In Canada, we try to tax business income the same whether it's earned as salary or as dividend income.
Active business income earned within a corporation should be taxed so the combined corporate tax paid on income, plus the personal tax paid on dividends, is taxed the same as personal salary income. Mechanisms such as the dividend tax credit help with that goal.
But actual tax rates don't always line up with that goal. In fact, in most provinces, it's more advantageous in 2013 to earn active business income through a corporation than to earn it personally.
Benefit and cost of earning active business income through a corporation (2013)*:
|B.C.||Alta||Sask.||MB||Ont.||Qc||N. B.||N. S.||P.E.I.||NFLD|
*We assume active business income is earned within the corporation and flowed to shareholders as a non-eligible dividend, at maximum personal marginal tax rates. Based on tax rates as of January 1st, 2013.
That's why the federal government is enacting measures, effective January 1, 2014, that will increase the dividend tax rate on non-eligible dividends.
Let's look at the mechanics behind these changes and how the changes will impact clients who are shareholders of small business corporations.
New tax rules for Canadian non-eligible dividends
Dividends received from Canadian-controlled private corporations (CCPCs) are known as non-eligible dividends, and have a distinct tax treatment.
When a shareholder receives a non-eligible dividend, the amount of dividend included in her income is 125% of the actual dividend received. This additional 25% is referred to as the gross up. Additionally, people who receive non-eligible dividends benefit from the Dividend Tax Credit (DTC) equivalent to 13.33% of the gross-up amount.
As seen in the above example, the non-eligible dividend tax system overcompensates people who operate a business through a corporation. As a result, in order to better integrate the tax system, the 2013 Federal Budget introduced an adjustment to the gross-up factor (from 25% to 18%) and the dividend tax credit (from 13% to 11% of the gross up amount). This measure is now law and will apply to non-eligible dividends paid after 2013.
The effect of these modifications
The following comparison illustrates how the new rules will affect an Ontario-resident shareholder who receives a $1,000 non-eligible dividend:
(1) On a dividend of $1,000 for income between $ 135,055 and $ 509,000.
For this person, the taxation rate on non-eligible dividends will rise from 32.57% to 34.95%.
Effect on business owners
The rule changes will increase the maximum marginal tax rate on Canadian non-eligible dividends in all Canadian provinces:
|B.C.||Alta||Sask.||MB||Ont. (1)||Qc||N. B.||N. S.||P.E.I.||NFLD|
|(1) The maximum marginal tax rate on non eligible dividend received on income over $ 509,000 was 36.47% in 2013 and will be 38.60% in 2014.|
|(2) Based on know rates as of June 30th, 2013 (Source EY.com).|
And the following table shows it's generally less beneficial to earn active business income through a corporation as non-eligible dividends, compared to business income earned as salary:
|B.C.||Alta||Sask.||MB||Ont (1)||QC||N. B.||N. S.||P.E.I.||NFLD|
|Top Personal Marginal Tax Rate:||45.8%||39.0%||44.0%||46.4%||46.4%||50%||45.1%||50%||47.4%||42.3%|
|Personal Income Taxes:||458||390||440||464||464||500||451||500||474||423|
|Net Income to individual:||542||610||560||536||536||500||549||500||526||577|
|Active Business Income||1000||1000||1000||1000||1000||1000||1000||1000||1000||1000|
|Small Business Tax Rate:||13.5%||14%||13%||11%||15.5%||19%||15.5%||14%||15.5%||15%|
|Corporate Tax Paid:||135||140||130||110||155||190||155||140||155||150|
|After Tax Profit:||865||860||870||890||845||810||845||860||845||850|
|Top Marginal Tax Rate on Dividends:||37.98%||29.87%||35.32%||40.77%||34.92% (1)||39.91%||36.02%||39.07%||40.03%||31.01%|
|Personal Tax on Dividends:||329||257||307||363||295||323||304||336||338||264|
|Net income to Shareholder:||536||603||563||527||550||487||541||524||507||586|
|Net income to Shareholder-Net income to individual:||(6)||(7)||3||(9)||14||(13)||(8)||24||(19)||9|
|Tax Savings/(Cost) for Shareholder:||(0.6%)||(0.7%)||0.3%||(0.9%)||1.4%||(1.3%)||(0.8%)||2.4%||(1.9%)||0.9%|
In 2013, it was generally more tax-efficient to earn business income through a corporation as non-eligible dividends everywhere but Quebec and P.E.I. After the proposed changes, however, it will be more tax-efficient to earn business income personally as regular income in 6 out of 10 Canadian provinces.
Dividends still most tax-efficient
Despite these changes, dividends will remain the most tax-efficient way to receive income from a corporation, as the tax rate for non-eligible dividends will be less than the tax rate from a salary. But for owner-shareholders earning active business income in their corporations, review the mix of salary and dividends paid out from their corporation.
They should consider paying themselves more dividends in 2013, and reducing the dividends to be paid in 2014, as the rate will go up next year. And, if clients do not need income, they will still benefit from a significant tax deferral by having the business income taxed in their corporations at the low small business rate and keeping the profits invested for the future.
Finally, for retired business owners receiving income from their corporation, the reduction in gross-up amounts might bring relief, as the claw back rules for OAS and GIS are based on the grossed-up amount of dividends.