I’ll be the first to admit, there are times when the way our tax codes play out seems more like magic than accounting – especially when integrating your personal and corporate taxes. “Look, nothing up my sleeves,” says your tax professional. Can you believe it? That’s what this series is for: Putting some of the acts into slow-mo, so you can see the sleight of hand for yourself.
Today, we’ll talk about the magical dividend refund, whose purpose is to ensure that corporate shareholders don’t end up being unfairly taxed twice on the same income. Ready to see how this nifty trick works?
In my last blog post, I showed how Canadian interest income is taxed within a corporation. In our example, an Ontario-based corporation was taxed 50.17%, or $5,017 on $10,000 of Canadian interest income. This left $4,983 of after-tax income to reinvest in the corporation’s passive portfolio or to distribute to shareholders.
Let’s say this money were distributed to you, a shareholder and Ontario taxpayer. If there were no further adjustments, you’d then incur an additional $2,258 of personal taxes on the non-eligible dividend. (Trust me on that figure, and I’ll spare you the details so we can get to the good stuff.)
If you’re keeping an eye on the action, you can see how unfair this would be. Your combined corporate and personal taxes would be $7,275, for an effective tax rate of 72.75%. That’s considerably higher than Ontario’s top personal tax rate of 53.53%.
A Part 1 corporate tax disappearing act
The government is well aware of this inconsistency, so they rightfully allow your corporation to “disappear” a portion of your otherwise unequal burden by obtaining a dividend refund when taxable dividends are paid out to shareholders. Specifically, we apply a bit of pixie dust to the federal 38.67% Part I tax payable on investment income to position your corporation to qualify for a refund on 30.67% of the aggregate investment income from Schedule 7. In our example, that’s $10,000 × 30.67% = $3,067.
The remaining 8% of the 38.67% federal Part I tax is non-refundable, as are provincial and territorial taxes like Ontario’s 11.5% tax.
Source: Corporate Taxprep – T2 Corporation Income Tax Return (2016)
Refundable dividend tax on hand (RDTOH)
We’re not yet done with the fancy footwork. There’s also the ever-so-catchy refundable dividend tax on hand (RDTOH) account, where the available dividend refund described above accumulates.
To obtain the full dividend refund available, the corporation must pay out a taxable dividend of sufficient size to shareholders. The corporation is refunded 38.33% of each dollar of taxable dividends it distributes to shareholders. So in our example, a business owner would need to pay out taxable dividends of at least $8,002 to reclaim the full $3,067 of refundable taxes available in the RDTOH account balance ($3,067 ÷ 38.33%). This refunded amount of taxes is the actual dividend refund.
Source: Corporate Taxprep – T2 Corporation Income Tax Return (2016)
The Dividend Refund
As mentioned in the discussion above, the corporation will have $8,050 available to distribute to its shareholders (once you include the dividend refund of $3,067 and the after-tax corporate income of $4,983). As this amount is higher than the required $8,002, we’ll have no issues receiving the full dividend refund.
To pay out the taxable dividends to shareholders, the business owner would include $8,050 of taxable dividends on Schedule 3 (line 450). This figure would feed through to the dividend refund section of the corporate tax return, resulting in a dividend refund of $3,067.
If you’re watching closely, you may notice that the $8,050 dividend payment should generate a dividend refund of $3,086 ($8,050 × 38.33%). But only $3,067 is actually refunded, since this is the balance available in the RDTOH account.
Source: Corporate Taxprep – Schedule 3 (2016)
Source: Corporate Taxprep – T2 Corporation Income Tax Return (2016)
Did you follow all that? Below is the summary.
Next week, we’ll look at how tax integration works (or doesn’t) with Canadian interest income. We’ll also look at whether it makes sense to retain the investment income within the corporation for reinvestment, or dividend it out to the shareholders.
| General formula |
Amount |
Calculation |
| 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 |