Canada amends taxation of investment income earned through a private corporation

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1 14 December 2015 Global Tax Alert News from Americas Tax Center Canada amends taxation of investment income earned through a private corporation EY Global Tax Alert Library The EY Americas Tax Center brings together the experience and perspectives of over 10,000 tax professionals across the region to help clients address administrative, legislative and regulatory opportunities and challenges in the 33 countries that comprise the Americas region of the global EY organization. Copy into your web browser: Tax/Americas-Tax-Center---borderlessclient-service Executive summary On 9 December 2015, Bill C-2, An Act to amend the Income Tax Act, received first reading in the House of Commons. This bill includes a number of the majority Liberal Government s election platform personal income tax proposals, including the proposed 4% increase in the top marginal personal income tax rate on income in excess of $200,000. The bill also includes amendments to the taxation of investment income of private corporations, including Canadian-controlled private corporations (CCPCs), by imposing an additional 4% refundable tax on such investment income and an additional 5% refundable tax on portfolio dividends. Consequential amendments have also been made to the refundable dividend tax refund mechanism and the gross-up factor that applies to foreign non-business income. These measures are considered substantively enacted for tax accounting purposes as of 9 December These consequential amendments are intended to prevent any incremental deferral advantage associated with earning investment income through a corporation, but introduce new complexities with respect to the integration of the tax system on future income and moreover to the future taxation of existing retained earnings. Affected taxpayers should discuss with their tax advisor before 31 December 2015 the implications to their private corporation s current retained earnings and their dividend policies.

2 2 Global Tax Alert Americas Tax Center Detailed discussion Summary of the changes As a result of the proposed increase in the top marginal personal income tax rate from 29% to 33% on an individual s taxable income in excess of C$200,000, the Government has announced consequential amendments to the refundable Part I tax, Part IV tax and the refundable dividend tax on hand (RDTOH) mechanism: Increase in the portion of Part I tax on investment income earned by a CCPC that is refundable, from 26.67% to 30.67% the Part I tax rate on investment income for CCPCs being increased from 34.67% to 38.67% Increase in the refundable Part IV tax rate on portfolio dividends received by a private corporation from 33.33% to 38.33% Increase in the rate at which dividend refunds are paid out of a private corporation s RDTOH balance from 33.33% to 38.33% Other consequential amendments related to the calculation of the RDTOH balance These amendments generally apply for taxation years that end after 2015 (prorated for taxation years that straddle 1 January 2016), except that the increase in Part IV tax applies to dividends received after The intent of these changes is to eliminate the incremental tax-deferral advantage for individuals earning investment income through a corporation that would otherwise have resulted from the 4% increase in the top marginal personal income tax rate. Background on integration of investment income Integration is a fundamental concept of the Canadian federal income tax system. The theory of integration is that the total tax paid on investment income (such as interest, capital gains and dividends) is the same whether the income is earned by an individual directly or through a corporation and paid to the individual as a dividend. As corporate tax rates are generally lower than personal rates, this is accomplished through refundable taxes, which are also designed to eliminate the deferral aspect of earning such income through a corporation. However the concept of integration generally assumes that the top marginal rate is being paid on a dividend distribution, which may not always be the case. Moreover, the effectiveness of integration is influenced by year-over-year rate changes and by varying top marginal rates by province. Similarly, dividends are permitted to pass between taxable Canadian corporations on a tax-free basis. However, this may result in an unintended deferral of personal tax when an individual arranges for his or her investments in shares to be held by a corporation (which would otherwise receive dividends on the shares tax free). Part IV tax reduces or eliminates any deferral that may be achieved. Implications of the changes Due to the significant increase in the top marginal personal income tax rate, the above-noted changes need to be considered in the context of both existing retained earnings balances (i.e., prior years earnings) and future earnings (in 2016 and later years). Prior years earnings Although the integration of future earnings (as described below) has not changed significantly on a current-year basis as a result of the federal changes, what has changed significantly is the pure tax cost of keeping prior years earnings in a corporation and distributing taxable dividends after 2015 when the top marginal personal income tax rates on eligible and non-eligible dividends are much higher. The increase in the top marginal personal tax rates on eligible and non-eligible dividends for 2016 and later years effectively results in a retroactive tax increase on the distribution of prior years retained earnings. It is therefore necessary for shareholders to consider whether it is better to distribute taxable dividends or retain funds within the corporation for a continued deferral of personal income tax. The required length of deferral and rate of return to recover the additional tax cost will depend on the individual s income bracket and province of residence.

3 Global Tax Alert Americas Tax Center 3 To illustrate, assume an individual who is in the top income bracket and resident in Ontario has a CCPC that earns C$100,000 of interest income in The tax consequences of earning the interest income in 2015 and distributing it as a dividend in 2015 versus 2016 or 2019 are as follows: Gross revenues Interest income $100,000 N/A N/A Corporate tax (federal and Ontario combined) $46,170 N/A N/A Net cash $53,830 $53,830 $53,830 RDTOH $26,670 $26,670 $26,670 Available for distribution to shareholder (assumes dividends can be paid to fully recover RDTOH) Personal tax (at non-eligible dividend rate) $80,500 $80,500 $80,500 $32,305 $36,467 $37,634 Net after-tax cash $48,195 $44,033 $42,866 Effective combined tax rate 51.81% 55.97% 57.13% Therefore, there is an additional tax cost of 4.16% if the 2015 earnings are distributed in 2016 instead of 2015, and 5.32% if the 2015 earnings are distributed in 2019 instead of It would require a very long deferral period and a significantly high rate of return to recover this additional tax cost if the earnings are left in the corporation. It is also important to note that no adjustments are being made to existing RDTOH balances. As such, a CCPC will be required to pay a smaller dividend in 2016 and later years to recover existing RDTOH, since the RDTOH will be refunded at a rate of 38.33% (instead of 33.33%) of taxable dividends paid. However, this smaller dividend will still be subject to the higher personal tax rate if the individual is in the top tax bracket. As a practical matter, the smaller dividend would leave retained earnings in the company for which the future distribution of it would not result in the benefit of a dividend refund. Future earnings (post-2015) In the context of future earnings, the changes ensure there is no incremental deferral advantage associated with earning investment income through a corporation as a result of the 4% increase in the top marginal personal income tax rate. The changes do not significantly alter the federal integration of future investment income earned through a CCPC and taxed at the federal top marginal personal income tax rate. However, it is also necessary to consider the impact of these federal changes in the context of the related provincial income tax implications. The integration analysis will vary by province and for individuals in lower income brackets. It is therefore essential for individuals earning investment income through a corporation to perform an integration analysis for their own particular situation. In addition, it is unclear at this time how the provinces will react to the federal changes and whether future changes to provincial personal or corporate income tax rates will be introduced.

4 4 Global Tax Alert Americas Tax Center Immediate planning considerations Individuals earning investment income through a CCPC should consult with their tax advisor on what immediate actions, if any, should be taken to minimize the impact of the proposed changes. Each individual situation will vary depending on: The individual s financial needs The individual s income bracket Availability of cash or liquidity of investments within the corporation The balances in the corporation s general rate income pool (GRIP), capital dividend and RDTOH accounts The province (or provinces) in which the individual and corporation is liable for tax. In some cases, it may be desirable to distribute income from the corporation before 2016 to avoid paying the higher rates of tax at the top federal income bracket on eligible and noneligible dividends in For additional information with respect to this alert, please contact your EY or Couzin Taylor advisor.

5 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Americas Tax Center 2015 EYGM Limited. All Rights Reserved. EYG no. CM NY ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com