What Business Owners Should Know About AAII And How To Avoid It

James Schofield - May 25, 2023
Adjusted aggregate investment income (AAII) rules were introduced to extract more revenue from successful businesses, but there are creative ways to protect more of your wealth.

If you own a business in Ontario, you probably know that the first $500,000 of active business income is taxed at an average rate of 12.20%, much lower than the 45.78% average rate on the same amount of personal income. In Canada, this small business deduction (SMD) is one of the great benefits of owning a business. To illustrate the savings available, here is an example: If you own a business with $400,000 of profit annually, after paying yourself and re-investing into the company, you can invest the amount leftover. Because the retained earnings are taxed at such a low rate, you'll have $351,520 after tax leftover to grow and compound when you invest, whereas you would only have 216,880 after tax if you earned $400,000 personally. The compound growth of an additional 134,640 every year can quickly turn into millions of dollars. For these reasons, and a few others, which we will explain in another article, many business owners invest their profits in an investment portfolio or real estate. Before 2018, there was not much need for coordination between Operating Company and Holding Company, but in 2018 the Canadian department of finance introduced a rule called adjusted aggregate investment income or AAII, whereby access to the SMD limit would decrease by $5 for every $1 of passive income in excess of $50,000, meaning that the SMD is not available for active businesses with passive income over $150,000. This gradual reduction in the SMD limit is referred to as the SMD limit grind down. Although this piece of legislation shook the Canadian business community and accountants to the core, most small businesses will not be affected by these rules in their lifetime. That being said, we wanted to investigate the difference in total taxes paid for companies that these rules will affect, situations that could lead to a small business limit grind down, and ways business owners can structure their corporations to avoid a grind down of SMD limit.

Let's start with a worst-case scenario; Assuming that a business has an active income of $500 K and passive business income is over $150 K. To make the comparison simple, we can look at 2018 (before AAII) and 2019 tax (after AAII). In 2018, the company would have paid $61,000 of tax based on its active income, whereas in 2019, the business would pay $132,500, for a total difference of $71,500. For an owner-operator approaching retirement, an additional $71,500 per year, for five years, compounding at 5% translates to an additional $415,000 in the corporation at retirement. An additional $415,000 compounding at 5% over 20 years of retirement translates to an additional ~$1.1 million in growth. Using an example of a business earning $350,000 of active income with a HoldCo earning $100,000 of passive income translates to $14,300 in additional taxes paid compared to pre-AAII.

We should mention here that some professionals are not able to have a holding company, due to restrictions imposed by their regulatory bodies. So, they invest the business profits inside their operating company. The principle of SMD limit grind down still applies the same way.

Ways to Reduce AAII Grind down

The first step is to lower the active business income to combat this negative tax outcome. In some instances, it may make sense to pay bonuses to high performing staff, recognizing staff has the added benefit of boosting morale and decreasing turnover. Another way to decrease profit while investing back into the business is by upgrading software or buying new equipment, though you may not be able to deduct the full amount of capital costs in oneyear. Next, you'll want to pay yourself a salary of (~$150,000) or more if necessary. Salaries are a deductible expense for the corporation, and they create RRSP room for the individual, contributions to an RRSP will help you defer taxes. In some instances, an individual pension plan (IPP) makes sense as well. IPPs are a kind of hybrid between an RRSP and a defined benefit pension plan that owner-operators can create for themselves to defer more business income than they would with an RRSP.

Planning and coordination with the HoldCo are essential. For example, Suppose you know you will have an unusually large amount of passive income in a particular year. It may make sense to increase expenses you had been putting off temporarily.

Another strategy is to hire family members, who are interested in joining the business, and pay them a reasonable salary. Many entrepreneurs will encourage their children to develop a skill set that compliments their own skills. This could be accounting, marketing or supply chain management.

Now that we’ve looked at reducing active income, we can look for ways to reduce passive income. From a tax perspective, the best investments to keep in your Holdco are those that do not pay interest income or dividends. Growth stocks have a lot of potential and are less likely to pay dividends, so it may make sense to start your search with established companies that are still growing at a high rate. Examples are Google and Facebook. The best examples are companies that pay minimal dividends to grow profits consistently. Ideally, the company has diversified business lines. On paper, a great fit in a passive-investment portfolio is Berkshire Hathaway because the company itself invests in other companies, allowing you to achieve greater diversification with just one stock; Berkshire has a proven track record, growing almost every year since the late '60s and pays zero dividends

Another way to reduce passive income is to purchase a permanent insurance policy. There are several great reasons for business owners to purchase permanent insurance, which we will cover in a future article, but there are even more reasons when considering AAII. You can overfund a universal life insurance policy, allowing you to pay for the cost of insurance and build a side account with investments. You can structure the policy such that the death benefit is the face value of the policy plus the value of the investment account, which grows tax-free. For conservative investors, this is a no-brainer because even the interest that accrues in the investment account within a universal life policy is tax-free unless it is withdrawn. We should note here that you can access the investment account or cash value, but if and when you make a withdrawal, it is taxed as regular income, however there are other ways to gain liquidity without tapping into the cash. The strategies around universal life policies can be fairly complex, so it is imperative that you understand these kinds of policies before purchasing one.

Though the AAII rules were introduced to collect more tax revenue from successful businesses, there are many creative strategies you can utilize to protect your wealth, allowing more of it to grow and support your life once you retire. When the the government changes the rules, it becomes even more important to surround yourself with competent professionals to help strategize your next move.