of Finance, which was forwarded to the office of the Minister of National Revenue.

Based on the limited facts in your correspondence, it appears that you are contemplating incorporating a company that will earn interest by making loans to small businesses and you have some questions regarding the potential impact that the proposed rules relating to the taxation of passive income may have on this situation.

Unless otherwise stated, every reference herein to a part, section, subsection, paragraph or a subparagraph is a reference to the relevant provision of the Income Tax Act (the Act).

Our comments

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

Subsection 9(1) provides that a taxpayer’s income for a taxation year from a business or property is the profit from that business or property. In general terms, the taxable income of a corporation is subject to tax at the general rate as set out in subsection 123(1). Information on the corporate tax rates is available at: https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/corporations/corporation-tax-rates.html.

Based on the limited facts in your query, it appears that you are contemplating the incorporation of a “private corporation” as it is defined in subsection 89(1). Specifically, a private corporation includes, among others, a corporation that is resident in Canada that is not a public corporation and that is not controlled by one or more public corporations. In such circumstances, section 125 provides that a “Canadian-controlled private corporation” (CCPC) may claim a corporate tax reduction (commonly referred to as “the small business deduction”) in respect of its income from carrying on an active business in Canada. However, income from an active business carried on by a corporation in Canada does not include a corporation’s income from a business that is considered to be a “specified investment business”.

In broad terms, a “specified investment business” (SIB) as defined in subsection 125(7) means a business carried on by a corporation in a taxation year (other than a business carried on by a credit union or a business of leasing property other than real or immovable property) the principal purpose of which is to derive income from property (such as interest, dividends, royalties and rent from real property) unless the corporation meets one of two conditions:

(a)   the particular corporation employs in the business throughout the taxation year more than 5 full-time employees; or

(b)   another corporation associated with the particular corporation provides, in the course of carrying on an active business, managerial, administrative, financial, maintenance or other similar services to the particular corporation in the year and it is reasonable to assume that the particular corporation would have required more than 5 full-time employees in its business if those services had not been provided.

General information on the application of the above-noted rules can be found in Interpretation Bulletin IT-73R6, The Small Business Deduction, dated March 25, 2002, which is available at: https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/it73r6.html.

Generally, investment income earned by a CCPC (unless it is incidental to an active business), including income earned from carrying on a SIB, is not eligible for the general rate reduction in subsection 123.4(2) or the small business deduction in subsection 125(1). In addition, a CCPC is subject to an additional amount of tax under Part I of the Act (additional refundable tax) on its investment income. This additional refundable tax, imposed under section 123.3, is reflected in a CCPC's “refundable dividend tax on hand” (RDTOH) under current subsection 129(3). The RDTOH of a corporation is a notional account that keeps track of the portion of the additional refundable tax that the CCPC paid on its investment income. A corporation’s RDTOH is refundable to it under current subsection 129(1), when the corporation pays a taxable dividend to its shareholder(s).

The additional refundable tax is intended to approximate the tax that would be paid by an individual had they received the investment income directly. The purpose of this RDTOH system is to prevent individuals from deferring personal tax on investment income earned and retained in a private corporation. Accordingly, the RDTOH system effectively provides for the integration of corporate and personal taxation of investment income of a CCPC. Integration is a fundamental objective of the Canadian tax system, with the underlying principle being that income earned by a corporation resident in Canada, and paid as a dividend to an individual, should be subject to the same total amount of tax as if the income had been earned directly by the individual. You can find more information on the RDTOH system in Interpretation Bulletin IT-243R3, Dividend Refund to Private Corporation, dated February 12, 1996, available at: https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/it243r4.html.

Lastly, as you know, the federal Government has recently released draft legislation that proposes to limit tax deferral opportunities associated with the reinvestment of after-tax corporate business earnings in certain “passive” investments made by private corporations. These “passive investment income” proposals include two measures: an additional eligibility mechanism for the small business deduction and a limitation in respect of the situations where a private corporation can receive a refund of its RDTOH.

A discussion of these proposals prepared by the Department of Finance can be found in Backgrounder: Tax Fairness for the Middle Class and Opportunity for All Canadians, which is available at: https://www.fin.gc.ca/n18/data/18-008_9-eng.asp. Additional guidance on these proposals is provided in a series of questions and answers prepared by the CRA, which is available at: https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/budget-2018-equality-growth-strong-middle-class/passive-investment-income.html.

We trust that these comments will be of assistance.

Yours truly,

Michael Cooke, CPA, CA
Manager
Corporate Reorganizations Section II
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without the prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5.

© Her Majesty the Queen in Right of Canada, 2018

Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistribuer de l'information, sous quelque forme ou par quelque moyen que ce soit, de façon électronique, mécanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.

© Sa Majesté la Reine du Chef du Canada, 2018