TaxMatters@EY - July 2013
Janna Krieger, Toronto
Back to basics: what is integration?
Integration is an important principle in the Canadian tax system, especially for Canadian-controlled private corporations (CCPCs) and their shareholders. It is based on
the premise that an individual earning income through a corporation should be in the same tax position as if that individual had earned the income directly. In other words, an
individual should be indifferent (from an income tax perspective) as to the type of entity used to earn income.
Dividend gross-up and tax credit – Income earned in a corporation is taxed first in the corporation and the after-tax amount is then further taxed at the personal level when it is distributed to an individual as a dividend. The combined corporate and personal tax represents the effective tax rate of earning income through a corporation.
In order to help achieve integration, dividends received by individuals from taxable Canadian corporations are subject to a dividend gross-up and dividend tax credit mechanism: the individual shareholder includes in income a grossed-up amount representing an approximation of the corporation’s pre-tax income, and then gets a credit representing tax paid in the corporation so that, in theory, tax is effectively paid at the personal rate.
The gross-up and dividend tax credit mechanism is based on notional federal and provincial tax rates, both at the corporate and personal levels. To the extent that the actual rates are different, perfect integration will not be achieved, and the effective tax rate on income earned through a corporation will be higher or lower than the personal tax rate. The difference is either an absolute cost or saving associated with earning income through a corporation.
Since corporate and personal tax rates vary across the country, so will the absolute cost or savings in each province, which will have different implications for how individuals use CCPCs to structure their business or investment income in each province.
Tax deferral on corporate income – Another increasingly significant component of an integration analysis (particularly in the context of earning active business income in a CCPC) is the deferral opportunity that exists because earnings in a corporation do not attract personal tax until they are paid out to the shareholder. The value of this deferral opportunity depends on how long funds can remain invested in the corporation, since as soon as funds are withdrawn as salary or dividends, they will generally attract personal tax.
Federal change to 2014 ordinary dividend gross-up and dividend tax credit
In the 2013-14 federal budget tabled on 21 March 2013, the minister announced an increase in the income tax rate applicable to ordinary dividends (i.e., dividends paid out of corporate earnings subject to a preferential tax rate, such as the small-business rate) paid after 2013.
The 2014 change in the federal gross-up and dividend tax credit rate on ordinary dividends (also sometimes referred to as ineligible dividends) will automatically increase the effective provincial tax rate on ordinary dividends for most provinces. We expect some provinces may consider changes to their dividend tax credit rates to preserve integration; however, to date, most of the provinces have not yet responded to the federal changes. Therefore, any 2014 integration analysis based on currently enacted rates may be subject to change.
Integration of active business income
Several years ago, the tax cost of leaving active business income in a corporation that was subject to the top general corporate tax rate was quite high, and generally outweighed the tax-deferral opportunity. At that time, the rule of thumb for shareholder-managers was to “bonus-down” to the level of income eligible for the preferential small-business corporate tax rate. That is, CCPCs would pay out their high-rate income as deductible bonuses, which were taxed only at the personal level.
Although it varies by province, the lower personal tax rate on eligible dividends has had the effect of reducing the overall tax cost of not paying a bonus, and thus has reduced the number of years the funds must be retained in the corporation to offset the tax cost. Also, declining general corporate tax rates over the last several years have increased the tax deferral benefits of leaving the funds in the corporation.
As a result, where shareholder-managers do not need the funds personally, it generally makes more sense to retain the after-tax corporate earnings in the business instead of automatically bonusing-down those earnings.
Current integration observations
For active business income eligible for the preferential small business corporate tax rate, over the past several years there have been small tax savings associated with distributing after-tax corporate earnings as dividends in most provinces, as well as a significant deferral benefit to leaving funds in the corporation in all provinces. These have remained consistent in 2013.
However, as the rates stand right now for 2014, the absolute savings are scheduled to become even smaller in most provinces and to switch to an absolute cost (albeit small) in several provinces. The deferral will remain significant across the country.
For active business income subject to the high general corporate tax rate, there is still a small tax cost for most provinces associated with distributing after-tax earnings as dividends in 2013 and 2014 (based on the current rates for 2014). The tax cost continues to be higher in Manitoba, Nova Scotia and Prince Edward Island. The tax deferral benefit achieved by leaving income in the corporation in all provinces continues to be significant, and will generally continue to outweigh the cost in 2013 and 2014 across the country.
Shareholder-manager remuneration can no longer follow a general rule of thumb and must be evaluated on an annual basis after considering the rates in the particular province (where the business is located and where the shareholder-manager resides), as well as the other relevant facts.
Your EY advisor can help review the implications of integration for your personal remuneration and estate plan in your province.
Integration of investment income
In general, integration of passive investment income earned by a CCPC is achieved with a refundable tax mechanism. The CCPC pays an additional refundable tax on its investment income that is only refunded to the corporation when the corporation ultimately pays out a taxable dividend to an individual.
The refundable tax has generally reduced the deferral element of earning investment income through a corporation as compared to the active business income scenarios. However, fluctuating tax rates across the provinces on the various types of investment income have had varying integration results, making it difficult to generalize.
Also, note that dividend income earned in a corporation from another connected corporation (basically one which it controls, or in which it owns more than 10% of the votes and value) is generally not subject to the refundable tax, so there may be deferral opportunities or other benefits to having a holding company own shares of an operating company.
Current integration observations
In 2013, there is a small cost of earning interest and capital gains through a corporation in all provinces but Ontario, where savings are minimal. The tax cost continues to be higher in Manitoba and Prince Edward Island. Also, most investment income earned through a corporation in most provinces continues to involve a prepayment of tax. There may be deferral opportunities in some provinces, mostly in the category of ordinary dividends, due to the personal tax rates in those provinces.
As the rates stand for 2014, Ontario’s minimal savings for earning interest and capital gains in a corporation will become a cost, and the cost will be higher in all other provinces. Deferral opportunities still exist in the category of ordinary dividends in some provinces.
In assessing whether your investment income should be earned personally or through a corporation, remember:
Your EY advisor can help you evaluate whether there may be a benefit for you in using a corporation to earn passive investment income.