Many business-owner clients are not taking advantage of investment opportunities in their corporations. Quite often, you will examine a corporation’s (specifically a Canadian-controlled private corporation’s) balance sheet only to see cash sitting idle in a low-interest bank account.
Often, the owner of the corporation wasn’t aware that corporate funds can be invested just like their personal holdings. If they were aware, some are reluctant to take on additional risk in their corporate holdings in addition to the ongoing business risk. Nonetheless, properly invested “retained earnings” can go a long way to supplementing a business owner’s retirement.
With that in mind, business owners and their financial advisors may turn their attention to investing in foreign dividend-paying stocks. Investing in stocks directly can help clients amass savings, generate income, protect against inflation while minimizing taxes through tax-deferred growth, and reduce risk through diversification.
However, foreign dividend income, whether earned personally or in a corporation, is considered “bad” income because it’s taxed as ordinary income (similar to the tax treatment of interest income). Using Ontario tax rates as an example, earning foreign dividend income inside a corporation can be particularly punitive from a tax perspective as it is taxed at a high rate initially (50.17%, including the foreign withholding tax) compared to Canadian dividends (38.33%) and capital gains (25.08%), and there’s also a “grind” to the refundable portion of the Part I tax payable.
In short, the amount that would be added to the corporation’s refundable dividend tax on hand account (RDTOH) is less than what it would have been from an interest-bearing investment due to the foreign withholding tax mechanism. On U.S dividends, the withholding tax requirement under the Canada-U.S. tax treaty is 15%. The withholding tax requirement differs depending on the source country and whether or not a tax treaty is in place.
As an example, imagine Kellie, an Ontario resident who is the shareholder of her corporation, Kellie Inc., located in Ontario. Let’s compare the combined integrated tax rates between Kellie Inc. earning interest income and foreign dividend income once the money flows out to Kellie by way of an ineligible dividend.
|Interest income||Foreign dividend income|
|Tax paid by corporation||50.17%||35.17%|
|Foreign tax paid via withholding||n/a||15.00%|
|Total taxes paid||50.17%||50.17%|
|Refundable portion of Part 1 tax||30.67%||18.77%|
|Combined corporate/shareholder tax rate1||57.93%||64.15%|
1 Assume highest marginal tax rate in Ontario on ineligible dividends of 47.74% for 2022.
To put this into context, let’s say Kellie Inc. earned $10,000 of foreign dividend income. Because Kellie pays the highest marginal tax rate personally, she would be left with only $3,585 in her hands after taxes are paid at both the corporate and personal level. Even interest income, which is traditionally known as “tax unfriendly,” comes out ahead: if Kellie Inc. had earned $10,000 of interest income, it would translate into $4,207 personally after taxes. As you can see, earning foreign dividend income in a corporation can be extremely punitive from a tax perspective and thus should likely be avoided.
So, is there a way for clients to invest in foreign securities inside their corporation without the punitive taxation? Yes, via a corporate class mutual fund. Corporate class funds never distribute interest or foreign income — only Canadian dividends, capital gains dividends, or return of capital. As a result, a corporate client could get exposure to international equities without having to worry about punitive foreign dividends.
From a tax perspective, it’s generally beneficial for a corporation to realize capital gains rather than earn other types of income. Furthermore, when a corporate investor receives capital gains dividends, the non-taxable portion will be added to the corporation’s capital dividend account, where money can be extracted by the shareholders tax-free. A capital gains dividend is a distribution paid by a corporate class mutual fund from its capital gains.
In addition to corporate class funds, clients seeking foreign dividend exposure inside their corporation without the punitive taxes have a few other options. Clients could also consider an Individual Pension Plan, personal registered accounts such as RRSPs and TFSAs, or non-registered accounts.
Jon Hreljac, CPA, CMA, CFP, TEP, is AVP regional tax and estate planning, wealth, at Manulife Investment Management