No doubt there was disappointment in the business quarter when the 2016 Federal Budget held the small business corporate tax rate at 10.5%. It was scheduled to decline by half points to reach 9% in 2019. Taking an optimistic view, this may only be a reflective pause, given that the Liberal government had earlier stated its intention to reduce the rate to that level. We shall see.
The news is even less rosy for those same business owners when considering the implications of the new 33% top bracket tax rate that was ushered in with the “middle class tax cut.” Not only will this new rate apply to personal income over $200,000, it also affects passive income inside their corporations. And the impact could be most costly to the smallest of those small business owners if they fail to adjust how they manage their corporate investments.
Corporate-personal tax integration
The proper functioning of our tax system is based in part on the integration of personal and corporate taxes. Absent such a coordinated approach, the use of a private corporation – especially a Canadian-controlled private corporation (CCPC) that uses the small business tax rate – could lead to unintended tax benefits or unfair tax costs.
Integration is carried out using a number of mechanisms at the corporate level and on passing income from corporation to individual as shareholder. Business owners would have some familiarity with integration when they think of the following two-stage process of how their dividends are taxed:
- The grossed-up dividend is the amount used to calculate the shareholder’s initial tax due as if he or she had earned the income out of which the corporation paid the dividend
- This initial amount is reduced by the dividend tax credit (representing the tax revenue the Canada Revenue Agency (CRA) already collected from the corporation) to arrive at the shareholder’s net tax bill
Tax system’s response to passive corporate income
While the gross-up/tax-credit process applies on a dividend distribution from corporation to individual, there remains the matter of how to deal with undistributed income.
When that income is reinvested to generate more business income, there is no problem from a tax policy perspective. Indeed, one of the main purposes of the small business rate (which is actually in the form of a deduction from the general corporate rate) is to enable greater reinvestment and business growth than would otherwise be the case if a higher tax rate applied, whether the business was run as a sole proprietorship or through a corporation.
But where excess corporate cash is not going back into operations and instead placed into portfolio investments, a problem arises. As only the corporate portion of the ultimate tax bill has yet been paid, more cash is being passively invested than would be possible in the shareholder’s hands. As the small business rate is intended as a business booster and not a portfolio bonus, the tax system’s answer is to impose a tax cost that emulates the corporation as a top-bracket personal taxpayer. In a sense, it is the reverse of the gross-up on dividends, but in a much more complex way.
Integration mechanisms, 2016 and beyond
Not only is a CCPC not entitled to use the small business deduction on its investment income, but it also faces an additional tax on that income, specifically the Part I refundable tax. This is tracked in the corporation’s tax records as refundable dividend tax on hand (RDTOH), a portion of which is refunded from the CRA to the corporation when taxable dividends are paid to shareholders. However, Canada-sourced dividends are subject to a different rate as Part IV tax, all of which is refundable. On the other hand, foreign dividends are given a reduced RDTOH credit.
Suffice it to say, there are a lot of moving parts, the full details of which are beyond the scope of this brief article. As to the changes, the increase in the top personal tax rate from 29% to 33% necessitates adjustments to these integration mechanisms, the clearest illustration being the four-percentage-point increase in the Part I refundable tax. The rest of the changes are produced here for reference, without getting into the underlying calculations.
Taken together, the changes make it a bit more punitive to earn investment income in a CCPC beginning in 2016. A shareholder whose personal income tax bracket is below $200,000 should take particular note, and perhaps consider adjusting how and when income is taken out of a corporation. And for all affected corporations, a closer look at the tax efficiency of investment choices in corporate accounts may be in order, to explore if and how exposure to RDTOH may be mitigated.
TABLE: Corporate-personal integration mechanisms
