Editor’s note: This article is from 2013. For 2017 information, read our article, “Salary or dividends: Which is better for business owners?”
There are nearly 2.5 million businesses in Canada, according to Industry Canada. A large portion of them are small and medium enterprises (SMEs) operated as corporations with one or a few shareholders. These shareholders generally rely on the income generated by their corporation’s business to fund their lifestyles and, above all, to accumulate capital to meet their needs in retirement.
Entrepreneurs are not always familiar with the rules governing the taxation of investment income inside a corporation and how this might impact their financial plans. This article reviews the benefits of operating a business inside a corporate structure; explains the taxation rules of investment income inside a corporation; and proposes a tax-efficient solution for entrepreneurs who want to invest inside their corporations.
Taxation of active business income
Canadian-controlled private corporations (CCPCs) have a tax rate of approximately 27.34% (Canadian national average) on annual active business income. As shown in the following chart, CCPCs benefit from a small business deduction that lowers their tax rate to approximately 14.3% (Canadian national average) on the first $500,000 of annual active business income.
|Federal (A)||Average Provincial Tax Rate (B)||Average Combined Tax Rate (A+B)|
|Active business income tax rate||11.0%||3.3%||14.3%|
Active business income is income generated from the core business activities of a CCPC. Consider the hypothetical example of John, who owns a CCPC that operates a restaurant. The corporation’s business income derived from the restaurant is considered active business income. But if John’s corporation invested its retained earnings in a guaranteed investment certificate (GIC), income generated by these investments would be passive income and subject to a higher level of taxation.
As shown on the following chart, the low active business income tax rate confers a significant advantage on the entrepreneur who operates his business within a corporation and does not need to withdraw all income for personal use. It allows the owner to defer personal taxation on the income until received from the corporation in the form of a dividend:
|Average Small Business Tax Rate on first $500 000 of income (A)||Average Maximum Marginal Rate on personal income (B)||Average Tax Deferral Available in Canada (B-A)|
|Average Tax Rate||14.3%||45.6%||31.3%|
Returning to the example of John, the corporation generates active business income of $100,000. He doesn’t need this income because he receives a salary that covers his cost of living expenses; he also has other sources of income. He is able to defer approximately $31,300 in taxes annually—money that can be invested to earn extra income.
If he operated his restaurant personally John would be taxed at his personal maximum marginal tax rate on all income generated by the restaurant.
Let’s now examine how passive income (investment income) is taxed inside a corporation.
Taxation of investment income within a corporation
Since there is a strong incentive for business owners to accumulate profits inside their corporation, business owners will accumulate investment assets within their corporations.
The conundrum is that while active business income receives favorable tax treatment, the same cannot be said for investment income. As shown on the chart below, interest income and the taxable portion of capital gains earned within a corporation will be generally taxed at an average rate of 47%.
|Federal Tax Rate (A)||Average Provincial Rate (B)||Average Combined Tax Rate (A+B)|
|Tax Rate on Investment Income Earned inside a Corporation||34.67%||12.34%||47.01%|
On the other hand, the 50% non-taxable portion of capital gains earned inside a corporation will be payable tax-free to shareholders through the corporation’s capital dividend account (CDA), while the taxable portion (50%) is taxed at the same rates that apply to interest income.
For eligible dividends (dividends typically paid by publicly traded Canadian companies) earned within the corporation, the taxation rate is 33 1/3%. This is known as Part IV tax.
To avoid double taxation (payment of tax on investment income earned inside the corporation followed by the payment of personal income tax when the income is paid as a dividend to shareholders), a system of refundable taxes was established. This allows a corporation to receive a refund of a portion (26.67%) of the initial taxes paid by the company on interest income at a future point in time, when a taxable dividend in paid to the shareholder.
Similarly, for eligible dividends, the full amount of Part IV taxes is refundable to the corporation when flowed out to the shareholder personally. Specifically, $1 will be refunded to the corporation for every $3 paid out as taxable dividends to the shareholders.
For simplicity’s sake, once income is received and taxed inside the corporation, and then paid out as a dividend to shareholders and taxed in their hands, the total combined tax rate (corporate/personal) would be as follows (Canadian national average):
|Average Combined (Corporate / Personal) Tax Rate on Interest and Other Income||Average Combined (Corporate / Personal) Tax Rate on Dividend Income||Average Combined (Corporate / Personal) Tax rate on Capital Gains|
|Average Combined (Corporate / Personal) Tax Rate||47.95%||27.89%||24.0%|
Once paid to and taxed in the hands of the shareholders, the different types of income keep their characteristics: interest and foreign income is taxed higher than dividend income, which is taxed higher than income generated from capital gains.
What type of investment instrument might be best suited to an entrepreneur who is looking to invest within his corporation?
Corporate class mutual funds
Entrepreneurs who invest within their corporation need products that offer a certain level of security. Many entrepreneurs believe they take enough risk with their regular business, so they want little or no additional risk when investing inside their corporation.
They also attach great importance to liquidity. Entrepreneurs are always looking for new opportunities, like acquiring a competitor, buying new equipment, purchasing a building for corporation business, etc. This makes it important to have the option to redeploy their investment.
Investment vehicles traditionally used by entrepreneurs within their corporations, like GICs, cannot offer both yield and liquidity. The website of a major Canadian financial institution tells us an entrepreneur would have to lock-in his corporation’s investment for a period of 5 years to receive a yield of 1.75%. Many do not want to commit to an investment for such a long period.
Corporate class mutual funds combine flexibility, security and tax efficiency. They benefit from a different legal structure than “traditional” mutual funds, which are structured as trusts. Corporate class funds are available in many different investment mandates, including fixed-income mandates that offer the security entrepreneurs want. Fixed-income corporate class funds combine the tax efficiency of corporate class funds with the relative safety of a bond portfolio. Benefits include:
- Their legal structure allows interest income to be transformed into dividends or capital gains, the most tax-efficient forms of investment income;
- They generally do not pay unwanted distributions , thus limiting an annual tax drag on investment growth;
- They allow the entrepreneur to defer taxation to a moment of his own choosing (when he directs the corporation to redeem the investment);
- They allow transfers between funds having different investment objectives within the same mutual fund corporation without triggering a taxable disposition;
- They allow the entrepreneur to receive tax-free capital dividends through the use of the corporation’s capital dividend account (CDA).
Consider this example. John does not need income from his corporation and will invest retained earnings within his corporation. He wants secure investments and wants to retain some flexibility; he might buy another restaurant in the near future. Finally, he wants to minimize taxes payable on income generated from this investment.
His financial advisor offers him two options: first, purchase a GIC yielding 4% or invest in a fixed-income- oriented corporate class mutual fund that produces a similar yield. The following chart shows his total rate of return on both investments, after the corporation pays taxes and after he receives the investment income by way of a dividend and pays personal taxes on it.
|GIC||Corporate Class Mutual Funds||Difference|
|Rate of Return after Corporate / Personal Taxes||2.12 %||3.06 %||+ 0.94
(+ 44 %)
|Inflation Rate in Canada Dec. 2012||(0.80 %)||(0.80 %)||–|
|Rate of Return after Corporate / Personal Taxes and Inflation||1.32 %||2.26 %||+ 0.94
If John opts to invest in a corporate class mutual fund, assuming interest income is converted into capital gains (interest income can be converted into dividends or capital gains depending on whether the mutual fund pays distributions), he could obtain a rate of return 44% higher than a similar GIC investment. Even better, if you factor in the effects of inflation on the after-tax return, John would receive a yield 71% higher than the GIC.
Why the difference? While the GIC produces taxable interest income, corporate class funds typically produce capital gains, even if the underlying mandate only uses fixed-income investments. At a time when interest rates are historically low, the tax efficiency of corporate class mutual funds produces a terrific advantage.
Financial advisors seek entrepreneur clients because they often have the opportunity to accumulate significant wealth. But entrepreneurs have different needs than other types of investors. Advisors who can educate them on the importance of using tax-efficient solutions to invest inside their corporation will benefit greatly from this business development opportunity.
Francois Bernier is Mackenzie Investments’ Director, Tax & Estate Planning. He can be reached at: email@example.com.