Penalty Tax on Investment Income – What Will Be Grandfathered?

The Liberal Government intends to bring in a new penalty tax on investment income earned by private corporations to the extent the investment income in any year exceeds a $50,000 threshold. That tax could be 73% or higher. If they do proceed with the new penalty tax, which I hope they won’t, what will the grandfathering be? The Government has been very careful in choosing its words on this.

On July 18, 2017, the Department of Finance said that “it is the intent that the new rules would apply on a go-forward basis. Once a new approach is determined for the tax treatment of passive investment income, the Government will consider how to ensure that the new rules have limited impacts on existing passive investments.” On October 18, 2017, in announcing the $50,000 threshold, Minister Morneau stated that “all past investments and the income earned from those investments will be protected.” This was repeated in the Fall Economic Statement. So, existing investments and the income from those investments will be grandfathered, but not retained earnings?

Private companies can have investments whether or not they have retained earnings. For example, if a private company carries on an active business and owns depreciable property or equipment, the depreciation can reduce its taxable income without reducing its cash. A company can have $100,000 of income and $100,000 of depreciation resulting in no net income or retained earnings and still have $100,000 cash to invest provided it doesn't pay down its debt. So, no retained earnings, $100,000 of investments. Will that be grandfathered? And a company carrying on an active business can borrow funds to make passive investments. Will those investments be grandfathered?

Now, take the same company with $100,000 of income with no depreciation expense. If the company is a small business, it pays tax at 15% and ends up with $85,000 of retained earnings. If the $85,000 is used to put back into the business, this company will have $85,000 of retained earnings and no investments. Will this company be grandfathered when it accumulates $85,000 of cash in the future that it can use to invest?

In the first scenario, the company with no retained earnings could be grandfathered with respect to $100,000 of investments it currently has. In the second scenario, the company with retained earnings and no investments may be out of luck with respect to grandfathering.

Let us take an extreme example. Assume a real estate development company has $5 million in retained earnings that is all invested in its real estate development business. Assume that the company has no investment assets and the owner is 63 years old and thinking of retiring. In 2019, after the new rules come into force, assume all the active assets have been sold and the company has $5 million to invest for the owner’s retirement. If the government only grandfathers existing investments, then the company and the owner will be taxed at the penalty tax rate in 2019 and following to the extent the company’s investment income exceeds $50,000. This would not be a fair result. Should the company borrow $5 million now and invest it so that their future investment income will be grandfathered and not subject to the penalty tax?

If the new tax is only going to apply on a going forward basis, then the sensible approach is that tax should only apply to investments in excess of the retained earnings existing on the date the legislation is enacted.