Master the Nuts and Bolts of 'Refundable' Taxes

Posted on Jun 15, 2011 | Tags: Not For Profit

Investment income is a key goal of financial planning, as is minimizing taxes. When it comes to dividends and other passive earnings, the Income Tax Act includes provisions aimed at ensuring you pay the same tax on that money as you would if you had earned it directly. Here's how the system works.

  

 It's All about Integration

Canada's income tax system has mechanisms aimed at ensuring that investors who receive income from passive investments in Canadian Controlled Private Corporations (CCPCs) can't avoid taxes on those proceeds.

 Selling Stock Through a Holding Company

   Although corporations are generally taxed at a low rate on active business income, that is not the case with investment income.
   For example, let's assume a corporation is resident in a province where the combined federal and provincial tax rate is 49 per cent on all investment income except dividends from other Canadian corporations. As only half of capital gains are included in income, the effective tax rate on capital gains would be 24.5 per cent.
   In addition to the RDTOH pool there is another  pool called the capital dividend account (CDA). This is where the corporation adds the 50 per cent of capital gains that is not included in income. From that account, the company can pay tax-free dividends. So if the company has a capital gain of $10,000, it can pay a $5,000 tax-free dividend.
   From the shareholder's perspective, say an Ontario resident in the highest marginal tax bracket owns shares with an adjusted cost base (ACB) of $1,000. ACB, in its simplest form, is the cost of the shares plus brokerage fees.
   Over time the shares appreciate to $100,000 and the holder wants to sell. The stockholder must pay 31.3 per cent tax on Canadian source dividends and 46.4 per cent on all other income. The individual transfers the shares to a holding company at the original ACB and the corporation issues a note payable in the amount of $1,000. The corporation then realizes the capital gain on the shares.
   To get the money out of the corporation after the stock sale, the holder takes part of the proceeds as a non-taxable repayment of the note and as a non-taxable dividend from the CDA balance. The remainder would be paid out as a taxable dividend, which would generate a refund to the corporation.
   Talk to your tax accountant about how to best handle your investment and dividend income while minimizing taxes.

To achieve this goal, the Income Tax Act requires CCPCs that receive dividends from another Canadian corporation to pay two "refundable" taxes, one on dividend income and one on investment income. The companies track those taxes with an account called refundable dividend tax on hand (RDTOH).

Combined, these two refundable taxes nullify any advantages to individuals of receiving dividends and other passive income, as well as capital gains, through a corporation. Essentially, CCPCs pre-pay the taxes individuals will owe once they receive the money. Here is how the mechanisms work:

Dividend Income

Typically, under Section 112 and Section 113 of the Income Tax Act, taxable corporations are allowed to deduct dividends from other taxable corporations because the company making the payouts has already paid the taxes. CCPCs, however, must pay a refundable tax of 33.33 per cent on those dividends. That percentage approximates the tax individuals at the highest marginal rate would owe if they had directly received the payouts.

Investment Income

Investment income is taxed at the general federal corporate tax rate of 28 per cent and is not eligible for the small business deduction or the manufacturing and processing deduction. In addition, under Part I of the Income Tax Act, CCPCs must pay a refundable tax of 6.67 per cent tax on such investment proceeds as taxable capital gains and interest or rental income. This tax is to ensure that the combined federal and provincial corporate tax rates aren't lower than the highest marginal personal tax rate.

Because of the way that the dividend tax credit works on the individual's income tax return, CCPCs add 26.67 per cent of investment income to the RDTOH even though the Part I tax is only 6.67 per cent. That way the total taxes paid by the corporation and the shareholders are equivalent to the taxes the investors would pay if they received the investment or dividend income themselves.

This RDTOH represents the accumulated amount of refundable taxes paid minus refunds received. The balance is not recorded on the corporation's financial statements, although there may be a note to the statements that shows the amount. Instead the account is tracked on the T2 Corporate Income Tax Return.

Both types of refundable taxes apply only to CCPCs. The taxes are refunded when the corporation pays dividends to its shareholders. Canada Revenue Agency refunds the money at a rate of $1 for every $3 paid out. So, for example, to receive a $1,000 refund the CCPC must pay out $3,000 in dividends.

The refundable tax situation is extremely complex and becomes even more so when affiliated corporations are involved. If you are considering holding passive assets such as rental property or other investments in a corporation, your accountant or financial advisor can help you sort out the tax implications.

Tags: Not For Profit