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February 19, 2019 by Ross Cammalleri

5 ways to mitigate the impact of the new passive investment rules

Prior to 2019, investment income did not impact a company’s ability to claim the small business deduction. However, for taxation years beginning after 2018, new rules have come into effect, decreasing the small business deduction for “adjusted aggregate investment income” in excess of $50,000. These new rules provide that for any dollar over $50,000, there is a grind down of $5 for every $1 of adjusted aggregate investment income to the small business deduction. In other words, if your corporation earns adjusted aggregate investment income above $150,000, you will fully reduce the small business limit to zero and increase your corporate tax bill. Fortunately, there are steps you can take to minimize the impact of these new rules.

1. Allocate expenses to adjusted aggregate investment income

In light of these new rules, you should do a detailed analysis of your expenses and try to allocate some of your overhead expenses against your net investment income, arguing that those expenses helped you earn the adjusted aggregate investment income. In essence, this is a process of reallocating expenses you would not normally consider direct expenses to arrive at a lower net adjusted aggregate investment income amount.

2. Review your investment strategy

Review investment strategy to consider investments where there’s more capital appreciation than income generation. For example, let’s say you invest in interest-bearing securities. You may want to consider investing in equity securities that do not pay regular dividends but have the potential for significant capital appreciation. If the equity securities are part of a long-term retirement strategy that will result in future growth, rather than regular annual dividends, your investment earns no adjusted aggregate investment income until a capital gain is realized on a sale in the future. As a result, this strategy does not give rise to annual adjusted aggregate investment income, so there should be no impact on your small business deduction until a sale is made. Another example is a real estate investment with little or no rental income. Although the value of this investment will appreciate in the future, it won’t impact your annual amount of adjusted aggregate investment income.

3. Change the way you borrow

Rather than spend your surplus cash on investments and borrow money to cover the cost of your operations, you should do the reverse. Let’s say you have $100,000 of what you would consider surplus cash but need to invest in equipment. Instead of borrowing, take your $100,000, buy the equipment and borrow from the bank to make your passive investments. If you borrow money to make your investments, you reduce your total adjusted aggregate investment income by the interest deduction on your loan.

4. Investing in life insurance

When you buy an insurance policy, there are some lump sum payments you make over five or 10 years (depending on the product), but not all of that money goes toward the cost of insurance. Since you are over-funding your policy, some of this money goes into a side investment account. This account will earn investment income, but it’s not considered adjusted aggregate investment income. Any side investment account that earns income while in an insurance policy grows tax free because investments in life insurance are tax exempt. You’re taking regular interest income — which increases your adjusted aggregate investment income, potentially reducing your small business deduction — and allowing it to grow tax free. In other words, you’re making an investment, but you’re doing it through a tax-exempt policy. This is a good way to make more money without grinding down your small business deduction.

5. Non-corporate investments

You should also consider making investments through non-corporate entities such as Retirement Compensation Arrangements (RCA) and Individual Pension Plans (IPP). From a commercial standpoint, there are advantages and disadvantages to these plans, but the investment income earned in these types of retirement plans is not reported by the corporation, as it is owned by a separate entity from the corporation. Any investment income is either taxed under RCA rules or tax deferred in an IPP. All you’re doing is moving the investments off the corporate balance sheet and the related investment income off the income statement, so they don’t impact adjusted aggregate investment income and grind down your ability to claim the full $500,000 small business deduction.

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Ross Cammalleri Ross Cammalleri
Vaughan, Ontario
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