Tag: Corporation

Tax on dividends rising – Changes for small business owners

Small business owners will generally be paying a little more on the dividends they extract from their corporations beginning in 2014.  

In the 2013 federal budget, the government expressed its concern that individuals were being over-compensated by receiving dividends from a corporation than if the individual had earned that income personally.  Changes were proposed, and now enacted, in an effort to bring the system of integrating corporate and personal taxes back into alignment. 

To be more precise, these changes target corporate income that has made use of the small business deduction.  Previous changes had already addressed corporate income that had been subject to the full corporate tax rates – the so-called eligible dividend regime introduced in 2006 and rolled-out over the following six years.

Ineligible dividends in 2014, and on

In our income tax system we have two main types of taxpayers: individuals and corporations. Despite that taxes are levied at the corporate level, ultimately those taxes are borne by individuals.  The dividend gross-up/tax-credit procedure accounts for previously paid corporate taxes when the shareholder/individual calculates personal taxes due.  

Since the introduction of the eligible dividend regime in 2006, the federal gross-up and tax credit rates on ineligible dividends had remained unchanged.  Beginning in 2014, the gross-up will change from 25% to 18%, and the federal tax credit will go from 2/3 to 13/18.  The provinces use the federal gross-up, so have been prompted to adjust their respective tax credit rates.  

Based on enacted and announced changes (and subject to potential change in upcoming 2014 budgets), this table shows the effective tax rate shareholders face at top bracket in each province:

Top bracket rates – Ineligible dividends
(Combined federal-provincial)

Province     2013      2014

BC            33.7%    38.0%
AB            27.7%    29.4%
SK            33.3%    34.2%
MB           39.1%    40.8%
ON*          32.6%    36.5%
QC            38.5%    39.8%
NB            33.0%    36.0%
NS            36.2%    39.1%
PE            38.6%    38.7%
NL           30.0%    31.0%

The other side of the story

In fairness to the tax authorities, these changes are not arbitrary.  They are designed to integrate with the actual small business rate that will have been used in calculating the original corporate income.   

In theory, an individual taxpayer should be indifferent about earning income personally, or through a corporation that then distributes to the individual.  This should hold true whether the distribution is in the form of salary to that person as an employee, or as a dividend to that person as shareholder/owner. 

In practice though, things had gotten a bit out of kilter, leading to a preference toward dividends in most provinces in recent years.  The effect of the changes will be to narrow the distinction between salary and dividends, and in some cases to slightly swing the pendulum past perfect integration and toward salary.  

Bearing in mind that these are not the only considerations in deciding on the salary/dividend mix, here is the starting point those owner/managers can use for that analysis:  

Tax savings or cost of using dividends
(A positive figure favours dividends)

Province    2013    2014

BC            1.0%    -0.6%
AB            1.2%    -0.3%
SK            2.0%     1.2%
MB            0.6%    -0.9%
ON*          3.4%     0.1%
QC            -0.3%   -1.3%
NB            1.6%     0.9%
NS            4.2%     2.1%
PE            1.4%     1.3%
NL           1.8%     0.9%

* Ontario is expressed at the top federal bracket rate, rather than the significantly higher Ontario rate of $500,000+. 

Corporate-owned life insurance – Tax keys for business needs

Most insurance advisors will have long and fulfilling careers operating almost entirely within the personal planning arena.  

For many though, the capability to service the business market may be seen as a useful complement or arguably a mandatory add-on to help build a moat around clients.  Still others might view that business market as their one true calling all on its own – and it certainly can be a financially rewarding calling to those who handle it well.

Whichever approach an advisor may take, informed needs analysis remains the core skill, often applied at an enhanced technical level, including a solid grounding in tax matters.

In the business context, determined needs may stand on their own, or they may be layered upon or be intertwined with personal needs.  This integration of business and personal needs can present both opportunities and challenges where the business is operated through a corporation, as is the preferred mode of operation for most growing businesses.  

Business needs framework

Though not exhaustive, these are the most common life insurance needs associated with a business:

Buy-sell funding … provides the financial means for a buy-out of a business on an unexpected death.  This paves the way for the timely payout to the deceased’s survivors, and smooth continuity of the enterprise for the continuing owners.  In the case of a corporation, it is most prudently documented in a binding shareholders’ agreement 

Key person protection … contributes capital to maintain the going concern value of the business on the loss of a key contributor.  Whether or not the deceased was an owner, the cash acts as a financial bridge until a suitable replacement can be found, or at least until operations can be stabilized.  It may also include an estimate of direct lost revenue and extraordinary expenses.

Estate tax liabilities … arise on deemed disposition of capital assets.  This applies to business interests generally, though qualifying small business corporation shares are entitled to make use of the $750,000 lifetime capital gains exemption (going up to $800,000 next year).  As well, the disposition related tax can be deferred if those capital assets are rolled to a surviving spouse. 

Income replacement … is a proxy for the lost income-earning capacity of a breadwinner to a household.  In effect, the insurance proceeds create a pool of wealth that can be drawn down over the time that the deceased would have otherwise contributed to the household.   Though unfortunately not physically present, the person is still there in financial spirit.

The first three of these needs are clearly commercial in nature, whereas income replacement is a personal need irrespective of the existence of any business.  The reason why this latter personal need is addressed here is that it is not uncommon for a business owner – and particularly a shareholder running a corporation – to wish to combine multiple insurance needs into a single contract, or at least to fund coverage at the corporate level. 

A careful review of the personal and business particulars is crucial to assure that such an approach does not compromise the availability of funds for each respective purpose at the appropriate time.  Assuming this passes muster, attention may turn to the tax implications of funding and receiving insurance through a corporation.

Corporate economics examined

To deal with a common misconception first, except in very isolated circumstances (none of which apply here), life insurance premiums are not tax-deductible for a corporation, no more than they would be for personally-owned life insurance.  

Even so, corporately-paid premiums are generally less costly than personally-paid premiums.  This is because the corporation can pay the premiums itself, or issue a dividend to the shareholder to pay the premiums personally.  Of course the shareholder will be taxed on the dividend, meaning less cash would be available for the purpose in those personal hands, thus requiring a larger dividend in order to net down to the required dollars for the premium cost.  

In turn, life insurance proceeds are a tax-free receipt to a beneficiary, whether that beneficiary is a corporation or an individual.  For a policy owned in a corporation, the corporation itself or a subsidiary corporation would be named as beneficiary; if not, the payment of the death benefit could give rise to a taxable shareholder benefit.  (Similarly, a shareholder benefit would apply if a corporation pays the premium on a policy owned by a shareholder.) 

Comforting though it is to know that a corporation receives insurance proceeds tax-free, even these business-based needs (except key person) still ultimately require the insurance proceeds to make it into personal hands to be most effective.  Fortunately, there is a mechanism that allows for the transfer of tax-free amounts received at the corporate level to make their way into shareholder hands, intact as tax-free amounts.  

A corporation’s capital dividend account or CDA keeps track of items such as life insurance proceeds and the non-taxable portion of capital gains.  Declared dividends to a shareholder will not be taxable if they are elected to come from the CDA, which consequently is reduced by the amount of such dividends.  This election may also apply to deemed dividends that occur when shares are redeemed, for example when a surviving spouse decides to wind up the corporation after the death of a business owner spouse.   

Appreciating the limits

Bear in mind that these are the fundamental tax issues underlying the corporate ownership of life insurance.  As one might expect, things can get much more complicated in practice, which is why conscientious due diligence is critical – both in terms of building ongoing technical expertise, and in clearly understanding the needs of the business and the individuals behind it.

Practical applications of corporate class mutual funds

Corporate class mutual funds have unique features that make them stand out from other investment options. Chief among the tax benefits of these features are the:

  • Ability to rebalance holdings within the corporation without triggering dispositions, due to the exchangeability of share classes at adjusted cost base; and
  • Expectation of lower current distributions, due to the netting of gains and losses across share classes under consolidated corporate accounting.

While these are key details for an advisor’s knowledge, seldom does a client explicitly request benefits or features, let alone ask for an asset class or particular product. Rather, clients view financial advisors as problem solvers: the client has a current concern or future expectation and looks to the advisor to resolve the issue or at the very least suggest options that assist in moving toward a satisfactory resolution.

With that in mind here are a few situations where an advisor may have the opportunity to discuss the merits of corporate class funds as an addition, alternative or complement to a client’s current condition or investment approach.

Personal annuities

An annuity can provide guaranteed lifetime income, the price being the commitment of a lump sum of capital. You can also purchase a guarantee in case you die early. So what’s the cost of betting against yourself on both ends?

It may provide a reality check to compare the annuity income against the drawdown of a continuing managed portfolio. In the RRSP world, a person can hedge expectations by allocating between the security of a registered annuity and the flexibility of a RRIF. Either way, all eventual flows are fully taxable.

For non-registered funds, the taxes are a little more complicated. Generally for personal annuities, each payment is a fixed proportion of non-taxable capital and fully taxable interest. By comparison, a systematic withdrawal out of a corporate class mutual fund yields both non-taxable capital and one-half taxable capital gains, with the taxable portion increasing over the years.

Using reasonable return assumptions, a comparison of those annuity flows against the projected draw from the mutual fund corporation can provide some context for the cost of those guarantees. Whether or not this review changes a client’s course, this type of analysis will assure a more fully informed decision.

Managing foreign dividends

In an article earlier this year (Fundamentals, March 2011: “Is home bias simply rational self-interest?”), I adverted to the interaction between foreign dividends and corporate class funds. I have had a few advisor conversations on the topic since then and thought this would be an appropriate place to flesh out those earlier comments.

Foreign dividends are treated as regular income, which from an investment perspective is the same rate applied to interest. Accordingly, a top-tax-bracket investor receiving foreign dividends faces a tax rate of nearly double the rate applicable to Canadian eligible dividends. The rate disparity is even more pronounced at lower brackets once the two-stage mechanics of the gross-up and tax credit procedure are applied.

Another possibility is for an investor to hold foreign interests through shares of a Canadian mutual fund corporation. Foreign dividends are income to the corporation itself, and the corporation can apply its expenses against that income to reduce its potential to pay taxes. The investor thus expects capital appreciation, with only one-half of eventual capital gains then being taxable.

Passive investments within private corporations

Private corporations may be entitled to a low tax rate on active business income, but passive investment income is subject to the full corporate rate plus a penalty tax. With their tax-deferral benefits and low distribution expectations, mutual fund corporation shares would be an ideal consideration for private corporations.

In terms of accessing the funds, a T-series overlay could be used to receive a greater amount of non-taxable return of capital in early years, deferring capital gains until later.

As corporations face flat taxation – as opposed to the graduated bracket treatment of individuals – the tax-deferral opportunity can therefore be particularly effective in the private corporation context.

For some numerical support on these examples and discussion of other practical uses of corporate class shares, you can view the replay of our recent webcast on the topic – and obtain continuing education credit in the process.