• Corporate Taxation: Tax Integration of Canadian Interest Income

Corporate Taxation: Tax Integration of Canadian Interest Income

There’s a quote I once read, attributed to somebody named Phil Pastoret. I’m not sure who Mr. Pastoret is either, but I like what he reportedly had to say about fair dealing: “If you think dogs can’t count, try putting three biscuits in your pocket and then give him only two of them.”

We taxpayers are a lot like Fido. If we get rooked, we may not know exactly how, but we know something’s missing. That’s why our tax system seeks to create a level playing field for taxes paid on personal income versus active business income. It tries to do the same for taxes due on Canadian interest income, whether incurred passively by a business or routinely by an individual investor.

As I’ll cover further down, the “equalizing” process isn’t always spot on perfect; sometimes it’s dog-gone confusing. But before we go there, let’s take a tour through what’s involved.

Continuing with our example from last week, we’ll compare how $10,000 of Canadian interest income is ultimately taxed in the hands of an individual investor versus a corporation that distributes after-tax corporate investment income and dividend refunds to its shareholders. As we’ve done before, we’ll assume that our individual taxpayer is in Ontario’s highest marginal 2016 tax rate. That is, they’ve already exceeded $220,000 in other income, so the dollars illustrated here are in addition to that

Scenario 1: Canadian interest income earned personally

In Ontario, a taxpayer in the top 2016 tax bracket would pay 53.53% in taxes on any additional income. So $10,000 of Canadian interest income would incur $5,353 of taxes, leaving $4,647 of after-tax cash.

Canadian interest income earned personally

General FormulaAmountCalculation 
Equals: After-tax cash$4,647$10,000 - $5,353
Canadian interest income$10,000
Deduct:
Personal tax payable
($5,353)$10,000 × 53.53% (Ontario)

Source: KPMG 2016 Personal Tax Rates

 

Scenario 2: Canadian interest income earned through a corporation

As we’ve already calculated the corporate taxes payable on $10,000 of Canadian interest income in last week’s post, we’ll continue the example from there.

After the corporation has paid $1,950 in non-refundable taxes, there is $8,050 left to distribute to shareholders. (This includes the after-tax passive investment income of $4,983 and the dividend refund of $3,067.)

In the chart below, I’ve taxed the $8,050 dividend at 45.30%, which is the top marginal tax rate for non-eligible dividends received by an Ontario taxpayer in 2016. So, the taxes are $8,050 × 45.30% = $3,647, which leaves $4,403 in after-tax cash ($8,050 – $3,647).

Canadian interest income earned through a corporation

General formulaAmountCalculation
Equals:
After-tax cash
$4,403$8,050 - $3,647
Canadian interest income$10,000
Deduct:
Part I tax – non-refundable
($800)$10,000 × 8%
Deduct:
Part I tax - refundable
($3,067)$10,000 × 30.67%
Deduct:
Provincial or territorial tax – non-refundable
($1,150)$10,000 × 11.5% (Ontario)
Equals:
After-tax corporate income
$4,983$10,000 - $800 - $3,067 - $1,150
Add:
Dividend refund
$3,067$10,000 × 30.67%
Equals:
Amount available to distribute as a taxable dividend
$8,050$4,983 + $3,067
Deduct:
Personal tax payable
($3,647)$8,050 × 45.30%

Sources: KPMG 2016 Personal Tax Rates, KPMG 2016 Corporate Tax Rates

 

I could have shown the entire dividend gross-up and credit mechanisms, but we’ll go with these short-cut calculations. Of greater interest, here’s how our two scenarios compare at a glance:

Taxation of $10,000 of Canadian Interest Income in Ontario: Individual vs. Corporate (2016)

Sources: KPMG 2016 Personal Tax Rates, KPMG 2016 Corporate Tax Rates

 

As the investment income is initially taxed at a slightly lower rate in the corporation (50.17% vs. 53.53%), this results in an investment tax deferral advantage of about $336 on $10,000 of Canadian interest income ($4,983 – $4,647). But this is not the typical result across Canada. As shown in the last column in the chart below, Ontario and New Brunswick are the only jurisdictions where retaining Canadian interest income in a corporation resulted in a more favorable tax deferral in 2016.

Plus, once the investment income is distributed to the business owner as a taxable dividend, the owner loses about $244 more to tax costs by having used a corporation in Ontario during 2016, with $4,403 of after-tax income versus $4,647 for the individual. As shown in the fifth column in the chart below, you’ll note that no provinces or territories realized any tax savings for business owners who used their corporation to invest.

Tax savings (cost) of using a corporation to earn Canadian interest income (2016)

Province or territoryIndividual after-tax income (A)Corporation after-tax income (B)Shareholder after-tax income (C)Tax savings (cost) using corporation (C - A)Investment tax deferral advantage (cost) (B - A) 
Alberta$5,200$4,933$4,780($420)($267)
British Columbia$5,230$5,033$4,811($419)($197)
Manitoba$4,960$4,933$4,341($619)($27)
New Brunswick$4,670$4,783$4,254($416)$113
Newfoundland and Labrador$5,020$4,633$4,436($584)($387)
Nova Scotia$4,600$4,533$4,030($570)($67)
Northwest Territories$5,295$4,983$5,175($120)($312)
Nunavut$5,550$4,933$5,092($458)($617)
Ontario$4,647$4,983$4,403($244)$336
Prince Edward Island$4,863$4,533$4,266($597)($330)
Saskatchewan$5,200$4,933$4,807($393)($267)
Yukon$5,200$4,633$4,606($594)($567)

Sources: Corporate Taxprep 2016, Personal Taxprep 2016, KPMG 2016 Personal Tax Rates, KPMG 2016 Corporate Tax Rates

 

Money doesn’t grow on CCPCs

So here’s where we return to my earlier statement about how the system may not be perfect. Given the widespread corporate tax disadvantages in the columns above, you may be wondering why the federal government has a bone to pick with business owners who invest passively in their corporations.

Before you call “foul,” we’ve got one more detail to cover, related to initial taxation of the business owner’s active business income. If you recall, an Ontario small business owner initially pays only 15% on active business income, allowing them to invest the remaining 85% in passive investments. In contrast, an individual salaried employee in Ontario in the top tax bracket could only invest about 46.47% of their additional earnings (after paying 53.53% in taxes).

That’s a lot of extra passive investment power in the hands of the business owner. In our example of $100,000 additional income, the business owner’s portfolio gets to start out $38,530 ahead ($85,000 versus $46,470), so it’s as if the government has given the business owner an interest-free, $38,530 loan to invest for as long as they’d like. If you factor that into the equation, it more than makes up for the additional tax cost of investing within a corporation.

To illustrate roughly how much this favours the business owner, I’ve compared the after-tax returns for an individual taxpayer investing after-tax earnings in a portfolio, versus a business owner’s after-tax, active business income. I’ve assumed each portfolio earns a similar 3% annual return. I’ve then assumed that the small business owner distributes net active business income and passive investment earnings as taxable dividends after 10, 20 or 30 years (using the top 2016 Ontario personal and corporate tax rates for non-eligible dividends, corporate investment income and personal income).

Sources: KPMG 2016 Personal Tax Rates, KPMG 2016 Corporate Tax Rates

 

Even after only ten years, the corporate after-tax investment earnings are more than 1.74 times as large as the personal after-tax investment earnings ($12,035 ÷ $6,900). This is certainly not the intention of corporate and personal tax integration, and precisely why there are proposed changes already in the works, to try to even things out. In my next blog, we’ll take a look at those proposals. Let’s just say, there’s never a dull day in the world of corporate taxes!

 

By | 2017-08-22T07:43:53+00:00 August 14th, 2017|Categories: Investment Taxation|6 Comments

6 Comments

  1. Grant August 15, 2017 at 9:31 pm - Reply

    Justin, thanks, very interesting to see the advantage of passive investing within a CCPC actually quantified.

    I’m not sure, though, that the intention of personal and corporate tax integration is to neutralize any advantage of investing in a CCPC. I think there is an intention to provide an incentive for people to risk their capital in order to start and grow a business. In the case of doctors, they were allowed to incorporate in lieu of fee increases.

    Now, tax fairness, like beauty, is in the eye of the beholder, and reasonable people can argue how much of an inventive there should be. And certainly the gap between the two tax rates has widened in recent years as the small business tax rate has fallen and the top marginal tax rate has gone up a lot (Canada now has the 4th highest marginal tax rates in the world) due to Liberal governments in Ottawa and Ontario at the same time, thereby creating a larger interest free loan from the government. However, I think it’s a mistake to reduce incentives to create small businesses

    • Justin August 16, 2017 at 1:28 pm - Reply

      @Grant: I think most business owners (and their accountants and advisors) would tend to agree with you. I’ll just provide the numbers and let the readers decide for themselves 🙂

  2. M August 15, 2017 at 6:12 am - Reply

    Thanks Justin,

    Hopefully this will still be relevant in a few months for my CCPC passive investments, although my accountant tells me “grandfathering” will only apply to previous capital gains and he suspects all future passive income will likely be taxed the same under new rules; are you hearing/suspecting otherwise?

    Also, a bit confused with the comment on “starting out ahead” heard this elsewhere and I think it is a misnomer but want to make sure i’m not misunderstanding. Mathematically isn’t the issue that makes CCPC come out ahead the RDTOH that can be paid out annually from active income?

    • Justin August 15, 2017 at 1:24 pm - Reply

      @M: This information will likely remain relevant for anyone with existing CCPC investments. From the sounds of it, the grandfathering will apply to previous earnings (not sure if this includes unrealized capital gains). It will be interesting to see how the government handles the existing unrealized capital gains in CCPCs (which would be significant).

      Your second question is a great one. In the government’s proposal https://www.fin.gc.ca/activty/consult/tppc-pfsp-eng.pdf on page 34 (Chart 7), they assume that the refundable taxes (30.67%) accumulate along with the after-tax corporate income (49.83%) – this would only be possible if the corporation made additional active business income that they could pay out to obtain the full dividend refund each year (however, I would argue that their example is no longer apples-to-apples to the personal taxpayer, as the corporation would need more active business income in addition to the initial $100,000).

      In my chart at the bottom of this blog, I’ve assumed that the dividend refund does not occur until the taxable dividends are distributed to the shareholder (i.e. the 30.67% dividend refund does not accumulate each year at 3%). As you can see, there is still a huge benefit to investing within your corporation (although not quite as large as the government’s illustration in Chart 7). This benefit is the result of what I’ve referred to as the interest-free loan from the government.

  3. Daniel S. August 14, 2017 at 11:25 pm - Reply

    Hi Justin. Once you factor in the additional administration cost of keeping a company open, it makes earning investment income in a company that much less attractive.

    Daniel

    • Justin August 15, 2017 at 12:52 pm - Reply

      @Daniel S: Another good point – the initial set-up costs and annual administration fees would make corporate investing less attractive.

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