Your Company – A User’s Guide Part 2 How Investment Income is Taxed
If you own your own Canadian Controlled Private Company (CCPC) (i.e. your own small incorporated business or holding company), you’re probably still trying to digest all the new tax changes enacted this January or penciled to come your way in January of 2019. The last change (for now, at least) occurred in the most recent Federal Budget this March and focuses on how passive income will be taxed in your CCPC going forward. While I will address the key changes from this March partially in this and mostly in other articles, the real problem is that many of us have no idea how this income was taxed in the first place. According, this makes it difficult to plan and strategize so you can make money work for you as efficiently as possible or to understand how the new rules might (or might not) affect you.
Due to all of this confusion, I want to go back to the basics and attempt to demystify the confusing blend of acronyms, rules and calculations that are small business taxation. In my last article, I tried to explain how active business income is taxed in your company and how the dividends it pays you are taxed personally. I even threw in some comments about something called “integration theory” (no, it still has nothing to do with the civil rights movement) and the government’s general goal of trying to put someone earning money from a corporation, whether they pay themselves with salary or with dividends, in the same position as a businessperson who decided not to incorporate but who earned the same amount.
In the hopes that my earlier effort has pushed ajar the doorway to enlightenment, today’s effort will try to turn this toehold into something far more substantial so that when your accountant throws a few acronyms your way, you can send a few back in his or her general direction and then say something witty about integration theory. There is no way I can say all that needs to be said in one article, so stay tuned for articles that will hopefully fill in the cracks one piece at a time until you hopefully know so much that you feel like an amateur accountant without the pocket protector.
Like last time, all tax rates and thresholds in this article will be based on British Columbia law. The numbers will differ from province to province, but the general principles remain the same whether you live in St John’s, Newfoundland or Fort St. John, British Columbia.
The Taxation of Passive vs. Active Income – Why Different Rules for Different Types of Income?
Unfortunately, there are a lot of different rules and rates for passive income compared to active business income. This makes sense because the government has a different game plan in mind for how they tax investment dollars earned inside a company. While the government is keen to give a break to entrepreneurs looking to reinvest money back into their business by keeping tax rates on business earnings low so there is more cash left to buy that new widget maker, they don’t want to reward you for instead investing leftover corporate profits into things like stocks and bonds. Although there will still be a lot more to reinvest in the stock market inside a CCPC that was only taxed at 12% than for a sole proprietor who may be taxed at as much as 49.7% (and even higher in provinces like Ontario where we’re looking at potentially 53.53% – gulp!), they want to try to level the playing field by making shareholders in a CCPC either pay tax on their investment earnings at a really high rate corporately (50.67% on interest in B.C., for example) or essentially forcing them to pay the money out of the CCPC as mostly as dividends, so the owners are taxed on them personally at their marginal tax rates. Either way, it’s about the government getting more tax dollars sooner.
The most recent budget takes this philosophy of limiting your ability to stockpile unused business profits in corporate investments rather than paying it as you earn it one step further by penalizing CCPS who earn too much investment income starting in 2019. If your various CCPCs earn more than a combined $50,000 in passive income (i.e. income from things like the total of net rental income from most investment properties, investment interest, investment dividends and the taxable 50% of capital gains from non-business assets) in a single tax year, less of your active business income qualifies for the 12% small business rate. Every dollar over this threshold will reduce the amount of income that can be taxed at 12% by five dollars.
Thus, instead of getting the first $500,000 of active business income taxed at 12%, someone with more than $150,000 in passive income will have all of their active business income for that year taxed at 27%. As you can see from the chart in my last article, the business owner will get most of the extra tax paid up front back by paying less on the eligible dividends s/he receives when this money is paid out of the company that are more tax-friendly than the small business or ineligible dividends they would receive on money that was first taxed at the 12% rate. On the other hand, if the business owner wants to reinvest the money corporately, they won’t have as much to put into stocks and bonds after paying corporate tax at 27% instead of 12%. As a result, the CCPC owner will lose some of the tax deferral advantage s/he has over those of us who haven’t incorporated but have extra profits left to invest in the stock market. They may still be in a better position than their incorporated friends who might have less than 50% of their excess income to salt away for the future, but the gap won’t be as wide going forward.
Dividends Paid from your Company Derived from Investment Income and Business Income
When trying to wrap your head around the difference between how corporate business and investment dollars are taxed, the good new is that three types of dividends generated by your CCPC are the same regardless of how the money was earned in the first place. Thus, it doesn’t matter to the taxpayer if s/he receives their small business, eligible or capital dividends from money originally generated from business activities or from investment dollars, as their dividend dollars will be taxed identically in their hands. The CCPC simply declares what type of dividend it is paying out and the recipient will be taxed accordingly, regardless of whether that dividend originated from business profits or from investment prowess.
The bad news is that there are a lot more moving parts regarding how investments taxed corporately before your CCPC can gets to the point where it can pay you dividends. Even though it won’t make a difference to the shareholder (other than determining the size of the dividend cheque) whether the dividends came from business or investment income, it will make a big difference to the CCPC not only as to whether it was investment vs business income, but also whether the money was originally dividends from Canadian investments, interest or similar types of income, return of capital or capital gains. These different types of income are taxed in different ways and at different rates.
As a result, how the CCPC earns its investment dollars will still have a huge impact on its shareholders, as the more tax paid on the money corporately, the less cash that will be left over to pay its shareholders dividends. Furthermore, the type of investment income earned inside the CCPC will determine what mix of dividend income it can pay out and, ultimately, how much of these dividend dollars the shareholder will be able to keep after taxes, since not all dividends are taxed the same and different types of investments produce different types of dividends.
Building on this last point, as you found out the hard way in my last article, CCPCs can pay out three different types of dividends, each of which produces different tax consequences. I’ll touch on these again in this article for those of you who need a refresher. I’ll provide a basic recap here, focusing on just how these types of dividends can be produced from investments but do remember that business earnings can also generate these types of dividends as well.
With no further ado, the three types of dividends you might receive from your CCPC from its investment portfolio are:
- “Capital Dividends”, which are tax-free to the recipients. They are generated from the 50% of any capital gains realized inside the company minus realized capital losses. As well, some to all of the death benefits of any life insurance policies earned inside the CCPC generate these tax-free dividends. Your company might own life insurance for business or investment purposes, but this won’t affect how much of the death benefit can be paid out tax-free to shareholders.
- “Eligible Dividends”, which are taxable in your hands, but provide an enhanced dividend tax credit which ultimately means that recipients in the lowest brackets might actually get money back from the government. For example, someone earning $30,000 in British Columbia who receives another $100 in eligible dividends would actually have $106.84 in their back pocket, or an extra $6.84 in bonus loot above the actual amount of the dividend. Those in higher tax brackets, however, might only get to keep as little as $71.32 of their $100 dividend cheque when the dust settles. Eligible dividends paid from a CCPC are taxed in the same way as eligible dividends paid directly to investors who own things like Canadian bank stocks in their non-registered accounts. This makes a lot of sense because eligible dividends paid out by a CCPC from investments come from the eligible dividends it receives from its own investments. In other words, for every dollar in eligible dividends your company receives from its own investments, your CCPC can pay out that same dollar in eligible dividends to its own shareholders, where it will be taxed in the same way as if they’d earned it directly from personally held investments.
- “Ineligible” or “small business dividends.” In a nutshell, any type of investment income generated inside a CCPC that can’t be paid out as a Capital or eligible dividend has to get paid out as an Ineligible or small business dividend (excluding rare circumstances when it gets paid out as a salary or bonus or is used to pay down shareholder loans owing to that shareholder). For example, interest, U.S. dividends, return of capital payments, royalty and rental income, net of expenses would all need to be paid out as ineligible dividends. People getting ineligible dividends do get a tax credit that reduces the amount of tax they would otherwise have to pay on the money personally, but it’s not nearly as generous as an eligible dividend. For example, the same Vancouverite receiving $100 in ineligible dividends who otherwise made $30,000 this year would only get to keep $90.23, while his tennis partner who is in the highest tax bracket would keep only $56.30 after taxes.
Although there is a lot more information to come, this is as good a place to stop for today. If you can now identify each of the three types of dividends you might receive from your CCPC and understand how they are or, in the case of capital dividends, are not taxed in your hands, I will consider myself a happy man. If you’re clear that any of the three types of dividends might be generated by either investment or business income, or a mix of the two, then even better. If you can also talk about why our corporate tax system is designed as it and how earning too many passive investment dollars might impact how your active business income will be taxed as of next year, I will be over the moon.
Next time, I will focus on how different type of investment earnings are taxed corporately so you can better understand how much you will have left to reinvest or pay out. Even more importantly, I’ll talk about how many of those dollars you will get to keep when you receive dividend payments from your company and compare where you’d be after taxes if you invest corporately or personally. My goal is to give you enough information so you can ultimately make an informed choice regarding how to allocate investments among your personal, registered and corporate accounts in order to make your money go as far as possible. As I love to remind clients, it’s not what you make, but what you keep after the tax man has come and gone that really matters.