This article was written in June 2017, prior to Finance Minister Bill Morneau’s business tax proposals.
Businesses make money in two main ways: selling products or services, and investing their cash on hand. The former is typically known as active income, and the latter, passive.
The distinction matters for tax purposes, because the rate of federal income tax paid by corporations varies based on the type of income earned.
The four main types of income are:
- active business income up to the small business limit ($500,000 federal limit);
- active business income in excess of the small business limit;
- aggregate investment income (e.g., rents, royalties, interest), often referred to as passive income; and
- dividend income, often referred to as portfolio dividends because dividends paid between connected corporations often are non-taxable.
Table 1, below, walks us through the corporate tax rates for those four types of income. As outlined, the effective tax rate on passive income is 50.7%, while dividend income is taxed at 38.3%. However, a portion of the federal tax on passive and dividend income is refundable when a taxable dividend is paid to a corporation’s shareholder. This is a federal calculation only, as the provinces do not have a refundable component.
Table 1: Development of corporate tax rates (2016)
■ Federal % ■ Provincial % ■ Total %
|Active business income|
|Starting federal tax rate||38|
|Less: The general rate reduction for corporations earning active business income||(13)|
|Less: Reduction for income taxed in a province, since provinces levy tax separately (provincial abatement)||(10)|
|Net tax rate on active business income in excess of $500,000||15|
|Add: Assumed average provincial tax rate on this type of income1||12|
|Effective tax rate on income not eligible for the small business deduction||27|
|Net tax rate on active business income in excess of $500,000||15|
|Less: Federal reduction for active business income up to $500,0002||(4.5)|
|Net tax rate on active business income up to $500,000||10.5|
|Add: Assumed average provincial tax rate on this type of income3||3|
|Effective tax rate on income eligible for the small business deduction||13.5|
|Additional refundable tax levied on Canadian-controlled private corporations||10.7|
|Add: 38% federal starting rate, less the 10% provincial abatement||28|
|Net tax rate for aggregate investment income||38.7|
|Add: Assumed average provincial tax rate on this type of income4||12|
|Effective tax rate on income eligible for the small business deduction||50.7|
|Tax rate on dividends5 received by a Canadian-controlled private corporation||38.3|
|Add: Nothing. The provinces do not levy a tax on portfolio dividends||0|
|Total combined tax on dividend income||38.3|
1 Provincial rates vary from 11% to 16%.
2 The small business limit is $500,000 federally and provincially, except for Manitoba ($450,000) and Nova Scotia ($350,000).
3 Provincial rates vary from 0% to 4.5%.
4 Provincial rates vary from 11% to 16%.
5 Dividends paid between connected corporations are often non-taxable. Corporations are connected when one corporation owns shares, of the other, that represent more than 10% of the votes and more than 10% of the corporation’s value.
The details are:
- The refundable portion on aggregate investment income (passive income) is 30.67%. Subtract that from the 38.7% figure shown in Table 1, and the net tax rate is 8%.
- All tax paid on portfolio dividends, 38.3%, is refundable.
Earning income personally
Let’s assume a person taxed at the top marginal rate earns $100,000 personally under three scenarios: as business, passive or dividend income (see Table 2, below). Under the business and passive income scenarios, the person’s net after-tax income is $50,000, whereas dividend income results in $64,000 of net after-tax income.
Table 2: Income earned personally (2016 rates)
|Combined federal and provincial tax||$50,000||$50,000||$36,000|
|Net after-tax income||$50,000||$50,000||$64,000|
Assumes a federal and provincial marginal tax rate of 50% on regular income and an effective rate of 36% for dividends.
Using a corporation—active income
How would the person’s financial position change if the $100,000 of income was earned through a corporation and subsequently paid to her as a dividend? The outcome will depend on the type of dividend—eligible or ineligible—and the type of income realized by the corporation.
Table 3 depicts four scenarios highlighting how different types of income earned by a Canadian-controlled private corporation would be taxed. Table 4 continues these scenarios to show how the shareholder would be taxed if the corporation’s net cash flow was used to pay a dividend to the shareholder.
Let’s look at scenario A-1 in Table 3, where the corporation earns $100,000 of income eligible for the small business deduction. The net after-tax position of the corporation is $86,500, which could be paid as an ineligible dividend to the shareholder, putting her in an after-tax position of $50,170 (A-1, Table 4).
Table 3: Income earned within corporation (2016 rates)
|Active business income eligible for the small business deduction||Active business income in excess of the small business limit||Aggregate investment income (passive income)||Portfolio dividends|
|Less: Federal tax||$10,500||$15,000||$38,667||$38,333|
|Less: Hypothetical provincial tax||$3,000||$12,000||$12,000||$0|
This results in $170 more for the shareholder compared to column A in Table 2, when the income was earned directly by the shareholder. In Table 3, column A-2, the $100,000 is not eligible for the small business deduction. The corporation’s after-tax position is $73,000, putting the shareholder in an after-tax position of $46,720 (A-2, Table 4). This represents $3,280 less after-tax income for the shareholder compared to column A in Table 2, when $100,000 of business income was earned personally.
Table 4: Corporation pays dividend to shareholder (2016 rates)
|Type of dividend||Ineligible||Eligible||Ineligible||Eligible|
|Dividend gross up||17%||38%||17%||38%|
|Taxable amount of dividend received||$101,205||$100,740||$93,600||$138,000|
|Taxes payable, assuming a 50% tax rate||$50,602||$50,370||$46,800||$69,000|
|Less: Dividend tax credit7||$14,272||$24,090||$13,200||$33,000|
|Net taxes payable8||$36,330||$26,280||$33,600||$36,000|
|Net cash flow (dividend paid minus net taxes payable)||$50,170||$46,720||$46,400||$64,000|
6 The corporation could pay out a dividend that anticipates its refundable taxes. This is reasonable if the dividend occurs in the same year, before the taxes due are paid, or if the corporation has other cash flow that can be used and replaced when the refundable taxes are received.
7 Based on the 2016 federal dividend tax credit of 12.3%, 15% of taxable amount of ineligible and eligible dividends, plus provincial dividend tax credit.
8 The net taxes payable reflect an effective combined provincial/federal tax rate of 36% and 42% for eligible and ineligible dividends, respectively.
Now, let’s assume the corporation earns $100,000 of passive income (column B of Tables 3 and 4). That results in the shareholder’s after-tax position of $46,400 on an $80,000 ineligible dividend (assumes full refund of refundable taxes). Earning this type of income through the corporation results in $3,600 less for the shareholder than if the income were earned directly (column B in Table 2). If we assume $100,000 of portfolio dividend income (row/column C of Tables 3 and 4), the net after-tax position of the shareholder is $64,000, which is the same outcome as having earned the income personally as dividend income (column C of Table 2). To visualize the comparison, Table 5 highlights the differences in the tax liability realized.
While the tax system strives for neutrality as to how the income is earned—personally or through a corporation—there is some arbitrage that can provide a financial benefit or cost to the taxpayer. To fully evaluate a taxpayer’s situation, this type of analysis must incorporate a person’s own tax profile using actual provincial rates.
Table 5: Outcome comparison (2016 rates)
|Extra tax paid because the income was earned indirectly||$3,280||$3,600||$0|
|Extra tax paid because the income was earned directly||$170||$0|