For a Canadian-controlled private corporation, the first $500,000 of active business income is generally taxed at low corporate tax rates. It’s taxed a second time when the funds are removed from the corporation through a dividend.
To avoid paying tax twice on the same income, the Income Tax Act has a gross-up and dividend tax credit, which attempts to achieve integration: a client should be able to receive the same amount of cash after-tax whether she earns income personally or through a corporation.
For example, if a client earns $1,000 of income and is in a theoretical 45% tax bracket, she would pay $450 in tax, and be left with $550. If she earns the same $1,000 through a private corporation, assuming a small business corporate tax rate of 20%, the company would be left with $800 after it paid $200 of corporate tax.
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This $800 would then be paid out as a dividend, which is then grossed-up by 25% and reported as $1,000 of taxable income on her personal tax return. She would pay $450 in tax, but get a dividend tax credit of $200, resulting in net personal tax of only $250. Integration is achieved, since she ends up with $550 regardless of how she earned the income.
This issue played into an Ontario family law decision (Rawluk-Harness v. Harness, 2014 ONSC 2531) that involved a request by a mother to obtain increased interim child support for her two children. The mother wanted the support based on the father’s prior year’s income, which came from dividends he received from his wholly owned private corporation. The issue was whether the actual dividends the father received ($50,000) or the 25% grossed-up amount ($62,500) should be used to determine his level of child support.
The father relied on the Federal Child Support Guidelines, which say, “Replace the taxable amount of dividends from taxable Canadian corporations received by the spouse [with] the actual amount of those dividends received by the spouse.”
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The father felt his support should be based on his actual dividends received. But the mother argued that, by taking a dividend from his corporation, the father (after his income was adjusted) would end up paying less child support than if he’d taken a salary. So, she felt the father’s dividend should be grossed-up for child support purposes. The Guidelines permit the court discretion in calculating a spouse’s income, including when the spouse “derives a significant portion of income” from “sources taxed at a lower rate than employment or business income.”
Citing Riel v. Holland (2003), the judge said the rules intend “to ensure that two parents, where one earns a salary and the other has a similar business income, but pays less tax, are treated consistently in respect of their child support obligations.” The judge concluded it was appropriate to include “in the payor’s income the […] grossed-up dividend, rather than the actual dividend received.” So, he ordered the father to pay additional interim support.
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by Jamie Golombek, CPA, CA, CFP, CLU, TEP, managing director, Tax & Estate Planning, CIBC Wealth Advisory Services. Jamie.Golombek@cibc.com