This article is from the quarterly Canadian Overview, a newsletter produced by the Canadian member firms of Moore Stephens North America. These articles are meant to pursue our mission of being the best partner in your success by keeping you aware of the latest business news.
The Canadian taxation system is structured so that investment income (such as interest income and rental income) earned in a corporation would be taxed at the same rate as investment income earned personally (at the highest tax rate). The way in which the system works is that a corporation pays tax on its investment income and at the same time a portion of the taxes (30 2/3%) notionally goes into an account called the refundable dividend tax on hand (“RDTOH”). The RDTOH is refundable to the corporation for each dollar of taxable dividend paid at a ratio of 38 1/3% of taxable dividends paid. The result of this approach is that a corporation does not provide for a tax deferral on investment income. Instead, there is corporate tax immediately on the investment income and a portion of that will be refunded once a taxable dividend has been paid out.
In Ontario, the highest personal tax rate is 53.53%. In a corporation, investment income is taxed at 50.17%. When the RDTOH is refunded upon the payment of a dividend, the net tax in the corporation is 19.50% (50.17-30.67%). This does mean that there is a small deferral by earning investment income in the corporation. The deferral is 3.36% (53.53% - 50.17%).
When a non-eligible taxable dividend is received by an individual and taxed at the highest rate, the tax rate to the individual is 46.65% in Ontario. Based on this, the personal tax on the funds available would be approximately 37.6% (46.65% x $80.50) . The net effect is that the overall tax rate including corporate and personal tax on earning investment income is 57.2%. This is 3.68% greater that earning the investment income directly (57.2% vs 53.53%).
For a capital gain, the cost of earning capital gains in a corporation versus directly is 1.84%. There is also a deferral in this case of 1.68%.
Based on this, what should taxpayers consider in determining whether they should earn investment income in the corporation or not? One of the first considerations is the cost of taking capital out of a company in order to earn the investment income personally. In other words, if a corporation has accumulated retained earnings, there is a cost to taking that capital out. The cost would be the dividend tax rate of 46.84%. In most cases, it is not efficient to accelerate the payment of personal tax on these accumulated retained earnings in order to reduce the corporate tax on the investment income on that capital. As well, if there are accrued gains on the capital in the corporation, there would also be a capital gains tax on the liquidation of any assets with accumulated gains. Therefore, in most situations where there is significant accumulated capital in a corporation, it does not make sense to wind up the corporation or liquidate the assets so that the assets are held personally.
Another consideration is the new rules wherein if a corporation earns more than $50,000 of adjusted aggregate investment income then the corporation will start to lose the small business deduction. This is only relevant in those situations where the corporation earning investment income has either active business income in the same corporation or active business income as part of an associated group. In those cases, consideration should be made as to whether or not the after-tax funds of the active business income should be left in the corporation or should be paid out as a dividend so that the capital can be used to earn investment income personally instead of in the corporation. Again, consideration must be given to the fact that there is an acceleration of personal income tax. Where active business income is earned in a corporation, the tax rate is 13.50%. This means that there is $87.50 available to be invested and earn investment income. If the funds are fully paid out, the net result would be capital available of approximately $46.00 personally. Obviously, from an investment perspective there is more capital available at the corporate level if a dividend is not paid out to the individual. However, by accumulating significant assets in the corporation, the corporation could lose access to the small business deduction and instead of paying 13.5% in the corporation, the corporation would pay 26.5% on active business income.
The next consideration is whether assets or funds should be put into a corporation to earn investment income. For example, if an individual is going to make an investment, should that individual first put the funds into a corporation and then make the investment. From a purely tax perspective, it is not beneficial to take personal funds to invest in a corporation to earn investment income because the investment income will be taxed overall at a higher rate (3.7%).
The above tax rates assume that the individuals receiving the dividends will always be in the highest tax bracket. However, if you are not in the highest tax bracket when you receive the dividends, the tax deferral can become a permanent tax savings.
However, there may be non-tax reasons, such as liability, why an individual would want to use a corporation to make the investment. For example, there was a rental property and there was concern for operational liability, a corporation might be considered. This would be a business decision.
Another consideration is U.S. estate tax. Individuals that own U.S. investments and assets personally could be subject to U.S. estate tax. At present, the estate tax exemption is over $US11m, so the exposure for most people is minimal. This, however, could change as there have been a number of different exemptions over the last few years. In order to be protected, one consideration is to own U.S. investments through a Canadian corporation as opposed to personally. There may be increased taxation on the investment income but there is reduced or eliminated exposure to U.S. estate taxes.
A final consideration is probate in Ontario. If assets are held personally, then there is exposure to Ontario probate tax of 1.5% (on assets in excess of $50,000). If, however, assets are held in a corporation, there is the opportunity that the shares held in that corporation are not subject to probate if the individual has dual Wills (the discussion of dual Wills is beyond the subject matter of this article). By holding assets in a corporation there could be a 1.5% savings on the capital of the corporation even though there may be increased tax on the investment income.
As you can see from the above, there are a number of considerations to determine if investment income should be earned in a corporation of not. As always, you should consult your tax advisor to determine the best course.
Contributed by
Howard Wasserman, CPA, CA, CFP, TEP, Principal in Taxation at Segal LLP. This piece was produced as a part of the quarterly Canadian Overview, a newsletter produced by the Canadian member firms of Moore Stephens North America.