How Is Investment Income Earned In My Corporation Taxed? It Can Be Costly!
As a business owner, you may have surplus cash accumulating in your corporation. Perhaps you have been setting aside funds for a large future business purchase or perhaps you received a cash inflow from a major sales contract.
Either way, you should determine how to maximize the value of this surplus cash. One method of increasing the value of the surplus is investing the funds within your corporation.
Taxation of investment income in a corporation
When you have surplus cash in your corporation, the first step is to determine if the business will need the funds in the near future. Perhaps your corporation will need the excess cash to pay tax instalments or make a major business acquisition.
If you decide to invest the surplus cash accumulating in your corporation, the income generated might be considered incidental to your business and may be taxed as active business income.
If it is determined that the income generated from investing the surplus cash is not incidental to your business, it would be taxed as passive investment income.
Passive investment income may include interest income, foreign dividend income, rental income, royalty income and taxable capital gains. This is the case whether the investment income is earned in your operating company or your holding company.
When a private corporation (not just a CCPC) earns passive investment income (excluding Canadian dividends), it is currently subject to a federal tax at a rate of 28%.
A private corporation is also subject to an additional refundable tax of 10 2/3 % on this investment income for a total federal tax of 38 2⁄3%.
A portion of the total tax paid is refundable to the corporation when taxable dividends are paid out to the shareholders. The refundable portion is calculated as 30 2/3% of the investment income.
The refundable portion is reduced if the corporation earns foreign investment income and claims a foreign tax credit for the non-resident withholding tax paid.
The mechanism for the refund is explained in greater detail in the dividend refund section. The purpose of this pre-payment and refund of tax is to achieve an important principle of the Canadian tax system commonly referred to as “integration”. When a tax system is perfectly integrated, an individual will be indifferent to earning investment income in a corporation versus earning it personally.
Without the refundable tax on investment income, a corporation would pay less tax on investment income than an individual (with a high marginal tax rate) and this advantage would encourage individuals to earn investment income in a corporation to defer tax.
Tax on Canadian dividends Canadian dividends earned in a corporation are not subject to regular corporate tax. Instead, they are subject to special tax rules depending on whether the dividends are received from a connected or non-connected corporation.
A payer corporation is connected to the corporation that receives the dividends if:
• the recipient corporation owns more than 10% of the voting shares and more than 10% of the fair market value of all of the issued shares of the payer corporation, or
• the recipient corporation controls the payer corporation. (For the purposes of determining whether two corporations are connected, the normal concept of control is expanded and provides that one corporation is controlled by another if more than 50% of its shares (that have full voting rights) belongs to the other corporation, persons that do not deal at arm’s length with the other corporation, or a combination of the other corporation and persons that do not deal at arm’s length with the other corporation.)
Dividends received from Canadian corporations that are not connected are subject to a special refundable tax at 381 ⁄3%. This entire tax is refundable to the corporation once taxable dividends are paid out to the shareholders.
Dividends received from connected corporations are generally not subject to this special refundable tax unless the paying corporation received a refund of its taxes when it paid the dividends.
In certain circumstances, inter-corporate dividends between connected corporations may be able to be paid tax-free.
an ordering rule requires that a private corporation paying a non-eligible dividend must exhaust its non-eligible RDTOH account before claiming a refund from its eligible RDTOH account.
If a corporation obtains a dividend refund when it pays a taxable dividend to a connected corporation, the recipient corporation is subject to a refundable tax.
For tax years beginning after 2018, this refundable tax will be added to the same RDTOH account from which the payer corporation received the refund.
Transitional rules have been introduced to deal with a corporation’s existing RDTOH balance. For a CCPC, the lesser of its existing RDTOH balance and an amount equal to 381 ⁄3% of the balance of its general rate income pool, if any, will be allocated to its eligible RDTOH account.
The general rate income pool is a notional account that keeps track of ABI that was taxed at the general corporate tax rate and eligible dividends received by the corporation.
Any remaining balance in its existing RDTOH account will be allocated to the CCPC’s non-eligible RDTOH account. For any other corporation, all of the corporation’s existing RDTOH balance will be allocated to its eligible RDTOH account