Business owners received greater clarity from the feds this week on proposed rules for passive investment income.
The first new rule is a reduction in the business limit for Canadian-controlled private corporations (CCPCs) that have passive investment income between $50,000 and $150,000 for tax years after 2018.
A second rule will result in decreased refundable tax on investment income inside corporations—that is, decreased refunds to a corporation’s refundable dividend tax on hand (RDTOH) account.
(RDTOH is used to achieve tax integration at the corporate level.)
Though this rule isn’t good news for corporations, it’s an improvement on the original July 2017 tax proposal, which considered eliminating RDTOH.
“Eliminating RDTOH essentially would increase the overall tax rate for business owners on their passive investments,” says Frank Di Pietro, assistant vice-president of tax and estate planning at Mackenzie Financial. He’s pleased that didn’t happen. (The capital dividend account for corporations also stands, he adds.)
Plus, the new changes to RDTOH aren’t severe, he says.
Read: Help corporations save taxes through RDTOH account
But they are potentially confusing, says Trevor Parry, president at TRP Strategy Group in Toronto. At least, he says, the greater clarity provided on the measures allows for some tax planning. His overall advice to clients is to get on with business. “Continue to use your corporations as a wealth generating engine,” he says.
Why target RDTOH?
To understand how RDTOH works, first consider the applicable tax regime for income and dividends, set out in the Tax Measures document, which accompanied the federal budget.
Passive investment income is taxed at roughly top personal tax rates while retained inside a corporation. Some or all of this tax is added to the corporation’s RDTOH account and is refundable at a rate of $38.33 for every $100 of taxable dividends paid to shareholders.
Dividends paid to shareholders are classified as either eligible or non-eligible for tax purposes.
Eligible dividends are presumed to be paid from a corporation’s active business income that’s been taxed at the general corporate rate. Shareholders who receive these dividends are entitled to the enhanced dividend tax credit, which is 15% at the federal level.
Non-eligible dividends are presumed to be paid from the corporation’s active business income that’s been taxed at the small business rate, or from passive investment income. Exceptions include eligible portfolio dividends, which may be paid as eligible dividends, and the non-taxable portion of capital gains, which may be paid tax-free from a corporation’s capital dividend account. Shareholders who receive these dividends are entitled to the ordinary dividend tax credit, which is proposed to be 10% in 2018 at the federal level (and 9% after 2018).
Read: All about dividend taxation
Here’s the problem: a corporation may receive a refund of taxes paid on investment income—reflected in the corporation’s RDTOH account—regardless of whether dividends paid are eligible or non-eligible.
Aaron Schechter, tax partner at Crowe Soberman LLP in Toronto, explains: “What [a corporation] could do is pay out an eligible dividend and recover RDTOH in [the] corporation. Then when the shareholder received the eligible dividend, they would pay tax at a lower rate than had the company paid a non-eligible dividend.”
(In Ontario, for instance, the personal tax rate on eligible dividends is about 39% versus about 47% for non-eligible dividends.)
This results in “a mismatch,” he says. Corporations have the ability to pool income sources at the corporate level (active and investment income) and “pay out a more tax-favourable dividend to the shareholder while still generating or recovering refundable taxes in the corporation,” he says.
Dan LeBlanc, partner at Ernst & Young private client services in Dieppe, N.B., adds, “It was really intended that the dividend refund was earned on investment income that flowed out to the shareholder as non-eligible [dividends],” resulting in greater tax at the shareholder level. “The integration between the corporation and the individual shareholders was a bit skewed […] because [the business owner] could pay eligible dividends, get the highest credit personally and also get the dividend refund in the corporation.”
That will no longer be possible after 2018.
As the government has indicated since it first introduced its tax proposals in July, it’s targeting a small proportion of corporations. Parry says not many corporations would be actively taking advantage of the refund mismatch.
New RDTOH rule
The budget proposes that a refund of RDTOH be generally available only when a private corporation pays non-eligible dividends.
The measure “streamlines integration to some extent,” says LeBlanc.
He says smaller corporations are more likely to be caught by the mismatch, but it’s difficult to quantify the new measure’s impact on individual corporations, he adds. A greater impact will be felt from the business limit deduction, which will more directly affect the amount of capital a business owner can grow in the company, he says. TOSI rules, effective Jan. 1, 2018, will also have a bigger impact.
Tax questions for business owners in 2018
What TOSI means for succession planning
Business owners will be able to live with the new reality of RDTOH, says Di Pietro. In effect, the measure means “we do have integration in the system between what the business pays at the corporate level and what the shareholder pays at the personal level on that dividend,” he says.
New rule in action
The measure requires the addition of a new RDTOH account, called eligible RDTOH, which will track refundable taxes paid on eligible dividends. Any taxable dividend (eligible or non-eligible) will entitle the corporation to a refund from this account.
The current RDTOH account will now be called non-eligible RDTOH and will track refundable taxes paid on investment income (part 1 tax under the Income Tax Act) and non-eligible portfolio dividends (part IV tax). Refunds from this account will be obtained only upon payment of non-eligible dividends.
Though tracking will be required, its complexity pales in comparison to potential tracking of passive income in the original proposal, says Di Pietro.
An ordering rule requires that, when non-eligible dividends are paid, the refund must come from the non-eligible RDTOH account before the corporation can obtain a refund from the eligible RDTOH account.
In light of both new measures to passive investment income, advisors should carefully consider investments inside clients’ corporations.
“Advisors might want to pay a little bit more attention to exactly the types of returns that are being generated,” Di Pietro says. For instance, it may be more advantageous to generate capital gains, which can be paid out as a capital dividend*.
Further, Schechter says it could make sense for private corporations to pay out eligible dividends to recover RDTOH before year-end, “because they won’t be able to that in the future.”
Likewise, LeBlanc says corporations should look at their RDTOH balances and their dividend policies and decide whether to pay dividends this year. “Before the rules came in, some people might have been sitting on [RDTOH] balances,” he says.
If a corporation doesn’t have enough cash flow to pay out eligible dividends, it could pay by way of a promissory note, adds Schechter.
Also, “if there’s no RDTOH, you would only pay out an eligible dividend if you needed the money,” he says.
What happens to existing RDTOH
The RDTOH measure applies for taxation years that begin after 2018.
The Tax Measures document says, “An anti-avoidance rule will apply to prevent the deferral of the application of this measure through the creation of a short taxation year.”
The document further explains how a corporation’s existing RDTOH balance will be allocated:
- For a CCPC, the lesser of its existing RDTOH balance and an amount equal to 38.3% of the balance of its general rate income pool, if any, will be allocated to its eligible RDTOH account. Any remaining balance will be allocated to its non-eligible RDTOH account.
- For any other corporation, the existing RDTOH balance will be allocated to its eligible RDTOH account.
For more details on the new measures for passive investment income, download the Tax Measures document.
*A previous version of this story stated that capital gains can be paid out as eligible dividends, which is incorrect. Return to the corrected sentence.