This article is taken from our quarterly overview of Canadian news, a newsletter published by the Canadian member firms of Moore Stephens North America. These articles are part of our mission to be your partner in success by keeping you informed.
The Canadian tax system is structured so that investment income (such as interest income and rental income) earned in a corporation is taxed at the same rate as personal investment income (the higher tax rate). The system works in such a way that a corporation pays tax on its investment income and, at the same time, a portion of that tax (30 2/3%) is notionally paid into an account called Refundable Dividend Tax on Hand (“RDTOH”). The RDTOH is refundable to the corporation at a rate of 38 1/3% for each dollar of taxable dividends paid. As a result, a corporation will no longer be able to defer taxes on investment income. Instead, investment income is immediately subject to corporate income tax, and a portion of this amount will be refunded once taxable dividends are paid.
In Ontario, the highest personal income tax rate is 53.53%. For a corporation, investment income is taxed at a rate of 50.17%. When the RDTOH is repaid on the payment of a dividend, the company’s net tax is 19.50% (50.17% – 30.67%). This means that investment income earned in a corporation can give rise to a small tax deferral. The carryover amounts to 3.36% (53.53% – 50.17%).
When an individual receives a non-eligible taxable dividend that is taxed at the highest rate, the tax rate for that individual is 46.65% in Ontario. Based on these figures, personal income tax on available funds would be approximately 37.6% (46.65% x $80.50). In the end, the overall tax rate, which includes corporate and personal income taxes, on earned investment income is 57.2%. This rate is 3.68% higher than the rate that would apply to directly earned investment income (57.2% vs. 53.53%).
For a capital gain, the cost of capital gains from a corporation, rather than direct gains, is 1.84%. A deferral of 1.68% is also permitted in this case.
Given these facts, what should taxpayers take into account when determining whether or not to earn investment income in the company? One of the first factors to consider is the cost of taking capital out of a company to earn personal investment income. In other words, if a company has accumulated retained earnings, a capital outflow will entail costs. This cost would correspond to a dividend tax rate of 46.84%. In most cases, accelerating the payment of personal income tax on these retained earnings to reduce the corporate tax rate on the investment income derived from this capital is not very effective. In addition, if gains are accumulated on the company’s capital, a capital gains tax will also have to be paid on the liquidation of assets with cumulative gains. As a result, in most cases, where there is a large amount of accumulated capital, there is no need to liquidate the company or the assets, so that they can be held personally.
The new rules also mean that if a company earns more than $50,000 in adjusted total investment income, it will no longer be able to claim the small business deduction. This is relevant only if the corporation earning investment income also has active business income in the same corporation or active business income as a member of an associated group. In such cases, it must be determined whether the after-tax funds from active business income should remain in the corporation or be paid out as dividends, so that the capital can be used to earn personal investment income, rather than in the corporation. Once again, we have to take into account the fact that the personal income tax deadline has been brought forward. The tax rate is 13.50% for active business income earned in a corporation. This means that $87.50 is available to invest and earn investment income. If the funds are fully disbursed, the net result is personal disposable capital of approximately $46.00. Obviously, from an investment point of view, there is more capital available within the company if no dividend is paid to the individual. However, if the corporation accumulates significant assets, it may no longer be able to take advantage of the small business deduction and, instead of paying tax at 13.5%, may have to pay tax at 26.5% on active business income.
You should also consider whether to put the assets or funds into a corporation to earn investment income. For example, if an individual makes an investment, does the individual have to put money into a company first, before making the investment? From a strictly tax perspective, it is not advantageous to use personal funds to invest in a company and generate investment income, because the investment income will be taxed at a higher rate (3.7%).
The above tax rates assume that individuals receiving dividends will always reach the highest tax bracket. However, if you don’t reach the top tax bracket when you receive dividends, the tax deferral can become a permanent tax savings.
However, there may be non-tax reasons, such as liability, why an individual may wish to use a corporation to make the investment. For example, in the case of a rental property involving operating liability, a company could be considered. This will be a corporate decision.
The U.S. estate tax is another factor. Individuals holding personal investments and assets in the U.S. may be subject to U.S. estate tax. At present, the estate tax exemption is US$11 million, so exposure is minimal for the vast majority of people. This situation could change, however, as there have been a number of different exemptions in recent years. To protect yourself, you can hold investments in the U.S. through a Canadian company, rather than on your own. The tax on investment income could be higher, but the U.S. estate tax would be reduced or eliminated.
A final factor to consider is Ontario certification. If the assets are held personally, then probate fees of 1.5% are charged in Ontario (on assets over $50,000). However, if the assets are held in a corporation, the shares held in the corporation may not be subject to probate if the individual has a double will (the issue of double wills is beyond the scope of this article). Holding assets in a company could result in a 1.5% saving on the company’s capital, even though taxes paid on investment income could increase.
As you can see above, there are a number of aspects to consider when determining whether or not investment income should be derived from a corporation. As always, you should consult a tax advisor to determine the optimal solution.
Written by Howard Wasserman, CPA, CA, CFP, TEP, Senior Tax Specialist with Segal LLP. This text was written as part of our quarterly overview of Canadian news, a newsletter published by the Canadian member firms of Moore Stephens North America.
