Earning Investment Income In a Corporation Reaps No Benefits
Earning investement income inside of you corporation will not shield you from higher tax rates. That is because investment income earned within your corporation is taxed at the highest tax rate and does not benefit from the SBD (Small Business Deduction). It is considered passive income and the SBD is reserved to a corporations ABI (Active Business Income).
The way that investment income will be taxed is through the RDTOH (Refundable Dividend Tax on Hand) in which:
The corporation pays tax on its investment income and
At the same time a portion of the taxes (30 2/3 %) is paid into a RDTOH account.
This balance needs to be tracked because because it is refundable back to the corporation of each dollar of taxable dividends paid at a ratio of 38 1/3% .
The result is that the corporation does not provide a deferral on investment income.
Instead, there is corporate tax immediately on the investment income and a portion of that will be refunded once a taxable dividend has been paid out to avoid double taxation.
In Ontario, the highest personal tax rate is 53.53%. In a corporation, investment income is taxed at 50.17%. When the RDTOH is refunded upon the payment of a dividend, the net tax in the corporation is 19.50% (50.17-30.67%). This does mean that there is a small deferral by earning investment income in the corporation. The deferral is 3.36% (53.53% - 50.17%).
When a non-eligible taxable dividend is received by an individual and taxed at the highest rate, the tax rate to the individual is 46.65% in Ontario.
Based on this, the personal tax on the funds available would be approximately 37.6% (46.65% x $80.50) . The net effect is that the overall tax rate including corporate and personal tax on earning investment income is 57.2%. This is 3.68% greater that earning the investment income directly (57.2% vs 53.53%).
For a capital gain, the cost of earning capital gains in a corporation versus directly is 1.84%. There is also a deferral in this case of 1.68%.
Based on this, what should taxpayers consider in determining whether they should earn investment income in the corporation or not?
One of the first considerations is the cost of taking capital out of a company in order to earn the investment income personally.
In other words, if a corporation has accumulated retained earnings, there is a cost to taking that capital out. The cost would be the dividend tax rate of 46.84%.
In most cases, it is not efficient to accelerate the payment of personal tax on these accumulated retained earnings in order to reduce the corporate tax on the investment income on that capital.
As well, if there are accrued gains on the capital in the corporation, there would also be a capital gains tax on the liquidation of any assets with accumulated gains. Therefore, in most situations where there is significant accumulated capital in a corporation, it does not make sense to wind up the corporation or liquidate the assets so that the assets are held personally.
Another consideration is the new rules wherein if a corporation earns more than $50,000 of adjusted aggregate investment income then the corporation will start to lose the small business deduction.
What qualifies as aggregate investment income? In general terms, “aggregate investment income” of a CCPC includes net taxable capital gains (i.e., half of capital gains, net of allowable capital losses), most forms of income from property like interest and rent, and portfolio dividends (dividends received from “non-connected” corporations)
Corporations with more than $50,000 of passive investment income in the previous year will see a reduction, and possible complete loss, of the small business deduction.
This is only relevant in those situations where the corporation earning investment income has either active business income in the same corporation or active business income as part of an associated group.
In those cases, consideration should be made as to whether or not the after-tax funds of the active business income should be left in the corporation or should be paid out as a dividend so that the capital can be used to earn investment income personally instead of in the corporation.
One must consider that if I earn Active Business Income inside my corporation, the tax rate is on average 13.5%. So there is a deferral inside the corporation until it is distributed to the shareholders and becomes taxable personally ( although dividends are grossed up and given a credit to take account of corporate taxes already paid).