Tag: Integration

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. 

Paying small business corporation dividends – Federal budget may be a call to action

One of the surprises in this year’s Federal Budget was the announced increase in the small business deduction for corporations.  Or in more common language, the small business tax rate is coming down.

This will be welcome news to small business owners who will benefit from being able to reinvest more of their after-tax dollars within their corporations.  While this is a win in the context of required reinvestment for business purposes, the effect is not so clear where it is a discretionary decision to forego dividends and invest to earn passive income.

And beyond that, this development could cause a reconsideration of existing investment accounts held at the corporate level.  Continuing to hold these funds in the corporation could result in the shareholder paying up to 2% more if dividends are delayed beyond this year.

Small business tax adjustments

The small business rate on the first $500,000 per year of qualifying active business income of a Canadian-controlled private corporation (CCPC) is going down from 11% to 9%.  The reduction will be implemented in half-percentage point in stages from 2016 to 2019.

In turn, corporate income that has benefited from the small business rate is treated as a non-eligible Canadian dividend when paid out to the shareholder.  To maintain balance for the integration of corporate and personal taxes, the gross-up and dividend tax credit (DTC) for non-eligible dividends will also be adjusted. (See table.)

These are changes at the federal level.  However, as the same gross-up is applied when calculating the shareholder’s provincial tax on the dividend, one would expect provinces to adjust their dividend credit rates accordingly.

Federal small business tax adjustments

                                                      2015        2016        2017        2018        2019

Small business rate              11%      10.5%        10%        9.5%          9%

Gross-up                                 18%         17%        17%         16%        15%

DTC                                            11%      10.5%       10%         9.5%         9%


Implications for dividend policies

In a given year, a shareholder (as director) may declare a dividend out of retained earnings, or continue to retain such funds in the corporation.  All else being equal (so the saying goes), the shareholder portion of income tax is deferred by retaining those funds corporately.  However, all else is not equal as we come into 2016 and roll through the next three years.

Consider a corporation that earns income in the current year, paying the 11% small business rate (focused on federal portion only).  On dividend of those funds in the current year, the DTC will be an equivalent of 11%.  However, if the dividend is delayed one year to 2016, the DTC will be the reduced 10.5%, meaning corporation and shareholder bear an extra 0.5% tax.  And of course that becomes as much as 2% if one delays to 2019.

This adds a wrinkle to the dividend/retention decision this year and in the next three years, though of course it is for the particular business owner to decide whether it is material. An obvious tradeoff arises if current dividends push the shareholder up through marginal tax brackets.

With respect to existing corporate investment accounts, the need for a decision is arguably more pressing.  This is retained money that has already paid its corporate tax, and has essentially been waiting to be subject to personal tax on dividend to shareholder.  As the corporate investments are likely part of eventual retirement, an early withdrawal may be undesirable, even in the face of this additional tax cost.   On the other hand, the reduction of the gross-up from 18% to eventually 15% will mean that later dividends will have less of a clawback effect on income tested benefits.

A thorough review will be necessary to determine the net effect on a given business owner.  And to repeat, it remains that person’s prerogative whether this is sufficiently material to take action.