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FMGT 4410 Chapter 13: Taxation of Corporate Investment Income

Integration Revisited Throughout this course, we have been touching on the concept of integration and its importance in the Canadian tax system. In this chapter, we are going to put it all together and look at all the rules in place that support Integration. Integration for tax purposes means: An individual will be indifferent as to whether he/she earns income directly or has a corporation that earns the income and flows it through to the individual. The amount of total tax paid is the same in either case. We have already looked at a few of the tax rules which help achieve integration, specifically around the taxation of dividend income as this represents income that flows from a corporation to individuals. When Corporation B receives dividends from Corporation A, Corporation B does not include these dividends in taxable income because Corporation A already paid taxes on that income stream. Therefore, Corporation B is not taxed on these dividends. When individuals receive dividend income, it is included in their income at a grossed-up amount and then a substantial tax credit is applied against taxes payable which results in dividends being taxed at a lower rate than other income received by an individual. Example Logan earns a substantial salary at his job as CFO of a mining corporation. Because of his high level of income, he is already in the 29% federal tax bracket. He is contemplating two different investments – one that will pay $20,000 in annual interest and the other that will pay $20,000 in non-eligible dividends. Which is preferable from a tax perspective?

This lower rate of tax on dividends is to reflect that the $20,000 dividend was paid out of a corporation’s after-tax income and, therefore, tax has already been paid on this amount. Integration attempts to make the total of the tax paid by the corporation and the tax paid by the individual equal to the amount paid by the individual if the income was received directly.

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income Example to demonstrate how integration is achieved Kari Claydon runs a retail store selling gourmet coffee. She currently runs the business as a sole proprietorship and is wondering if she could save some tax if she incorporates the company. (Ignore personal tax credits) The business generates net income of $140,000 per year and she estimates that she needs $50,000 a year to cover her personal expenses. Applicable tax rates are as follows:   

Corporate tax rate = 20% Kari’s individual tax rate = 50% Kari’s rate on grossed-up dividends = 37.5%

In addition to dividends, she could choose to pay herself a salary from the corporation to cover her personal expenses. In either case, the total taxes are the same:

The total tax being equal is only true when dividends are paid. But what if Kari chose not to immediately pay herself dividends because she had enough cash-on-hand?

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income This creates a challenge for the Canada Revenue Agency where an individual chooses to leave cash in the corporation for long periods of time (as perhaps they do not need the cash for personal use). o Issue: What if the taxpayer chooses to leave the cash in the corporation?

 The lower rate of tax paid by corporations creates an incentive for individuals to leave income in the corporation and not pay any personal taxes on it (i.e. the individual could defer taxes). The lower rate of corporate tax was set based on the assumption that the funds would be paid out as dividends. o Solution: Create an incentive for corporations to pay dividends.  Refundable Taxes

Refundable Part I tax By the end of Chapter 12, we had covered the calculation of Ordinary Part I Tax. However, there are a couple more components of total taxes paid by a corporation, the first being Refundable Part I Tax. In order to encourage corporations to pay dividends and, therefore, increase the tax revenue base to the CRA, corporations are initially charged a higher level of tax on their income (to approximate the same rates charged for individual taxes). However, the corporation can have a portion of the tax refunded as soon as they pay out dividends. As you may remember, in the calculation of corporate taxes payable, there was a 10 2/3% Additional Refundable Tax levied on the Aggregate Investment Income of a CCPC. The precise calculation for ART is as follows: 10 2/3% x the lesser of:  

The corporation’s aggregate investment income for the year The amount, if any, by which the corporation’s Taxable Income for the year exceeds the amount that is eligible for the small business deduction.

This is part of the tax that can be refunded to a corporation when dividends are paid out. There is also another additional tax that is considered to be refundable, but it is not a separate line in the corporate tax calculation. It is calculated to be 20%.

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income Therefore, in total 10 2/3% + 20% = 30 2/3% of a CCPC’s AII earned is considered to be refundable Part I tax. The refund is triggered on the payment of a taxable dividend. Calculation of Part I Refundable Tax (ignoring foreign tax credits): Least of:  302/3% x Aggregate Investment Income  302/3% x (Taxable Income – SBD amount)  Part I Tax Example 4M Corp is a CCPC with $400,000 of taxable income. Of this amount, $240,000 is Canadian ABI and the remainder is Canadian AII. 4M is not associated with any other corporations. Calculate the company’s Part I taxes payable and determine how much of a dividend they would need to pay to receive the full refund of Part I tax.

Note: In the example above, a dividend of $128,000 must be paid out in order to receive a refund of $49,067. We will discuss this later on in the notes when we cover Part IV Tax. The refundable portion of Part I Tax is the maximum portion of Part I Tax that may be refunded, but this may be different from the amount actually refunded. We will discuss this later on in the notes when we cover RDTOH.

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income Issue: What if the dividends are paid out to another corporation?

o Although refundable Part I tax solves the problem of encouraging corporations to pay dividends, it does not actually ensure that those dividends will be taxed. o Knowing that inter-corporate dividends are tax-free (through the Division C deduction), a corporation could trigger a refund of its Part I tax by paying a dividend to another corporation rather than to an individual. Example ACo and BCo are CCPCs. ACo is 100% owned by BCo which is, in turn owned 100% by Kris Halliday. ACo has 2018 taxable income of $120,000 – all of which is AII. BCo’s only income is a $96,000 dividend from ACo. What are the Part I tax consequences to ACo and BCo?

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income

Kris O

BCo wns

$96,000 Dividend from ACo

ACo

TI = $120,000, AII

Issue: Aco received AII, paid ART on it. Aco then paid dividends to BCo, received refund on ART. BCo received the dividend tax-free. Now the CRA has refunded tax back to ACo and received nothing in return! Solution: To achieve integration, inter-corporate dividends need to be free from Part I tax. However, the Tax Act has multiple parts and one of them – Part IV – exists to tax those dividends.

Part IV Tax Part IV tax is assessed on dividends received by private corporations, and is calculated differently depending on whether the dividend is received from a “connected” corporation or is

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income simply a portfolio dividend. Connected corporations are those in which the company owns at least 10% of the shares. Anything less than 10% ownership constitutes a portfolio dividend. 2 Circumstances in which Part IV tax is triggered: 1. If dividends are received from an unconnected corporation. 2. If dividends are received from a connected corporation that received a dividend refund as a result of making that dividend payment. Calculation of Part IV Tax  38 1/3% of portfolio dividends, plus  The company’s % ownership of a connected corporation * the dividend refund received by that corporation

The tax is, again, refundable upon the payment of dividends but, if the dividend is paid to another corporation rather than an individual, it will trigger Part IV tax for that receiving corporation. The only way to fully eliminate Part IV tax is for the corporation to pay a dividend to an individual, which is what the tax legislation is trying to encourage.

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income Applicability of Part IV tax for Connected Corporations Part IV tax on dividends received from a connected corporation is expressed in terms of the recipient’s share of the refund received by the paying corporation. This is because Part IV tax on dividends from a connected company is only applicable when the paying corporation receives a refund. Dividends paid out of the paying corporation’s aggregate investment income will be subject to Part IV tax. If, however, the paying corporation was only earning active business income, no refund would be available when this after tax income was paid out as dividends (because ABI benefits from a lower tax rate and is not assessed a surcharge). Therefore, if a connected corporation paid out dividends using only funds from Active Business Income, no Part IV tax would be assessed on the corporation receiving the dividend. Note that regardless of whether or not a corporation is connected, capital dividends received are not subject to Part IV tax.

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income Example Following from the previous example, assume that, in addition to the ACo dividend, BCo also earns a $12,000 dividend from non-connected public company shares. Calculate the Part IV tax consequences of the dividend to BCo.

If the dividend was paid to another corporation (i.e. XCo), XCo would then owe $41,400 in Part IV tax. Therefore, corporations can transfer the burden of Part IV tax to other corporations but the only way to eliminate it is to pay the dividend to an individual shareholder (i.e. Kris Halliday) who would gross it up in income, then receive a dividend tax credit on it.

Refundable Dividend Tax on Hand (RDTOH) Given that there are two different types of refundable tax that can be levied on a corporation and that payment of dividends triggers refunds of both taxes, it is useful to have a tracking mechanism to know how much a company has paid in refundable tax. We refer to this mechanism as Refundable Dividend Tax on Hand (“RDTOH”). The mechanism can be thought of as a T-account that starts with an opening balance and adds in the current year’s refundable taxes paid to determine the total available refund.

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income Example CDW Corporation is a CCPC that had an RDTOH balance of $22,500 at the end of 2017. During 2018, the company: o earned AII of $130,000 o received portfolio dividends of $20,000 o received $30,000 dividend from 25% owned subsidiary, AXM Corp. AXM, the subsidiary, received a $10,000 refund on payment of the dividend to CDW. In February 2018, CDW received an $11,000 refund based on dividends that CDW paid out in the prior year. Calculate CDW’s 2018 RDTOH balance (assuming Part I Tax payable > $40,000):

Refundable Part I Tax

Refund received for PY

Part IV Tax

CDW is eligible for a refund of this balance upon payment of taxable dividends. The refund is calculated as the lesser of 1. 38 1/3% * taxable dividend paid 2. Ending balance in the RDTOH account Therefore, if CDW pays a $50,000 dividend in 2018, their refund would be:

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income

Comprehensive Corporate Tax Payable Example Kyser Corporation is a CCPC with a factory located in Prince George, BC. The majority of its sales are in Western Canada but they also have a few large customers located in Oregon state. They are not associated with any other corporations and apply all loss carryovers at the earliest possible opportunity. Kyser did not pay a dividend in 2017 but did pay a $12,000 dividend at the end of 2018. Other 2018 financial information is as follows: o Canadian sales income o o o o o o

US sales income * Dividends from a connected corporation ** Interest income on Canadian bank account (operations) Net rental income *** TCG on disposition of shares Net Capital loss carryover from 2014

o RDTOH balance – end of 2017

$875,000 $100,000 $ 15,000 $ 3,200 $ 61,400 $ 10,700 $ 7,100 $ 22,750

*

No foreign taxes were withheld on the US income.

**

Kyser owns 15% of the connected corporation which received a total refund of $33,000 on payment of the dividend.

***

Kyser moved to a new factory space in 2017 and, rather than sell the old building, decided to rent the space to another company. The other company signed a 10 year lease on the building.

Calculate the total 2018 Part I and Part IV taxes payable for Kyser, as well as any balance in their RDTOH account. Will a refund be available to Kyser?

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income

Designation of Eligible Dividends In order to achieve integration, dividends received by individuals are designated as either eligible or noneligible, with the following objective in mind: a) If income has been taxed at a high rate at the corporate level, then the individual receiving dividends should be taxed at a low rate on those dividends received – this is the case with eligible dividends (which are eligible for enhanced gross-up/tax credit procedures). b) If income is taxed at a low rate at the corporate level, then the individual receiving dividends should be taxed at a higher rate on those dividends received – this is the case with non-eligible dividends (which are not eligible for the enhanced gross-up/tax credit procedures). Up until this point, we have noted that eligible dividends are generally those from Public corporations, and non-eligible dividends are generally those from Private corporations. Recall that… Eligible dividends – Assumed to be paid out of “full rate taxable income”, which is taxed at a high corporate tax rate. Public companies often pay dividends out of “full rate taxable income”, so we say that dividends paid from Public companies are generally designated as Eligible. Eligible dividends have a gross-up of 38%, and a dividend tax credit of 6/11 of the gross-up. Non-eligible dividends – Assumed to be paid out of “active business income”, which is taxed at a low corporate tax rate (due to application of the small business deduction). CCPCs often pay dividends out of “active business income”, so we say that dividends paid from CCPCs are generally designated as Noneligible. Non-eligible dividends have a gross-up of 16%, and a dividend tax credit of 8/11 of the gross-up.

Issue It may be the case that public corporations pay dividends out of income that was taxed at low rates, and private corporations pay dividends out of income that was taxed at higher rates. 



If a public corporation pays dividends out of income taxed at low rates, and the individual receives these dividends as eligible, both the corporation and individual are paying low tax rates and integration is not achieved. If a private corporation pays dividends out of income taxed at high rates, and the individual receives these dividends as non-eligible, both the corporation and the individual are paying high tax rates and integration is not achieved.

Solution There is a system in place to track which income has been taxed at which rate in order to determine whether dividends paid out can be designated as eligible or not.

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income For a CCPC, there is an account in place which tracks components of income that have been taxed at full corporate rates known as the General Rate Income Pool (GRIP). The balance in this account is available to pay eligible dividends.

The GRIP account is used to track balances that can be used by a CCPC as the basis for designating eligible dividends. While the presence of a GRIP balance does not require that dividends be designated as eligible (it is at the discretion of the corporation), a CCPC can designate dividends as eligible until the GRIP balance is exhausted. In other words, if a CCPC has a positive GRIP balance, at least some of the dividends paid out can be designated as eligible (and the individual receiving the dividend can therefore benefit from the enhanced tax rates on those dividends received).

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income Example Norgrave Ltd., a CCPC, had no GRIP balance at the end of 201 6. During 2017, the Company received eligible dividends of $106,600 and designated $25,000 of its dividends paid as eligible. At the end of 2017, Norgrave has a GRIP of $106,600. For 2018, Norgrave has Taxable Income of $225,000. This amount includes aggregate investment income of $55,000. In addition, the Company receives eligible dividends during the year of $50,000. In determining 2018 Tax Payable, the Company has a small business deduction of $27,000 (18% x $150,000). During 2018, Norgrave pays dividends of $40,000, with $20,000 of this amount being designated as eligible. Calculate the 2018 ending balance in GRIP for Norgrave.

Solution:

FMGT 4410 Chapter 13: Taxation of Corporate Investment Income For a non-CCPC (i.e. public company or private company that is not Canadian controlled), there is an account in place which tracks components of income that have been taxed at low corporate rates. These may be amounts retained by a CCPC that benefitted from the small business deduction before it became public, or non-eligible dividends received from a CCPC which should flow to the individual shareholder as such. This account is known as the Low Rate Income Pool (LRIP). The balance in this account must be reduced to nil by the payment of non-eligible dividends prior to the payment of eligible dividends.

The LRIP account is used to track balances that have not been subject to full corporate tax rates. The presence of LRIP requires that dividends paid must be designated as non-eligible until the LRIP balance is exhausted (it is not at the discretion of the corporation).

Example At the end of 2017, Ovamp Ltd. has an LRIP balance of $450,000. During 201 8, the Company receives non-eligible dividends from a CCPC in the amount of $225,000. During 201 8, the Company pays dividends of $360,000. What amount of the dividends paid out can be designated as eligible?

Solution: Ending 2018 LRIP balance is $450,000 + 225,000 = $675,000. Given that Ovamp paid out $360,000 in dividends, none of these dividends can be designated as eligible because the LRIP balance exceeds the total dividends paid....