Corporate Investment Income: Navigating the Rules of the Tax Game
If you’ve made it through my first two articles, you’ve hopefully learned a few important things about how Canadian-Controlled Private Companies (“CCPCs”) are taxed. My first article talks about how profits from an active business are taxed inside your operating company, whether you take it salary, dividends or keep it in your company for a rainy day, showing how unincorporated and corporate business owners pay a similar amount of tax if withdrawing each year’s profits as they go in their own names. It also explains, on the other hand, why business owners who incorporate can still be far better off than their sole proprietor pals if they have excess earnings that they can spend inside their business to grow their earnings or to invest in the stock market.
My second effort began the discussion regarding how this extra dough you’ve set aside for the future gets taxed when it’s invested in the stock market rather than spent growing your active business. Key points include the fact that you pay a lot more tax corporately on investment dollars than you do when your CCPC turns a profit selling widgets, that a bunch of this tax is refundable, and that your company can pay you both eligible and small business dividends from both investment and business income.
Today’s offering attempts to talk about each of the three main types of investment income you might earn corporately and how they get taxed first in your company’s hands and then in yours when making withdrawals from the corporate coffers. I then try to tie these together so you can ultimately get an idea of how much money you’d actually get to keep for groceries or to fund luxury vacations after you and your company have both paid their share of the tax bill. Not only is this vital for budgeting and tax planning – knowing how much of each type of investment income stays in your own hands net of taxes can help guide your investment decisions as well. When looking at investments, I’m far less interested in my raw rate of return than how much I get to keep after I’ve made the tax man happy!
To apply the information in this article to your own situation, you’ll need to use the corporate and personal tax rates for your province of choice. Here are a couple links to get you started. The examples I use in this article use British Columbia rates as of July 2018:
When your company owns investments that pay out eligible dividends from publicly-traded Canadian companies, which I’ll call “portfolio dividends” to distinguish them from the eligible capital and small business / ineligible dividends that your company pays out to you, things look pretty bad at first glance – there are potentially three levels of tax paid on the same dividend dollar that might leave you wondering at first glance why you didn’t just pay it all to the government in the first place. When the dust settles, however, things work out pretty well – ultimately, if your company passes along all the portfolio dividends it receives each year, its’ shareholders will be left with as about as much post-tax dollars as they’d have if they’d earned these portfolio dividends directly. In fact, families that can still income-split corporate money under the new rules, might be substantially better off than an family where the money is taxed in the hands of single investor!
First the bad news. Assume your CCPC owns shares in RBC and gets a cheque for $73 in eligible dividends. In order to write this cheque, RBC would have had to earn about $100 before tax at 27% to be left with $73 to pay out to your company. Your CPP then pays 38.33% on this $73. And, if you’re in the highest personal tax bracket, you may need to pay another 34.2% or more on the eligible dividend your company passes along to you! At first blush, some of you doing some quick math might gasp in horror when you realize that these rates total about 99.5%!
Now for the silver lining, and it is a big one and has many parts – the 38.33% tax charged in the company is totally refundable if the company pays out as many eligible dividends to shareholders as it receives in portfolio dividends. Put differently, this 38.33% tax charged to your company is more like an interest-free loan to the government that is designed to encourage you to pay out portfolio dividends when you earn them rather than reinvesting them corporately. Although you can still keep the money in the company if you want (and might, such as if you think might be able to pay them out in later years when you expect to be in a substantially lower tax bracket) your company will be out of pocket the 38.33% tax the meantime and won’t earn any interest on it. Any of this refundable tax still owing to your company is tracked by your accountant in a notional account known as the Eligible Refundable Dividend Tax on Hand or “ERDTOH”. At the same time, your accountant will also track how many eligible dividends your company can pay out in the future to recapture these tax dollars.
Just as importantly, the 34.2% rate you might have to pay personally is charged against only the $73 you actually received rather than the $100 actually received by RBC in the first place. Thus, think of it as a 24.966% tax on the original $100, which sounds a lot better than 34.2% tax on what you actually receive. Finally, I’ve picked a taxpayer in the highest tax bracket, which is a bit north of $200,000 in taxable income per year in B.C. For people in lower tax brackets, the rates are far less. In fact, someone in B.C. in the lowest tax bracket ($39,676 or less) would actually get a tax refundof $4.99 on that $73 dividend. For these taxpayers, they would get to keep almost 78% of the original $100 earned by RBC after pocketing their tax refund!
For those of you wondering about why these low-income taxpayers are getting a refund, I suggest reviewing my earlier article discussing how business income is taxed, as the same principals apply. Ultimately, any shareholder getting $73 in eligible dividends from the company will be taxed on $100 (i.e. the actual amount received of $73 is “grossed up” by 38% more than it really receives so the taxpayer is taxed on the original $100 received by RBC). They then get a tax credit for a good portion of the $27 tax already paid on that money by RBC, which is more than low income earners would have paid if they’d earned $100 in business income directly, thus entitling them to a refund.
To make life slightly simpler for the rest of the article, I’ll just use the effective tax rate on the actual amounts of dividends received rather than going through the more detailed calculation. In other words, I will use a short-form method of calculating the tax bill that just focuses on the tax rate charged against the actual dividend you receive rather than going through the “gross up” calculations, calculating the tax bill at that marginal tax rate as income and then applying the dividend tax credit. Again, read my earlier article if you’re a glutton for punishment and want to do things the hard way.
Finally, although my example assumes RBC originally earned $100 and a $73 portfolio dividend payment, my calculations below will assume that your company receives $100 which would have required RBC to earn about $136.98 before taxes to generate that larger payout. I needed to use the $73 dividend example to show you how our tax system works. Now, I need to use a $100 dividend example to provide a fair comparison to how much of that you’d get to keep when earning $100 in portfolio dividends compared to $100 in interest or capital gains.
Summary: If your CCPC earns $100 in portfolio dividends, it will be taxed on this amount at 38.33% for a corporate tax bill of $38.33 unless it pays out $100 in taxable dividends that year. The entire $38.33 is credited to the ERDTOH Account and is recouped when your company pays out $100 in taxable dividends ($38.33 x 2.61).
For someone in B.C. making $100,000, their tax bill on $100 in eligible dividends is $18.31 based on a 18.31% tax rate on the actual eligible dividends received. Thus, after receiving their tax refund in recognition to the tax already paid on the $100 by RBC, the tax payer pockets $80.85 (or slightly less because I did some rounding on the corporate calculations) after his personal and company tax bill.
Comparison: If the shareholder instead received $100 in eligible dividends directly from RBC while earning $100,000, he would get to keep $80.85, which is about the same, ignoring rounding, as if the portfolio dividend had been earned by the company instead and paid out to him as an eligible dividend.
The tax for interest income inside a CCPC is calculated in a different way than for portfolio dividends, although there are several similarities. The tax rate is a disconcerting 50.67% but, like for portfolio dividends, a good portion of this tax is refunded when it pays out small business / ineligible dividends to shareholders. Note: until next year, you can also get back the refundable portion of your interest dollars even when paying out more tax-friendly eligible dividends generated from business income taxed at 27%.
Going forward, the refundable portion of the tax paid on interest, rental income and the taxable portion of capital gains, etc. will be tracked by your accountant and your friends at the CRA in another notional account called the Ineligible Refundable Dividend Tax on Hand or “NRDTOH” Account. For now, both this account and the ERDTOH account discussed previously are combined to form a single RDTOH account.
To recapture the refundable tax paid to the government, your company will need to pay out 2.61 times the amount of tax owing to it in ineligible dividends. Put another way, it gets back $1 in the money owing to it for every $2.61 it pays out in ineligible dividends. Unfortunately, while people receiving the ineligible dividends do get a tax credit they can use to reduce their personal tax bill owing on this money, it is not nearly as attractive as the tax credit earned on eligible dividends.
Perhaps more unpleasantly, there is another big difference between how portfolio dividends and interest income etc. get taxed inside your company. While you can get back all of the 38.33% tax paid on portfolio dividends, your CCPC will probably be out about 20% of its interest earnings even after recouping the refundable portion. Thus, of the $50.67 tax bill otherwise owing by your company on each $100 in interest, only $30.67 is refundable.
Summary: If your CCPC earns $100 in interest income next year, it will be initially left with $49.33 after taxes, unless it pays out lots of ineligible dividends to its shareholders. Of the $50.67 paid in taxes, $30.67 is refundable and is credited to the NRDTOH Account. If the company pays out about $80in eligible dividends ($30.67 x 2.61), it gets back the entire $30.67 in refundable tax, but has still paid about $20 in taxes.
If the shareholder was earning $100,000 in total income, the $80 he receives in ineligible dividends is taxed at 30.38% for a tax bill of $24.30, leaving the taxpayer with $55.70 or slightly less after rounding.
Comparison: If this shareholder had instead earned $100 in interest income personally, he would pay 38.29% tax leaving behind $61.71 in after-tax profits or about $6 more than when earned through the company.
Just like if earned personally, only 50% of the total gain is taxed inside your company. The other 50% is tax-free and also gets paid out tax-free to shareholders through yet another notional government account called the “Capital Dividend Account” or “CDA”. For example, if you made a $10,000 gain, $5,000 would be credited to the CDA and could be paid out as a tax-free capital dividend while the other $5,000 would be taxed in the CCPC like interest income as a “taxable capital gain”.
On the other hand, if you’d also had a $2,000 capital loss that year, this would be offset against your gain, in the same way as if you’d earned the gain and loss in your open account. As a result, although your company would only have to pay tax on $4,000 after deducting $1,000 in taxable losses from the taxable $5,000 capital gain, it would also only get a $4,000 credit in its capital dividend account since the $1,000 in non-taxable losses are also deducted from the $5,000 in non-taxable gains.
Finally, if your company has a balance in its CDA that it carries forward that can be used to pay out tax-free loot in future years, be careful about declaring capital losses in future years until you’ve paid out this entire tax-free balance. Any losses realized in later years can ultimately eliminate this credit.
In terms of calculating the tax bill on the net taxable capital gain, that portion is taxed at $50.67 per $100 in B.C., of which $30.67 is refundable and is credited to the NRDTOH (as of next year), while the other $20 is gone but not forgotten. If the company pays out 2.61 times more in ineligible dividends as its outstanding NRDTOH balance, then it would get back the full $30.67 / $100 it paid on the taxable gain, just like for interest income.
Summary: If your CCPC earns $100 in capital gains, net of its capital losses, $50 is tax-free and gets paid out tax-free to shareholders. The other $50 is taxed at 50.67%, resulting in a potential tax bill of $25.34, unless it pays out enough ineligible dividends. $12.67 is credited to the NRDTOH Account. If the CCPC pays out $40 ($12.67 x 2.61) in ineligible dividends, the company is only out of pocket $10 in taxes. Ultimately, it would pay out $90 in dividends, $50 tax-free capital dividends and $40 in ineligible divdiends.
If the shareholder receiving the dividends was otherwise earning $100,000 in taxable income, she would receive $50 in capital dividends tax-free while the other $40 in ineligible dividends would be taxed at 30.38%, or $12.15. She would ultimately keep $77.85 of the $100 originally received by her company.
Comparison: If the shareholder instead earned a $100 capital gain directly instead she would get $50 tax-free, with the other $50 taxed at 38.29% leaving behind $80.86 in after-tax money. This would leave her with about $3 more in her back pocket than if the gain had been earned corporately and then paid out as a combination of capital and ineligible dividends.
Return of Capital
Just like if earned in your non-registered portfolio, some investments pay out tax-free money to your company. Perhaps the two most common types are Corporate Class Mutual Funds or Real Estate Investment Trusts. Most payments from these investments are considered to be a return of your original capital or “ROC”. Accordingly, since this money has already been taxed, the government doesn’t tax it again. This can be particularly valuable starting next year when active businesses earning more than $50,000 in investment income will be at risk of having to pay higher tax rates on business income since ROC income won’t be included as part of this calculation.
On the other hand, as the expression goes, there is no free lunch – although there is no immediate tax bill when you receive ROC, you will have to pay the piper when you sell your investments. When calculating your capital gain at that time, all your cumulative ROC payments are deducted from your original purchase price, which means paying a bigger capital gain tax bill. For example, if you own a REIT that cost you $10,000 and has paid you $2,000 of ROC before you sell it for $13,000, the $2,000 in ROC will be deducted from the $10,000 initial investment so that your capital gain will be calculated as $13,000 minus $8,000 or $5,000.
Likewise, if you own a rental property in your holdco or opco, you might be able to avoid pay tax on some of your rental earnings (and thus have extra tax-free money sitting in your company) by claiming depreciation of the building as a business expense even though you’re not actually paying this cost each year. When you sell your property down the road, you will have to settle up with the CRA if you’ve depreciated the building more than you get for it at the time of sale. For example, if you bought a property for $600,000, perhaps you spent $500,000 for the land and $100,000 for the building. If you’d depreciated the building down to $70,000 at sale but it was worth $120,000 at that time, you would have to pay back the $30,000 in depreciation (which would be fully taxed, rather than treated like a capital gain), as well as paying tax on the $20,000 increase in value from what you originally spent on the building.
Despite this eventual day of reckoning, investments that pay tax-free cash to your company allow your money to compound faster than money that is either taxed yearly at high corporate rates or forces you to pay it out in order to trigger a corporate tax refund when you’re in a high tax bracket. Quite simply, you’re left with more money to grow. As an added bonus, since you control when you trigger your capital gain bill, you can do so at a tax savvy time, such as when you’re in a low tax bracket or are once more allowed to income-split the money with a spouse under the new income-splitting rules. In other words, not only are capital gains far more tax efficient than interest and also better for taxpayers in higher tax brackets than taxable dividends, they provide extra savings by allowing you to trigger taxes during years when your tax bill might be lower.
On the other hand, return of capital may not be the best thing for you if you’re not planning on reinvesting the money inside the company. Although the company gets the money tax-free and can pay out the full amount it receives, it will usually have to pay it out to its’ shareholders as a ineligible dividend unless it still has capital or eligible dividends that it hasn’t paid out or it still owes loans to shareholders. The tax bill will still be a lot less than for interest income, but it will be bigger than if you were earning eligible dividends and, in many cases, capital gains.
By way of explanation, this is because ROC payments are treated like the original after-tax business profits you were able to squirrel away in the first place for a rainy day. This was money that you were going to be taxed on upon withdrawal anyway since you were taxed on it at low business rate in the first place on the understanding that you’d to pay more tax on it personally upon withdrawal. Thus, this money isn’t taxed like income or capital gains, but as a withdrawal of your original business earnings and are taxed accordingly.
Along the same lines, you will face a similar situation most of the time when withdrawing other tax-paid money from your company. For example, when the $10,000 you might invest in a GIC is returned to you upon maturity and want to pay the money out to yourself as a dividend rather than reinvesting it corporately, your company would likewise get the money tax free but you’d likely be stuck paying tax personally on the $10,000 as an ineligible dividend.
Summary: If your CCPC earned $100 in ROC payments, it would keep the full amount. If reinvested, this provides a great opportunity for growing a bigger nest egg for the future. On the other hand, the $100 in ROC payments would eventually produce a $100 capital gain for the company in most cases, although this may be many years in the future. I’ve already shown how such a capital gain would be taxed earlier in this article.
If the shareholder received $100 in non-eligible dividends, he would pay $30.38 in personal taxes on the money, leaving him with $69.62 of the original $100.00 received by the company. At least he is receiving the full $100 as a dividend, unlike a dividend paid from $100 originally taxed as interest or a capital gain in your company, since no tax was deducted at the corporate level.
Comparison: If the shareholder received $100 of ROC personally, he would be left with the full $100. Like the company, however, he will likely have to pay tax on an extra $100 capital gain when he sells the investment that produced the $100 in ROC. Although it seems highly unfair that this investor pays no tax upfront on the $100 when received personally when he would have to pay 30% tax in this example when first earned by his company, low corporate tax rates allowed the company to squirrel away a lot more money to invest in the first place. The tax bill the shareholder pays now is what he avoided paying in the year that the company earned the money in business profits had the dividend been paid out then rather than invested inside the company. If the shareholder is in a lower rate now, he might actually be saving on that delayed tax bill.
As you can hopefully see, after we put our calculators down and our headaches start to fade, other than when receiving ROC, shareholders earning and paying out their yearly corporate investment income are left in a similar position to where they’d be if they had earned the income personally, albeit perhaps sometimes slightly worse off. Their real advantage over their sole proprietor friends is that they have a lot more money to invest in the first place by investing business profits taxed only at as low as 12% corporately. The catch, and it is a big one, is that this all assumes your company pays out its yearly investment income. If it does not, then the government collects a rather large tax bill and holds that money until you pay out the profits and income in the future. That’s because the government doesn’t want to allow business owners to benefit from deferring the personal tax bill on their investments like they are able to do for business income.
By the same token, just like for people investing in their non-registered accounts, owning eligible-dividend-paying investments inside your company can still provide extremely tax-efficient income when flowed out to shareholders in lower tax brackets, but capital gains can be even more efficient for investors in higher tax brackets.
Unlike investing personally, however, the new tax rules may provide a few new wrinkles for business owners trying to pick corporate-owned investments. Some investors unable to income-split with a spouse until age 65 under the new rules may try to avoid taxable income now in order to take advantage of income-splitting opportunities later. Likewise, the new rules regarding more than $50,000 in passive corporate investment income may cause some investors to minimize high income investments if worried about losing all or some of their small business tax rate. Others with large unrealized capital gains may look at triggering some of the gains before the new rules kick in next year or will need to be careful about when they trigger them in the future when running an active business.
In conclusion, financial planning is often like an elaborate chessboard with bonus pieces and random rule changes that leave you scratching your head. The taxation of private companies is stellar example of this. Although mastering the rules of the game can’t guarantee success, I still like to think it usually leaves you a couple moves in front of the competition.