Corporation – Page 3 – Doug Carroll

Securities commissions may be earned through a corporation, but it still depends on facts

At issue

Being able to earn income through a corporation has historically allowed for more flexibility as to how and when tax will apply to the income.

I say “historically” because we are in the midst of proposals from the current federal government that would significantly affect private corporation taxation. The focus there is not on whether the corporation can be used to earn the income, but on what happens to the assets of a corporation after it has legitimately earned it.

For advisors in the business of trading in securities, the first issue to resolve is whether commission income can be earned through a corporation at all. The CRA commented on this in a letter released in the summer of 2017, tying together its past commentaries in an effort to clarify its position on the issue.

IT-189R2 Corporations used by practicing members of professions

Last updated in 1991, this Interpretation Bulletin outlines the conditions under which professional practices may be incorporated. As a first condition, it will be allowed “unless provincial law or the regulatory body for the particular profession provides that only individuals may practice the profession.” Paraphrasing the second condition, it must be factually true that the corporation carries on the business.

The IT refers to professions “such as law, medicine, engineering, architecture or accounting.” Though it’s a short list, it does not rule out other professions qualifying.

Income Tax Technical News 22 (January 11, 2002)

This ITTN dealt with the more nuanced issue of whether commissioned income earned by an individual could be transferred to a corporation. CRA’s comments were prompted by the case of Wallsten v. R. 2001 DTC 215 that ruled in favour of the taxpayer, despite that Mr. Wallsten’s contract with Sun Life prohibited him from assigning his commissions to any third party, in this case his corporation. The case proceeded under the informal court procedure, and therefore had no binding precedent value.

In the ITTN CRA maintained its position that it was not bound by Wallsten. However, it accepted that if a given professional is “not otherwise precluded” from assigning income to a corporation, and if “the corporation is carrying on the business, then the commission income would be reported by the corporation.”

CRA 2017-0693761E5 (July 11, 2017)

The principal issue in this CRA letter is “whether an individual in the business of trading in securities can earn commission income through a corporation.” I’ve added the underline here to emphasize what is being asked, so you can compare against how it is answered.

The author reproduces the key extracts from IT-89R2 and ITTN-22, then ties them together in the concluding sentence:

“Whether a corporation is factually carrying on that business is a question of fact that must be determined on a case-by-case basis and in our view, requires more than a mere assignment of income.” [emphasis added]

Thus, the CRA will not give a blanket approval, harkening back to the factual foundation. At the same time, it does not say that assignment of income to the corporation is not possible, but rather that it is not sufficient on its own to enable the corporation to report it.

Practice points

Securities commissions cannot be earned by a corporation if that is forbidden by a provincial regulation, a governing professional body or a private business contract.
The corporation must be factually carrying on the business.
Assignment of commissions from an individual to a corporation may be acceptable, but that action alone will not suffice to allow the corporation to report the income.
Keep an eye on the current federal proposals regarding private corporation taxation, as this could affect longer term usefulness of a corporation, and thereby influence the decision to use a corporation in the first place.

New 33% tax bracket effect on passive income in private corporations

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

Professional corporations: Who, how and why?

Business owners have a few options when choosing the legal structure for providing goods and services – most commonly sole proprietorships, partnerships and corporations.

Of those, a corporation is clearly distinguished as a separate legal entity from those who own and operate it. This opens the door to potential tax advantages, enhanced creditor protection, extended business continuity and sharing of ownership. However, not every business is entitled to unbridled use of a corporation, particularly in the case of professional services.

The availability and constraints placed on “professional corporations” varies from one profession to another and across provinces. Navigating the rules can be challenging, but doing so will allow a professional to make an optimal decision on how to best structure a practice. This article outlines the key issues that are explored in greater depth in our Tax & Estate InfoPage titled Professional corporations.

Corporations, liability and malpractice

To repeat, a corporation is a separate legal entity from its owner/shareholders. To the extent that shareholders have not given guarantees, their personal exposure is generally capped at – or “limited” – to losing their initial investment.

This characteristic is also true of professional corporations in general business dealings, but there is no shield against malpractice claims. The professional remains personally responsible for the professional services and advice given, for which appropriate liability insurance is invariably required as a condition of the licence to practice.

Tax aspects of incorporation

Our tax system is set up so that roughly the same amount of tax is paid whether income is earned personally or through a corporation then paid as a dividend to a shareholder. The accompanying table illustrates how this integration of corporate and personal taxation works.*

Professional income earned personally

Income $1,000
Personal tax (45%) ($450)
After-tax cash $550

Professional income earned by corporation

Income (A) $1,000
Corporate tax (15.3%) (B) ($153)
Net income $847
Dividend to shareholder $847
Gross-up (18% rate) $153
Taxable dividend $1,000
Personal tax (45%) ($450)
Dividend tax credit $153
Net personal tax (C) ($297)
After-tax cash (A – B – C $550

* Model tax rates are used for illustration purposes and rounded for ease of display. Actual rates will vary by province, but there is no material difference in the comparative after-tax cash, being on average less than a quarter of a percentage point across the provinces.

Still, the use of a corporation may enable both tax savings and tax deferral.

Simply put, tax savings arise where the rate of tax is lower than would otherwise apply. Personal tax rates for an unincorporated professional may be 50% or more depending on province, whereas the corporate small business tax rate ranges from 11% to 19%. Comparatively, a corporation will usually have significantly more to reinvest in building the business than will an unincorporated professional.

Tax deferral is the ability to push taxation to a later point in time. If the professional does not need all the earnings of the business for current personal needs, the excess could be left in the corporation, thereby deferring tax otherwise applying to a dividend. That excess may be invested by the corporation (though some professions are limited in this respect), with the earnings and originally invested principal paid out as dividends when desired in future.

As you may expect, the actual tax operation of a corporation is more complex than this high-level outline. Our Tax & Estate InfoPage titled Illustrated corporate-personal tax integration explains these concepts step by step, and our Tax & Estate InfoCard titled Personal and corporate tax integration – 2015 summarizes the current effective rates by province and income type.

Qualifying professionals and shareholders

To one degree or another, incorporation is available to the traditional professions: accountants, doctors, dentists, engineers and lawyers. As well, those who provide services subject to provincial licencing are often able to incorporate, for example in health care support and a variety of financial services. Normally this is achieved through a combination of a provincial regulation and a bylaw passed by the particular profession’s governing body.

Beyond the professional personally, other individuals may also be allowed as shareholders, though without voting control. At the least, that usually means a spouse and children, but it may extend to parents, siblings, other blood relatives and possibly beyond. Those other shareholders will be able to receive dividends and may be entitled to some amount of the proceeds of the future sale of the practice.

Our Tax & Estate InfoPage titled Professional corporation – Shareholder rules 2015 provides details on who can incorporate, who can be shareholders and what restrictions may apply to operation and ownership.