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Ask the expert: How is investment income taxed in my Ontario holding company?


January 9th. 2015

Investment income is not taxed at the preferential small business rate of 15.5%.  Investment income can be broken down into three main categories:  interest, capital gains and dividends from Canadian publicly traded companies.  Each of these types of investment income is taxed differently with the result that it is taxed at rates higher than the 15.5% small business rate.  Unrealized gains on marketable securities are not taxed until they are disposed.

 

The income tax rules in Canada have been drafted in a way that attempts to achieve an integration of tax rates between corporations and individuals so that an investor is largely indifferent between investing corporately or in their individual name.  A key feature to achieving integration is a corporation’s refundable dividend tax on hand account (RDTOH).  A second feature is a notional account called the capital dividend account (CDA).  For the purposes of this article we are using 2014 income tax rates.

 

Interest and capital gains

Included in Appendix A is an illustration of the tax calculation on interest income and capital gains.  You will note that these are both similar with the difference being that only one-half of capital gains is taxable.

 

Interest income earned in a CCPC is taxed at 46.17%.  This compares reasonably to an Ontario taxpayer in the tax bracket between $136,271 and $150,000 in 2014 (46.41%).  Capital gains in a CCPC are taxed at half the rate of interest, or 23.08%.  This compares to an Ontario taxpayer in the same 2014 tax bracket at 23.20%.

 

Dividends

Dividends received from public Canadian companies are taxed under Part IV of the Income Tax Act at a flat rate of 33.33%.  You will also note in Appendix A that this tax is all absorbed into the corporation’s RDTOH account.  This compares unfavorably to an Ontario taxpayer in the same tax bracket who will pay tax at a 29.52% rate on eligible dividends.  Earning dividends in a CCPC therefore has a tax prepayment of 3.81% (33.33% - 29.52%).

 

Please note that eligible dividends are paid by corporations who designate them as such and who have not been permitted the benefit of the low rate of tax caused by the use of the small business deduction.  Eligible dividends are paid out of a notional account called the General Rate Income Pool (GRIP) that is tracked by corporations in their corporate tax filings.  Normally CCPCs earning under the $500,000 small business limit do not have GRIP balances and so therefore are only permitted to pay ineligible dividends.

 

To summarize, the taxes payable on investment income in a corporation are taxed at rates roughly equivalent to an Ontario taxpayer in the bracket of $136,271 to $150,000 in 2014.

 

Dividends paid out of the CCPC

At this point however, the after-tax proceeds have not been returned to the individual shareholder in the form of a dividend.  A taxable dividend paid to an Ontario taxpayer will be taxed as a non-eligible dividend at the rate of 36.45% or as an eligible dividend at the rate of 29.52% in the bracket of income between $136,271 and $150,000.

 

The payment of a dividend to an individual shareholder triggers a refund of corporate taxes out of the RDTOH account at the rate of $1 of tax for every $3 of dividends paid.

 

In the case of the Canadian public company dividends, if a CCPC receives $10,000 of eligible dividends in the year and pays the same $10,000 of eligible dividends to an Ontario individual shareholder, the corporate taxes are reduced to $nil ($3,333 of Part IV tax less a $3,333 RDTOH refund) and the shareholder pays tax at 29.52%.  In this case we have perfect integration in that corporate taxes are netted to $nil and only personal taxes are payable.  The receipt of eligible dividends are added to the company’s GRIP pool and then out again to the shareholder.

 

In the case of interest and capital gains, a refund out of the RDTOH account also happens when a taxable dividend is paid to a shareholder at the same $1 for $3 rate.  Let’s focus on the interest income since the mechanics for the capital gain are the same but at half the rate.

 

Interest earned in a CCPC of $10,000 is taxed at $4,617 leaving behind retained earnings or retained cash of $5,383.  The payment of an ineligible dividend of $5,383 will trigger a corporate tax refund from the RDTOH account of $1,794 ($5,383/3).  This further tax refund could then be paid as a further dividend to the shareholder of $1,794 triggering a further refund of $598 ($1,794/3).  You can see that this is a circular calculation and that if a corporation had other resources it could pay a taxable dividend of at least $8,001 (3 times the $2,667 RDTOH balance) and get the entire RDTOH balance refunded.

 

So if we can get all of the RDTOH refunded the net corporate tax rate on interest income is 19.50% (46.17% - 26.67%).  The tax on the net dividend of $8,050 to an individual shareholder in the same bracket is 36.45% or $2,934.  This gives us a combined tax rate of 48.84% on $10,000 of interest income.  This compares unfavorably to earning that interest income personally at a 46.41%.  Earning interest income in a CCPC therefore has a tax cost of 2.43% (48.84% - 46.41%).

 

The untaxed portion of capital gains may be paid tax-free to a shareholder out of the CDA account when a prescribed form (Form T2054) is filed with the CRA.

 

Summary

It is preferable to earn interest income personally to earning it in a CCPC and by extension capital gains when you compare rates in the $136,271 to $150,000 bracket.  Earning dividends in the corporation where they are distributed out to the shareholders results in no advantage or disadvantage.

 

 

 

 

 

 

 


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