Investment income earned within a private corporation is subject to tax in a significantly different manner than business income. Private corporations pay a high rate of corporate tax in the year the investment income is received. A portion of the taxes paid are in effect a pre-payment of personal taxes and may be refunded to the corporation when taxable dividends are paid to the shareholders, at which point the actual personal taxes will be paid. Refundable taxes exist to implement the integration system and are a critical component of an effective tax plan.
The primary objective of the integration system is to ensure that individuals do not receive preferential tax treatment by earning income through a corporation rather than personally. The laws governing refundable taxes are in place to prevent individuals from accessing the lower corporate rates and reinvesting the tax-deferred investment income to gain compound growth. The corporate taxes payable, including refundable taxes, generally approximate the tax that would have been paid by the individual if the income were subject to tax at the highest marginal rate. There are two primary sources of refundable taxes: dividends subject to Part IV tax and aggregate investment income subject to the refundable portion of Part I tax.
Dividends received from taxable Canadian corporations are deductible in the determination of taxable income for Part I tax. As a result, a fully refundable Part IV tax may be assessed. Private corporations are required to pay Part IV on dividends received from non-connected corporations, referred to as portfolio dividends, or dividends received from connected corporations that generated a dividend refund to the connected corporation. Portfolio dividends are subject to a refundable tax of 38 1/3%. These dividends are usually eligible dividends, so the rate approximates the highest marginal rate on eligible dividends. The Part IV tax payable on dividends from connected corporations is equivalent to the dividend refund received by the connected corporation. For the purposes of Part IV, a connected corporation is a corporation that is controlled by the corporation receiving the dividend, or a corporation that the recipient corporation owns at least 10% of the voting power and fair market value.
While all private corporations are subject to Part IV tax on dividends, Canadian-Controlled Private Corporations (CCPCs) are also subject to a refundable portion of Part I tax on other investment income. Generally, 30 2/3% of a CCPCs aggregate investment income is paid as a refundable tax. Aggregate investment income may include the taxable portion of capital gains net of the deductible portion of capital losses, interest income, rental income and foreign investment income. Certain items are excluded from this calculation, such as incidental property income, deductible dividends and passive income from associated corporations that is deemed to be active business income. The total tax payable for the year, including the non-refundable portion, ranges from 46 2/3% to 54 2/3% depending on the corporation’s provincial residence.
Refundable taxes paid accumulate in two accounts: eligible refundable dividend tax on hand (ERDTOH) and non-eligible refundable dividend tax on hand (NERDTOH). Part IV tax paid on portfolio dividends and eligible dividends received from connected corporations is added to ERDTOH. Part IV tax paid on ineligible dividends received from connected corporations is added to NERDTOH, as well as the refundable Part I tax paid on aggregate investment income. When dividends are paid to the shareholders, a dividend refund up to 38 1/3% of the dividend paid may be received from these accounts depending on the balance of the accounts and the ordering rules.
A refund from ERDTOH can be triggered by paying either eligible or non-eligible dividends, while a refund from NERDTOH can only be triggered by paying non-eligible dividends. Furthermore, a refund of ERDTOH can not be received on the payment of non-eligible dividends until the NERDTOH account has been depleted. The purpose of this once again relates to integration: the personal tax rates on non-eligible dividends are higher than eligible dividends, so an individual would have the opportunity to obtain a benefit if NERDTOH was refunded on the payment of an eligible dividend. We would be happy to provide additional information to you regarding the determination of whether a dividend is eligible or non-eligible.
Due to the refundable tax mechanisms, there is often a higher tax cost associated with earning investment income within a private corporation rather than personally based on current tax rates. It is critical to pursue planning opportunities to minimize the overall non-refundable tax cost to both you and your corporation, as well as maximize your current cash flow.
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