The federal government is reducing the small business tax rate from 11% on the first $500,000 to 9% over the next four years. There’s a corresponding change to the Dividend Tax Credit (DTC) and gross-up factor, but clients still stand to have an extra $10,000 in tax-advantaged investment capital if they plan properly.
The 2% reduction will be phased in as follows:
- 10.5% effective January 1, 2016;
- 10% effective January 1, 2017;
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- 9.5% effective January 1, 2018; and
- 9% effective January 1, 2019.
The DTC will go from 11% in 2015 to:
- 10.5% in 2016;
- 10% in 2017;
- 9.5% in 2018; and
- 9% in 2019.
The current gross-up factor of 18% will drop to 17% in 2016 and stay there until 2018, when it drops again to 16%. In 2019 it falls to 15%.
Dave Walsh, a partner at EY in Ottawa, says that generally speaking, the changes should have no impact on whether clients pay themselves a salary or dividends. “There shouldn’t be any difference in your analysis. If you thought before [Budget 2015] that paying a dividend was better, after this you should come to a similar conclusion.” That’s because Finance was careful to match the DTC and gross-up adjustments to the tax cut.
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Heath Moore, a tax partner at Grant Thornton in Halifax, reaches the same conclusion: “If the right answer was to take a dividend before [Budget 2015], the right answer today is very likely still to take the dividend.”
Donald Carson, a partner in MNP’s Markham office, says advisors should tell clients they’ll soon have potentially $10,000 a year more in tax-deferred funds to invest.
The 2% tax-rate reduction means that on $500,000 of active business income, $10,000 less goes to CRA ($500,000 × 0.02). “The great opportunity is […] if they don’t need to remove it [from the corporation] for personal consumption, there’s an extra 10 grand for them to invest. If the owner-manager is in his mid-30s or mid-40s, you can have a 30-year run of an extra 10 grand, which could amount to a very decent incremental investment portfolio.”
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Carson says he often advises clients to set up an investment holding company on top of the operating company. The extra $10,000 can flow from Opco to Holdco as a dividend, and it does so tax-free. “There’s no immediate tax on those inter-corporate dividends.”
Walsh adds that while Holdco doesn’t get any special tax treatment, the client still reaps the benefit of the tax deferral on the original $10,000.
Carson says clients always do well to leave as much as possible in their corporations, removing only what’s needed to fund their essential and lifestyle spending. Say the combined federal and provincial corporate tax rate is 15%. In Ontario the top combined personal rate is 49.53%. “That differential is horrific—it’s almost 35%. If you don’t need the money, keep it inside the corporation.”
Once the 2% tax cut fully kicks in, if the owner pulls the extra $10,000 out of the corporation for personal use, the deferral benefits of the cut are completely lost, notes Carson. Clients who keep the money within the corporation may want to use it for reinvestment in their businesses, he adds, but advisors should show them how the extra funds can benefit their portfolios.
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Additional issues for CPCCs
Canadian Controlled Private Corporations (CCPCs) pay an additional 26.67% tax on investment income, above the small business tax. So, on $100 of investment income, it’s another $26.67.
That $26.67 goes into a notional pool called the Refundable Dividend Tax on Hand (RDTOH) pool. The CCPC can get that $26.67 refunded if it issues a taxable dividend equivalent to 3x the tax, or $80. That dividend is usually non-eligible.
Kim Moody, director at Moodys Gartner Tax Law in Calgary, says there will now be a 2% increase in the dividend’s tax rate, “and you don’t have a corresponding deduction of 2% corporately.”
That’s because the extra 26.67% paid goes to the RDTOH fund. The only way to get it refunded is to issue the dividend – and that dividend will be taxed at the new, higher-by-2% rate.
There’s no corresponding reduction because the 2% reduction is for business income, not for dividend income.
“If the CPCC is earning investment income, that’s automatically taxed at the highest rate, plus the RDTOH [rate of 26.67%]. If you’re pushing out the non-eligible dividend to recover the RDTOH, now you’ve got an extra two points.”
Regardless, it still makes sense to push out the dividend—it just costs an extra 2%.