corporate-business

There are certain circumstances when a Canadian-controlled private corporation will receive a refund of some income taxes paid.

Why? Thanks to the Refundable Dividend Tax on Hand (RDTOH) account.

What is the RDTOH?

RDTOH is a notional account used to track a defined portion of a private corporation’s income tax paid on Aggregate Investment Income (AII), along with tax paid on dividends from non-connected corporations (corporations where share ownership is 10% or less). This will generally mean investment portfolio dividends.

Aggregate investment income

AII includes interest, rent, royalties, income from property and net taxable capital gains, less business investment losses and related expenses.

AII (passive income) is taxed at 45.67% to 50.67%, depending on the province. The calculation for that tax rate is:

  1. basic federal tax of 38%, less
  2. federal tax abatement of 10%, plus
  3. additional refundable tax of 6.67%, plus
  4. provincial tax rate (11% to 16%, depending on the corporation’s province of residence).

The corporation adds 26.67% of the AII amount to its RDTOH account. RDTOH is a federal mechanism; no provinces participate in the account’s operation. When RDTOH is factored into the effective rate of tax paid by a private corporation, the federal government nets 8% tax on AII.

Dividends from non-connected corporations

Portfolio dividends are taxed under Part IV of the Income Tax Act, at a rate of 33% (federal tax). The entire Part IV tax is added to the RDTOH account and becomes refundable. Portfolio dividends are not taxed by the provinces. Intercorporate dividends between connected corporations (greater than 10% of votes and value) can be paid tax-free, and do not impact the RDTOH account. But, there’s an exception if the payor corporation has a balance in its RDTOH account. To the extent the payor receives a refund of RDTOH due to paying incorporate dividends, the receiving corporation has a tax liability of the same amount.

How does the refund work?

When there’s a balance in the RDTOH account, amounts are refunded to the corporation at a rate of $1 for each $3 of taxable dividends paid.

How do you calculate RDTOH?

The corporation’s tax return is used to track its RDTOH account activity. The account’s opening balance is the prior year’s closing balance less any dividend refund paid the prior year. The next step is to add 26.67% of AII and 33% of portfolio dividends to determine the RDTOH balance at the end of the year. The dividend refund from the RDTOH is calculated as the lesser of 33% of taxable dividends paid and the RDTOH balance at the end of the year.

Example

Let’s look at an example of $1,000 of investment income, analyzed from the perspective of interest, eligible dividends and capital gains (see Chart 1). The $1,000 could be earned directly by an individual, or indirectly through a corporation and subsequently distributed as a dividend.

The chart highlights the shortcomings of the theory of integration—the idea that the amount of tax someone pays should be the same whether she earns income directly or indirectly through a corporation. Under the interest option, the indirect receipt as a shareholder results in $20 of extra tax compared to earning the interest income directly. Capital gains are similar, resulting in an extra $10 of tax paid. The receipt of eligible dividends under either option is neutral, because the 33% tax applied on dividends received by the corporation is fully refundable.

The chart also highlights the deferral of income taxes through a corporation. Under the interest option, the individual pays $500 in taxes in the year when the interest income is earned, whereas the corporation pays $467 in the year the interest income is earned. The indirect option provides a deferral of $33 that holds until the corporation pays a dividend to its shareholder. The capital gain option is similar, with a $17 deferral. Eligible dividends create a tax disadvantage because the corporate tax rate exceeds the personal rate.

As the account is notional (no money actually changes hands), RDTOH is not necessarily reported on the corporation’s balance sheet; rather, it’s tracked on the corporation’s annual tax return. Only private corporations have this notional account; public and foreign corporations do not.

The account is designed to prevent a significant deferral of tax on portfolio income by encouraging the flow-through of investment income.

CHART 1: Treatment for $1,000 of investment income
Income Type Interest Eligible Dividends Capital Gain
Income Amount $1,000 $1,000 $1,000
Personal Situation
Effective Tax Rate 50.00% 33.00% 25.00%
Taxes Payable $500 $330 $250
After-tax Amount B $500 $670 $750
Corporate Situation
Effective Tax Rate 46.67% 33.33% 23.33%
Taxes Payable C $467 $333 $233
After-tax Cash Position $533 $667 $767
Refundable Portion $267 $333 $133
Indirect To Shareholder
Capital Dividend $0 $0 $500
Ineligible Dividend $800 $0 $400
Eligible Dividend $0 $1,000 $0
Effective Tax Rate 40.00% 33.00% 40.00%
Taxes Payable $320 $330 $160
After-tax Amount A $480 $670 $740
Efficiency (A-B) -$20 $0 -$10
Tax Deferral
Personal taxes paid (B) $500 $330 $250
Corporate taxes paid (C) $467 $333 $233
Tax deferral (B-C) $33 -$3 $17

by James W. Kraft, CPA, CA, MTax, CFP, TEP, and Deborah Kraft, MTax, LLM, TEP, CFP. Deborah is faculty and director, Master of Taxation Program, School of Accounting & Finance, University of Waterloo. James is vice-president, Head of Business Advisory & Succession, BMO Nesbitt Burns.

Originally published in Advisor's Edge Report

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