Wes Unger, Saskatoon
Corporate business owners have great flexibility in making decisions about their remuneration from a private company. This flexibility is available to all types of businesses, including incorporated professionals and business consultants. However, the planning process is not a simple one, as there are many tax issues that must be addressed. It’s important that decisions about remuneration be considered before year end, as well as during the business’s financial statement and tax return finalization processes.
The federal government’s proposals on income sprinkling were enacted in 2018 and are applicable to 2018 and later years (See Rules limit income splitting after 2017 below). These rules have impacted some of the traditional planning that was previously available to corporate business owners.
In addition, the 2018 budget introduced legislation impacting the taxation of private corporations in 2019 and later years. Further discussion of these rules continues below.
Rules limiting income splitting after 2017
The tax on split income (TOSI) rules introduced in 2017 broadened the base of individuals affected and increased the types of income subject to the existing rules, (formerly known as “the kiddie tax”) aimed at preventing income splitting. In essence, the TOSI rules limit income splitting opportunities with most adult family members through the use of private corporations after 2017.
Beginning in 2018, any income received by an individual that is derived directly or indirectly from a related private company (with the exception of salary) could be subject to the TOSI legislation. Any income subject to TOSI will be taxed at the highest marginal tax rate, which eliminates any tax advantage. To avoid application of the TOSI, the type of income needs to meet one of the exceptions or the individual receiving the income must fall into one of the exclusions. The application of the rules will also depend on the age of the individual receiving the income.
Exclusions are provided to recipients who are actively engaged in the business, as well as to payments that represent a reasonable return (based on a number of factors) and payments received by certain shareholders. Certain other exclusions are also provided. For more information, refer to EY Tax Alert 2017 No.52, Finance releases revised income splitting measures, and the February and May 2018 issues and February and November 2020 issues of TaxMatters@EY.
In general, if a corporate owner-manager does not need personal funds for spending, earnings should be left in the corporation to generate additional income and defer personal tax until a later date when personal funds are needed. For 2021, this tax deferral benefit resulting from the difference between corporate tax rates and personal tax rates can range, for individuals taxed at the highest marginal tax rate, from as little as 20.4% in Prince Edward Island when applying the general corporate tax rate, to as high as 42.5% when applying the small business corporate tax rate in Nova Scotia and British Columbia.
Deferring personal tax allows you to reinvest the corporate earnings and earn a rate of return on the personal tax you would have otherwise paid if you had extracted the funds from the business.
For fiscal years starting in 2019, the amount of income eligible for the federal small business deduction is generally reduced if the corporation (together with all associated corporations) has passive investment income greater than $50,000 in the previous year and is eliminated entirely if the amount of passive investment income exceeds $150,000, similar to the reduction that is applied to a corporation whose taxable capital exceeds $10m in the prior year. See the May 2018 issue of TaxMatters@EY.
A corporation with too much passive investment income in the prior year will be taxable on its active business income at the general corporate rate.1 Paying tax at the higher general corporate tax rate will decrease the amount of the tax deferral benefit but will allow the corporation to pay out eligible dividends in the future. Not all provinces have decided to follow this federal provision.2
Even if funds are not required for personal consumption, business owners may want enough salary to create sufficient earned income to maximize their RRSP contribution and use tax savings associated with graduated income tax rates. Whether or not this is an appropriate strategy depends on an overall review of the owner-manager’s financial plan for the near future and the long term.
To contribute the maximum RRSP amount of $29,210 for 2022, business owners will need 2021 earned income of at least $162,278. One method to generate earned income is to receive a salary in the year. Note that salary must be earned and received in the calendar year. Receipt of a salary would also allow the business owner to maximize CPP pensionable earnings for the year (based on maximum pensionable earnings of $61,600 for 2021).
If funds are needed for personal consumption, the CRA has a longstanding policy of not challenging the reasonableness of remuneration where the recipient is active in the business and is a direct or indirect shareholder. This criterion of reasonableness is relevant when considering if the remuneration is deductible to the paying corporation.
It’s generally more advantageous to distribute corporate profits as a salary or bonus to an active owner-manager based on current provincial corporate and personal tax rates. However, this may not be applicable for all provinces, and certain provinces levy additional payroll taxes, such as Ontario’s employer health tax, which may impact an analysis of the optimal compensation strategy.
In almost all provinces there is an overall “tax cost” to distributing business profits in the form of a dividend, meaning the total corporate and personal tax paid on fully distributed business earnings exceeds the amount of personal tax that would be paid in that province if the individual earned the same amount of income directly. However, business owners may still wish to earn money through a corporation and defer the tax if future cash needs can be satisfied by salaries or bonuses from future profits.
Earnings subject to a large deferral of tax can remain reinvested in the business or corporate environment for many years, sometimes indefinitely. However, this strategy has to be used carefully, because accumulating excessive business earnings could impact the corporation’s ability to claim the small business deduction on its active business income in the future. See the previous discussion on passive investment income changes. It could also affect a shareholder’s ability to claim the lifetime capital gains exemption (see comments on QSBC shares below).
Shareholder loans made to the corporation can be repaid tax free and represent an important component of remuneration planning. Advance tax planning may permit the creation of tax-free shareholder loans.
Complex tax rules associated with otherwise tax-free intercorporate dividends could result in the dividends being recharacterized as capital gains. However, advance tax planning may be available to mitigate this issue, and it also may be possible to benefit from corporate distributions taxed at reduced tax rates associated with capital gains.
A business owner who holds personal investments such as marketable securities can sell them to a private corporation in exchange for a tax-paid note or shareholder loan. While capital gains may arise on the transfer, the personal tax rate on capital gains is generally lower than the personal tax rate on eligible or non-eligible dividends. Advance tax planning may also allow recognition of the capital gain to be deferred, but tax losses may not be realized on a transfer to an affiliated corporation.
Corporate-level merger and acquisition transactions, such as the divestiture of a business or real estate, may also generate favourable tax attributes such as tax-free capital dividend account (CDA) balances or refundable taxes. These attributes form an important component of remuneration planning.
A business can claim a capital cost allowance (CCA) deduction for the purchase of depreciable assets that are available for business use on or before the business’s fiscal year end. A business that is contemplating a future asset purchase and has discretion in the timing of acquisition may choose to make the purchase sooner rather than later and then bring the asset into use to allow a CCA to be claimed. This strategy should be carefully considered in light of the opportunities for an enhanced CCA deduction currently available. Refer to EY Tax Alerts 2019 Issue No. 15 and 2018 Issue No. 40.
The 2021 federal budget proposed to enhance the CCA deduction for certain assets acquired by a CCPC after April 18, 2021. This proposal will allow a CCPC to deduct the full cost of certain assets purchased up to a maximum of $1.5 million per year (to be shared with other members of an associated group of CCPCs) provided the asset is available for use prior to January 1, 2024. Refer to EY Tax Alert 2021 Issue No. 19.3
Retaining earnings in a corporation may affect a CCPC’s entitlement to refundable scientific research and experimental development (SR&ED) investment tax credits. A business should compare the investment return from deferring tax on corporate earnings against the forgone benefit of high-rate refundable SR&ED investment tax credits.
Leaving earnings in the corporation may also impact the status of the corporation’s shares as qualified small business corporation (QSBC) shares for the purpose of the shareholder’s lifetime capital gains exemption (currently $892,218). Advance tax planning may be available to mitigate this issue and permit continued accumulation of corporate profits at low rates without impacting the QSBC status of the shares.
A private member’s bill received Royal Assent on June 29, 2021 (Bill C-208). This new legislation was introduced to facilitate intergenerational transfers of family businesses. The Department of Finance has indicated that amendments to this legislation will be introduced in the future to address unintended tax avoidance loopholes. Refer to EY Tax Alert 2021 Issue No. 25.4
Paying dividends may occasionally be a tax-efficient way of getting funds out of a company. Capital dividends are completely tax free, and eligible dividends are subject to a preferential tax rate. For fiscal years that begin after 2018, eligible dividends are only eligible to generate a dividend refund out of the eligible refundable dividend tax on hand (ERDTOH) account.
Non-eligible dividends can generate a dividend refund out of the ERDTOH and the non-eligible refundable dividend tax on hand (NERDTOH) account. A review of the company’s tax attributes will identify whether these advantageous dividends can be paid.5
Dividends and other forms of investment income from private corporations do not represent earned income and so do not create RRSP contribution room for the recipient. An individual also requires earned income to be able to claim other personal tax deductions, such as child care and moving expenses. Business owners should consider how much earned income they need in light of the RRSP contributions they wish to make or personal tax deductions they wish to claim.
Income splitting considerations (subject to TOSI)
Consider paying a reasonable salary to a spouse or adult child who provides services (e.g., bookkeeping, administrative, marketing) to the business in order to split income.
If a spouse or adult child (older than 24 years of age) is not active in the business and has no other sources of income, consider an income-splitting corporate reorganization whereby the family members become direct shareholders in the business, owning 10% or more of the votes and value of the corporation. This planning is still available even with the TOSI rules in effect, as long as the corporation is not a professional corporation and has less than 90% of its gross business income from the provision of services and at least 90% of the company’s income is not derived directly or indirectly from one or more related businesses.
For non-active family members, there generally must be a direct shareholding as described above.6 Non-active family members are no longer able to be indirect shareholders and avoid the TOSI legislation. Active family members can be indirect shareholders and avoid the TOSI legislation, as long as they fit into one of the exclusions under the TOSI rules.
Depending on the province of residence, an individual who has no other source of income can receive a certain amount of dividends tax free. For eligible dividends, the range would be $18,740 to $53,810, and for non-eligible dividends the range would be $10, 255 to $30,170. These amounts increase where the recipient has access to tax credits such as the tuition tax credit in the case of adult-children students.
Commercial and family law considerations, in conjunction with the tax benefits, will determine whether it’s worthwhile pursuing such a strategy. In select cases, a low-interest family loan can be advantageous for permissible income splitting. Given the low 1% “prescribed rate,” it may be worthwhile exploring this planning option, especially if the return on investment exceeds the prescribed rate.
Managing tax cash flow7
If there’s a plan to pay a salary, remember that bonuses can be accrued and deducted by the business in 2021, but not included in the business owner’s personal income until paid in 2022. To be deductible to a corporation, the accrued bonus must be paid within 180 days after the company’s year end, permitting a deferral of tax on salaries of up to six months.8
If earnings left in the corporation exceeded the available small business deduction limit for the preceding tax year, corporate taxes for the current year will be due two months, rather than three months, after the year end. The current rate for late payment arrears interest is 5% and is not deductible for income tax purposes.
Monthly and quarterly tax instalments (for corporate and personal income, respectively) must be managed to avoid arrears interest and penalty interest. A single midyear payment strategy can be used to simplify the obligation of making recurring payments, and generally reduce or eliminate interest and penalties.
Use of a shareholder “debit” loan account (where the corporation has a receivable from the individual shareholder) may simplify the need to project exact owner-manager remuneration requirements. Shareholder debit loans must be repaid within one year after the end of the year in which the loan was made, or else the loan will be included in the business owner’s income in the year funds were withdrawn. The repayment of a shareholder loan cannot constitute a series of loans or other transactions and repayments if the one-year repayment is to be considered valid.9
Borrowing from the company within the permissible time limits will cause a nominal income inclusion at the prescribed rate, which is currently only 1%. The cost of financing from the corporation using shareholder loans can therefore currently be achieved at tax-effected rates of 0.475% to 0.54% at the highest marginal tax rates, depending on your province of residence.
For more information on remuneration planning and other tax-planning and tax-saving ideas, contact your EY advisor.