There are nearly 2.5 million businesses in Canada, according to Industry Canada. A large portion of them are small and medium enterprises (SMEs) operated as corporations with one or a few shareholders. These shareholders generally rely on the income generated by their corporation’s business to fund their lifestyles and, above all, to accumulate capital to meet their needs in retirement.
Entrepreneurs are not always familiar with the rules governing the taxation of investment income inside a corporation and how this might impact their financial plans. This article reviews the benefits of operating a business inside a corporate structure; explains the taxation rules of investment income inside a corporation; and proposes a tax-efficient solution for entrepreneurs who want to invest inside their corporations.
Taxation of active business income
Canadian-controlled private corporations (CCPCs) have a tax rate of approximately 27.34% (Canadian national average) on annual active business income. As shown in the following chart, CCPCs benefit from a small business deduction that lowers their tax rate to approximately 14.3% (Canadian national average) on the first $500,000 of annual active business income.
|Federal (A)||Average Provincial Tax Rate (B)||Average Combined Tax Rate (A+B)|
|Active business income tax rate||11.0%||3.3%||14.3%|
Active business income is income generated from the core business activities of a CCPC. Consider the hypothetical example of John, who owns a CCPC that operates a restaurant. The corporation’s business income derived from the restaurant is considered active business income. But if John’s corporation invested its retained earnings in a guaranteed investment certificate (GIC), income generated by these investments would be passive income and subject to a higher level of taxation.
As shown on the following chart, the low active business income tax rate confers a significant advantage on the entrepreneur who operates his business within a corporation and does not need to withdraw all income for personal use. It allows the owner to defer personal taxation on the income until received from the corporation in the form of a dividend:
|Average Small Business Tax Rate on first $500 000 of income (A)||Average Maximum Marginal Rate on personal income (B)||Average Tax Deferral Available in Canada (B-A)|
|Average Tax Rate||14.3%||45.6%||31.3%|
Returning to the example of John, the corporation generates active business income of $100,000. He doesn’t need this income because he receives a salary that covers his cost of living expenses; he also has other sources of income. He is able to defer approximately $31,300 in taxes annually—money that can be invested to earn extra income.
If he operated his restaurant personally John would be taxed at his personal maximum marginal tax rate on all income generated by the restaurant.
Let’s now examine how passive income (investment income) is taxed inside a corporation.
Taxation of investment income within a corporation
Since there is a strong incentive for business owners to accumulate profits inside their corporation, business owners will accumulate investment assets within their corporations.
The conundrum is that while active business income receives favorable tax treatment, the same cannot be said for investment income. As shown on the chart below, interest income and the taxable portion of capital gains earned within a corporation will be generally taxed at an average rate of 47%.
|Federal Tax Rate (A)||Average Provincial Rate (B)||Average Combined Tax Rate (A+B)|
|Tax Rate on Investment Income Earned inside a Corporation||34.67%||12.34%||47.01%|
On the other hand, the 50% non-taxable portion of capital gains earned inside a corporation will be payable tax-free to shareholders through the corporation’s capital dividend account (CDA), while the taxable portion (50%) is taxed at the same rates that apply to interest income.
For eligible dividends (dividends typically paid by publicly traded Canadian companies) earned within the corporation, the taxation rate is 33 1/3%. This is known as Part IV tax.
To avoid double taxation (payment of tax on investment income earned inside the corporation followed by the payment of personal income tax when the income is paid as a dividend to shareholders), a system of refundable taxes was established. This allows a corporation to receive a refund of a portion (26.67%) of the initial taxes paid by the company on interest income at a future point in time, when a taxable dividend in paid to the shareholder.
Similarly, for eligible dividends, the full amount of Part IV taxes is refundable to the corporation when flowed out to the shareholder personally. Specifically, $1 will be refunded to the corporation for every $3 paid out as taxable dividends to the shareholders.
For simplicity’s sake, once income is received and taxed inside the corporation, and then paid out as a dividend to shareholders and taxed in their hands, the total combined tax rate (corporate/personal) would be as follows (Canadian national average):
|Average Combined (Corporate/Personal) Tax Rate on Interest and Other Income||Average Combined (Corporate/Personal) Tax Rate on Dividend Income||Average Combined (Corporate/Personal) Tax rate on Capital Gains|
|Average Combined (Corporate/Personal) Tax Rate||47.95%||27.89%||24.0%|