Does the additional tax on investment income inside a corporation affect capital gains?

Yes. Capital gains earned inside a Canadian-controlled private corporation (CCPC) are subject to corporate tax, and the rules affecting investment income inside a CCPC have become more complex following federal tax policy changes aimed at limiting the use of corporations for passive investment accumulation.

When a CCPC earns investment income — including the taxable portion of capital gains — it is subject to a refundable tax that makes the overall corporate rate on investment income higher than it might appear. However, the corporation can recover a portion of this tax as a "refundable dividend tax on hand" (RDTOH) when it pays taxable dividends to shareholders. The system is designed so that the overall tax on corporate investment income, when combined with personal tax on dividends, roughly equals the personal rate on the same income earned directly.

Additionally, a CCPC's eligibility for the small business deduction (the preferential low tax rate on active business income up to a threshold) is reduced if the corporation earned more than a threshold amount of passive investment income in the prior year. Capital gains inside the corporation can erode the small business deduction available on active income in the following year.