By Millie Bojic
Per the Canadian government’s 2018 Federal Budget, Canadian-controlled private corporation (“CCPCs”) and their investment income will be impacted effective on or after January 1, 2019 – in particular, certain changes to the Refundable Dividend Tax On Hand (“RDTOH”) regime. CCPCs are private corporations in Canada that are not controlled, directly or indirectly, by one or more non-resident persons. This article is particularly relevant to CCPCs, corporations connected to them (i.e. wholly-owned holding companies), as well as their shareholders that are familiar with different types of dividends issued by corporations and already enjoy the refund regime that applies to the CCPC.
The integration principle for dividend taxation in Canada
To provide context for the RDTOH regime, it is important to understand one of the chief taxation principles in Canada, ‘integration,’ concerning corporate and shareholder taxation for corporations earning business income in Canada. The principle, generally described, is that a shareholder’s income in a corporation should be taxed at the same rate as if such income was earned personally by the shareholder. Integration varies for a Canadian corporation, as it can pay tax at different rates depending, amongst various factors, on which province it operates in and its annual revenue threshold.
The whole purpose of this principle is to avoid double taxation of corporate income (i.e. taxing the shareholder’s income in the corporation once and then taxing once again personally upon issuance to the shareholder). However, because of varying tax rates set on a province-by-province basis, integration is not a perfect phenomenon. Ultimately, where the shareholder resides in Canada will impact its application most of all.
To illustrate this misalignment, let’s look at some numbers. The general federal corporate rate of tax is 15%. However, CCPCs are eligible for tax breaks on the first $500,000 of “active business income” they earn. This tax break effectively lowers the federal corporate tax rate to 10% for CCPCs. As mentioned, provincial taxes vary depending on each province’s tax policy as well as whether we are dealing with a small business or not – ranging in rate across Canada from 0% for small business corporations to 16% for general corporations. As integration only works where shareholders are taxed in accordance with the tax the company pays on its income, you can quickly see how these varying rates impact a smooth application of the principle.
In order to apply integration, we must also understand what sort of investment income is being issued to a shareholder, in particular dividends. Generally, there are two types of dividends: “eligible” and “non-eligible” dividends. An eligible dividend is when the corporation pays its shareholders from income that does not qualify for the small business deduction (“SBD”) in Canada. This income is called the general rate income pool (“GRIP”) — that is, income that is not taxed at lower small business rates. This is great news for individual shareholders who receive eligible dividends and receive larger tax credits on their dividends and larger gross-ups to make up for the fact that the income did not benefit from the SBD (i.e. to cancel out federal-level double-taxation as the corporation already paid tax on income at the full corporate rate).
Eligible dividends include those issued by public corporations (which falls outside of the scope of this article); and by CCPCs that pay shareholders out of business income above the small business limit of $500,000 (as both sorts of corporations are taxed at the general corporate rates).
Conversely, a non-eligible dividend is derived from income that does qualify for the SBD. Generally, a CCPC pays a non-eligible dividend derived from income taxed at a lower rate after the SBD is applied on its active business income and from dividends out of its investment income received from other corporations – termed the low rate income pool (“LRIP”).
2018 Federal Budget Changes to the RDTOH Regime
RDTOH is generated from a CCPC’s passive investment income. This income is refunded to the corporation once it pays taxable dividends, and typically is not counted as part of the eligible dividend GRIP described above. Historically, a CCPC could pay an eligible dividend and still receive a RDTOH refund. In effect, RDTOH on passive investment income would not be pooled into the eligible dividend GRIP, and the eligible dividend would be taxed in the shareholder’s hands at a rate of roughly 39% at the personal dividend tax level in Ontario – as opposed to the highest personal dividend tax rate in Ontario of roughly 47% that would otherwise be paid from passive investment income earnings. Meanwhile, the corporation would receive the benefit of the RDTOH refund.
Under the new RDTOH regime however, a corporation’s RDTOH account is set to be segregated into eligible RDTOH and non-eligible RDTOH accounts. Only non-eligible dividends are refundable on non-eligible RDTOH balances.
In addition, refunds are inapplicable from the eligible RDTOH account until such time as the non-eligible RDTOH balance is refunded first and in full. Significantly, RDTOH paid on dividends received from a connected corporation (such as a holding company) are furthermore set to match the corporation’s segregated eligible and non-eligible RDTOH accounts.
Transitional rules apply for a CCPC to determine their opening eligible RDTOH and non-eligible RDTOH accounts before the legislative rules take effect. During the time of transition, the eligible RDTOH amount is the lesser of:
- The existing RDTOH balance
- 38 1/3 % of the GRIP balance
Any outstanding RDTOH amount is then placed into the non-eligible RDTOH account. However, the transition rules included in the legislation create some issues for connected corporations such as wholly-owned holding companies where such account allocation is concerned. In particular, these holding companies are prevented from obtaining an RDTOH refund when GRIP dividends are paid through operating companies to holding companies and then ultimately to the individual shareholders.
To mitigate the lack of relief on RDTOH earned by holding companies, one tactic is to balance the GRIP and RDTOH balances in holding companies by having their connected operating companies pay an eligible dividend prior to January 1, 2019. The effect of such planning is that eligible dividends can continue to be paid by operating companies through to holding companies and finally to individual shareholders, while still allowing for the holding companies’ RDTOH refund.
With January 1, 2019 just around the corner, we recommend you examine your corporate structure to mitigate the effects of the transitional rules described above, and to identify whether tax structuring can assist you with the changes set to take place to the RDTOH regime in Canada.