A look at new personal tax rates

The Canadian tax system is designed so that the total amount of income tax is the same regardless of whether the income is earned directly by the individual (i.e., investment income) or indirectly through a corporation (i.e., corporations earning investment income and paying dividends to shareholders).

This concept is often referred to as integration, and tax neutrality is an important outcome.

The federal government’s December 2015 Notice of Ways and Means Motion introduced the much-anticipated change to personal income-tax rates affecting middle- and high-income earners, including the new 33% top personal rate. But to uphold the tax system’s neutrality, Finance fine-tuned the provisions that affect Canadian-controlled private corporations (CCPCs). Here are the significant provisions.

• A CCPC’s additional refundable tax is set at 10.67% beginning in 2016, compared with 6.67% previously. The Department of Finance explains this change will “reduce personal income tax deferral possibilities that individuals earning income directly might otherwise obtain by earning such income through a CCPC.”
• Part IV tax levied on dividends received by a private corporation is now 38.33%, up from 33.33%.
• Similarly, the refund of refundable taxes is set at 38.33%, up from 33.33%.

Consider the following example of two Ontario taxpayers, Rashida and Byron, both in the new top tax bracket of 53.53% (33% federal and 20.53% provincial) on taxable income greater than $220,000.

• Rashida earns $10,000 of interest income personally. She pays $5,353 of income tax, leaving $4,647 to reinvest.
• Byron is the sole shareholder of a holding company (Holdco). Holdco earns $10,000 of interest income. Holdco’s tax rate on passive income is 50.17%, creating a $5,017 corporate income tax liability. A portion of Holdco’s income tax (30.67%, or $3,067) is refundable to the corporation when it pays a taxable dividend to Byron. The corporation could declare and pay a dividend of $8,000, which is comprised of $4,933 from its after-tax position, plus $3,067 of its refundable taxes. The $8,000 dividend paid to Byron is taxable at 45.30% (the effective marginal rate on ineligible dividends). The $3,624 tax bill leaves Byron with $4,376 in cash, which is $271 less than receiving the interest income directly.

While Rashida’s net position is 3% higher than Byron’s, they are very close in terms of the total amount of tax paid and after-tax cash. This is an example of neutrality: neither Rashida nor Byron are enticed, for tax reasons, to change how they hold their investments—personally or through a corporation.

Chart 1, page 22, depicts the outcome graphically. The left bar reflects Rashida’s outcome. The purple segment shows the total individual taxes paid on $10,000 of income, whereas the light green segment highlights $4,647 of after-tax income.

The middle bar depicts the corporate situation. Holdco earns $10,000 of interest income, paying $5,017 in total tax. The dark green segment represents $3,067 as the refundable portion of the total tax paid and the light green segment is the after-tax net income.

The right bar reflects the outcome when Holdco pays the $8,000 dividends to Byron. The net after-tax amount of $4,376 retained by Byron is light green.

Table 1, this page, shows the taxation of investment income earned directly by an individual or indirectly through his holding company, assuming the top tax rates for Ontario in 2016.

Integration is never perfect and exact amounts will depend on the tax brackets of the individual.

Table 1: Taxation on $10,000 of investment income

Income Type		Interest	Eligible Dividends	Capital Gain
Income Amount		$10,000	$10,000	$10,000
Personal Situation
Effective Tax Rate		53.53%	39.34%	26.77%
Taxes Payable		$5,353	$3,934	$2,677
After-tax Amount	B	$4,647	$6,066	$7,324
Corporate Situation
Effective Tax Rate		50.17%	38.33%	25.08%
Taxes Payable	C	$5,017	$3,833	$2,508
Refundable Portion		$3,067	$3,833	$1,533
After-tax Cash Position		$4,983	$6,167	$7,492
Capital Dividend		$0	$0	$5,000
Ineligible Dividend		$8,000	$0	$3,738
Eligible Dividend		$0	$10,000	$0
Indirect To Shareholder
Effective Tax Rate		45.30%	39.34%	45.30%
Taxes Payable		$3,624	$3,934	$1,693
After-tax Amount	A	$4,376	$6,066	$7,044
Efficiency (A-B)		-$271	$0	-$279
Tax Deferral
Personal Taxes Paid (B)		$5,353	$3,934	$2,677
Corporate Taxes Paid (C)		$5,017	$3,833	$2,508
Tax Deferral (B-C)		$336	$101	$168

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.