Dan Bortolotti’s recent blog post raised a number of questions from his readers concerning the impact of foreign withholding taxes within a corporate account. This is a hot topic, as many successful professionals are choosing to save within their corporation. Couch Potato investors often allocate 40% or more to foreign stocks, so it’s important for them to grasp these tax concepts before implementing their own portfolio.
Foreign interest income vs. foreign dividend income
The taxation of foreign income is often lumped into the “interest income” category, but this is not entirely accurate. Foreign interest income (the kind that is generally not subject to foreign withholding taxes) is taxed in a similar manner to Canadian interest income in a corporation. So holding a tax-efficient global bond fund in your corporate account should be just fine.
Foreign dividend income, on the other hand, can affect the amount of corporate taxes that are refundable when dividends are paid to you as a shareholder. For Couch potato investors, this foreign dividend income is typically received on a quarterly basis from your US, international and emerging markets equity ETFs. Foreign dividends are not specifically the issue – it is technically the foreign non-business income tax credit that throws a wrench into the refundable tax calculation.
In order to better understand the taxation of foreign dividend income in a corporation, we’ll start with the calculation of Part I tax, and move to the calculation of the refundable portion of Part I tax. We’ll then follow the dividend income out of the corporation and into the personal hands of the shareholder in order to calculate the overall taxes paid. To make the math easier, we’ll use $10,000 as our foreign dividend income figure, and assume a 15% withholding tax rate on the income (or $1,500).
Part I tax calculation
Similar to the corporate taxation of interest income, there is a base federal tax amount of 38%, along with an additional refundable tax of 6.67% (this has been increased to 10.67% in 2016). A federal tax reduction of 10% is then applied, and the foreign non-business income taxes paid are offset by the foreign non-business income tax credit of 15%. This results in Part I tax payable of 19.67% (38% + 6.67% - 10% - 15%).
Once we include provincial tax of 11.5% (for an Ontario corporation), our total taxes payable increase to 31.17% (19.67% + 11.5%). As we had initially paid 15% foreign withholding tax on the dividend income, this amount should also be included in order to calculate our total taxes. This equals 46.17% (31.17% + 15%), which is the combined federal/provincial tax rate for passive investment income earned within an Ontario corporation in 2015 (this amount is increasing to 50.17% in 2016).
Part I Tax Calculation
Source: CCH Corporate TaxPrep Software
Refundable portion of Part I tax
A portion of Part I taxes are refundable when dividends are ultimately paid out of the corporation to the shareholder. For interest income, the refundable amount is 26.67% (increasing to 30.67% in 2016). In our example below, the tax refund is only 15.24% of the dividend income. As mentioned earlier, this difference is due to the foreign non-business income tax credit. The refundable amount of tax would change depending on the withholding tax rate levied on the foreign dividends (for example, if you held an international equity ETF that withheld 12% instead of 15%, the refundable amount would differ).
Refundable portion of Part I tax calculation
Personal Tax Calculation
Of the $4,617 of total taxes paid on our $10,000 of foreign dividend income, $3,093 is non-refundable, and $1,524 is refundable when sufficient dividends are paid out to the shareholder. Since the after-tax corporate income is $5,383 ($10,000 - $3,093 - $1,524), there is currently $6,907 available to distribute to the shareholder ($5,383 after-tax corporate income + $1,524 refundable taxes).
If we assume that the distribution is in the form of a non-eligible dividend paid to an Ontario resident in the highest tax bracket, their personal taxes would be $2,772 in 2015 ($6,907 non-eligible dividend × 40.13% tax on non-eligible dividends). This would leave them with $4,135 of after-tax income ($6,907 - $2,772). I’ve illustrated the concepts in the chart below (adapted from Jamie Golombek’s 2014 article).
Foreign dividend income earned in a corporation in Ontario in 2015
Sources: Adapted from In Good Company: Retaining investment income in your corporation, Deloitte 2015 Top marginal income tax rates for individuals
The overall taxes paid on the $10,000 of foreign dividend income was $5,865 ($3,093 non-refundable corporate tax + $2,772 personal tax) or 58.65%, which is 9.12% higher than the top 49.53% tax rate in 2015 which would apply for an Ontario resident that earned the foreign dividend income personally.
This would suggest that an investor may be better off investing in foreign equities outside of their corporate account (i.e. in personal non-registered accounts, RRSPs, TFSAs, etc.). For investors who are comfortable with swap-based ETFs (such the Horizons S&P 500 Index ETF (HXS)), this may also be a suitable option, as the fund does not distribute foreign dividend income, and will therefore avoid foreign withholding taxes and the offsetting credit.