One of the surprises in this year’s Federal Budget was the announced increase in the small business deduction for corporations. Simply put, this means the small business tax rate will be lower.
This is welcome news to small business owners, who will benefit from being able to reinvest more of their after-tax dollars within their corporations. While this is good for owners who will reinvest in their business operations, it’s not clear whether this change will help owners who decide to invest those after-tax dollars to earn passive income, or owners who decide to pay themselves dividends.
Beyond that, this development could cause owners to reconsider existing investment accounts held at the corporate level. Continuing to hold these funds in the corporation could result in the shareholder paying up to 2% more tax if dividends are delayed beyond this year.
Small business tax adjustments
The small business rate on the first $500,000 per year of active business income for a Canadian-controlled private corporation (CCPC) is going down, from 11% to 9%. The reduction will be implemented in half-percentage point in stages from 2016 to 2019.
In turn, corporate income that has benefited from the small business rate is treated as a non-eligible Canadian dividend when paid out to the shareholder. To maintain balance for the integration of corporate and personal taxes, the gross-up and dividend tax credit (DTC) for non-eligible dividends will also be adjusted:
|Federal small business tax adjustments|
|Small business rate (%)||11||10.5||10||9.5||9|
These changes are at the federal level. However, as the same gross-up is applied when calculating the shareholder’s provincial tax on the dividend, experts expect provinces to adjust their dividend credit rates accordingly.
Implications for dividend policies
In a given year, a shareholder (as director) may declare a dividend out of retained earnings, or continue to retain such funds in the corporation. All else being equal, the shareholder portion of income tax is deferred by retaining those funds corporately. However, all else is not equal as we come into 2016, and roll through the next three years.
Consider a corporation that earns income in the current year, paying the 11% small business rate (focusing on the federal portion only). If the corporation issues a dividend in the current year, the DTC will be an equivalent of 11%. However, if the dividend is delayed one year to 2016, the DTC will be the reduced 10.5%, meaning corporation and shareholder bear an extra 0.5% tax. And that amount becomes as much as 2% if delayed to 2019.
These changes add a wrinkle to the dividend/retention decision this year, and in the next three years, though it’s for the business owner to decide. A tradeoff arises if current dividends push the shareholder up through marginal tax brackets.
With respect to existing corporate investment accounts, the need for a decision is arguably more pressing. This is retained money and corporate tax has already been paid — the funds have essentially been waiting to be subject to personal tax on dividend to shareholder. As corporate investments are likely part of eventual retirement, an early withdrawal may be undesirable, even in the face of this additional tax cost. On the other hand, the reduction of the gross-up from 18% to eventually 15% will mean that later, dividends will have less of a clawback on income-tested benefits.
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A thorough review will be necessary to determine the net effect on a given business owner. And it remains the client’s prerogative whether this is sufficiently material to take action.