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Corporate Tax Integration for Shareholders & Business Owners in Canada
The theory behind corporate/shareholder integration for taxes in Canada is that there should be the same amount of tax paid on income earned through a corporation, having paid the corporate tax and then distributing the tax-paid corporate surplus by way of a dividend; as opposed to the individual earning the income directly or by having the corporation pay out all of its earnings in the form of a salary to the shareholder.
In effect, the Canadian tax system strives for “neutrality” and fairness, in order to avoid creating a tax preference for taxpayers who have structured their financial affairs in one particular manner, over another.
However, in reality, individual tax rates will vary depending on the provincial corporate and personal tax rates combined with the individual’s tax bracket. Perfect and equal integration is therefore only theoretical so there’s still some leeway for tax optimization for business owners.
Understanding the tax rates that apply to different forms of corporate income, and then also understanding how such income will be taxed in the hands of the individual shareholder, will enable the practitioner to utilize the mechanics of “integration” in order to optimize the tax results intelligently.
The following tables summarize current combined corporate and personal tax rates for selected provinces – demonstrating the difference between different tax integration scenarios.
Corporate integration also ensures that a taxpayer is not subject to double tax on a single source of income. For instance, if investment income, earned and tax-paid by a corporation, is subsequently distributed to an individual shareholder and subject again, to tax at the shareholder’s personal marginal tax rate, double tax could apply on the same, single source of income.
In order to prevent this from occurring, our tax system provides for a mechanism called RDTOH and it also afford a dividend tax credit (“DTC”) to the individual shareholder, so that the basis of a “neutral” tax system is maintained and corporate/personal tax integration is preserved.
Other than with SIBI, income earned in a Canadian corporation is generally always taxed at a rate that would be lower than the corresponding personal tax rate of the individual shareholder.
Consequently, earning income in a Canadian corporation provides the owner/shareholder, with an opportunity to defer taxes. If the income earned within the corporation is not required personally by the shareholder, a lower rate of tax can be paid on the income, if it is retained within the corporation. This principle is referred to as the “tax deferral concept”.
Now, let’s take a look at the tax deferral possibilities for Canadian companies. The deferral between corporate and personal tax will vary. This is because corporate tax rates in Canada vary significantly from province to province and the top personal individual tax rate for an individual will similarly vary from province to province. The benefit of deferring tax on ABI, eligible for the SBD is substantial in all Canadian provinces.
Tax deferral is an effective way for a corporation earning ABI eligible for the SBD to accumulate tax-paid capital and to re-invest in business operations to facilitate growth. In comparison to earning business income on an unincorporated basis, the corporation is an overwhelmingly greater tax-efficient vehicle.
Tax deferral can still be enjoyed at the corporate level for ABI earned on income not eligible for the SBD. Such income is taxable at the higher general corporate tax rate and is included in the corporation’s general rate index pool (“GRIP”).
While the tax deferral (or differential) is not as great for ABI subject to the high rate of corporate tax, as compared to ABI subject to the SBD, the deferral still warrants having such income taxed within the corporation if there is not an immediate requirement for the surplus to be paid out to the shareholder personally.
While there is an ultimate overall tax cost to retaining such “high-rate” corporate income, the tax deferred surplus can be corporately re-invested and should, over a period of time, compensate for the fact that a slightly higher aggregate tax is paid by retaining the funds within the corporation.
A dividend paid from this surplus is taxable to the individual on a grossed-up basis as a dividend, and a DTC is given to the individual taxpayer to offset corporate taxes already paid.
ABI which is eligible for the SBD is taxed at the lowest corporate rate. Consequently, when this type of surplus is distributed to an individual shareholder, it is taxed as a dividend, other than an eligible dividend. The personal marginal tax rates on such “non-eligible” dividends are higher than the personal marginal tax rates on eligible dividends, in order to integrate the overall taxes paid by both the corporation and the individual, with the theory of attaining a “tax neutral” result.
A dividend paid form this surplus is taxable to the individual as an “eligible dividend”, with a gross-up factor and a DTC greater than a dividend paid out of “low-rate” corporate surplus. Since the corporation would have paid a higher rate of corporate tax on this type of surplus, the effective tax rate on the dividend, in the hands of the individual shareholder is lower than compared to a dividend, other than an eligible dividend.
A dividend paid from this surplus is taxable to the individual as a dividend (other than an eligible dividend). However, because the corporation would have paid a very high tax rate on this type of income, the RDTOH created on this source of income would be refunded to the corporation, thereby lowering its effective overall rate of tax. Therefore, on an integrated basis, tax neutrality is maintained.
A dividend paid from this type of surplus is accorded a special tax treatment. One-half of the net taxable capital gain reported by a corporation is added to its capital dividend account (CDA) so that the CDA can be paid out on a tax-free basis to the shareholder. Because only ½ of a capital gain is subject to tax (whether earned by a corporation or an individual), the CDA becomes a useful mechanism, by which the corporation can distribute the tax-free portion to the recipient. By using this mechanism, the recipient shareholder is not adversely affected by having to pay tax to extract that surplus from the corporation.
The taxable portion of the capital gain is taxed as SIBI within the corporation, and the same fundamental principles of integration as other SIBI income apply when this surplus is then distributed. That is, the RDTOH which accrues to the corporation on net taxable capital gains, will be refunded on the payment of a taxable dividend to the shareholder.
At the end of the day, it really comes down to one thing – arranging the financial affairs of our corporate clientele to their best overall advantage by reducing the tax bite.
Integration means combining the tax effects of the Canadian corporation together with the personal tax return in order to retain as much wealth as possible and optimizing the tax implications within the permissible framework of the legislation.
A corporation offers the tax specialist a separate legal entity, taxed as a separate entity, to assist in controlling;
Including the use of a Canadian corporation into the tax planning and wealth building activities of the client gives the tax specialist another tool in the never ending quest to reduce the tax bite to the lowest possible amount while respecting the framework of the Canadian tax legislation.
We can assist you with arranging your corporate financial affairs and determining the best solutions for your Small Business in White Rock, Langley or Surrey, BC. Here at Green Quarter Consulting - Accounting and Bookkeeping Services for Small Businesses in White Rock South Surrey, Langley and Surrey BC, we navigate Small Business Owners with analyzing transactions, sources of income and your tax risks and how they relate to your business strategy.