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June-19-17

Corporate Taxation: Tax Integration of Active Business Income

In my last blog post, I introduced the wild world of corporate taxes, illustrating how an Ontario business owner could end up paying only 15% in combined federal and provincial corporate taxes. If this amount seems low to you, fear not. The government has a way of making sure everyone pays their relative due by having corporate shareholders perform personal and corporate tax integration.

Big picture, here’s the end goal: Once a corporation’s after-tax business income is distributed to its shareholders and personal taxes are paid on the proceeds, each taxpayer’s combined corporate and personal taxes should come out about the same as if he or she were a “regular” taxpayer. Admittedly, the results ain’t always perfect, but they usually come pretty close.

Would you like to see how this sausage gets made? Let’s grind out the calculations.

We’ll begin by assuming that our sample taxpayers are in Ontario’s highest marginal 2016 tax bracket. That is, they’ve already exceeded $220,000 in other income, so the dollars illustrated here are in addition to that. This makes the math a little easier. In this context, let’s compare an individual earning an additional $100,000 of personal income, versus someone who’s received an extra $85,000 through a non-eligible corporate dividend. (I’ll explain in a moment why, tax-wise, these are comparable figures.)

Scenario 1: Income earned personally

In Ontario, a taxpayer in the top 2016 tax bracket would pay 53.53% in taxes on any additional income. In our example, the $100,000 of income earned personally by an individual would incur $53,530 of taxes, leaving the taxpayer with $46,470 of after-tax cash. Pretty simple.
Income earned personally

Income earned personally

General Formula Amount Calculation
Personal income $100,000  
Deduct:
Personal tax payable
($53,530) $100,000 × 53.53% (Ontario)
Equals:
After-tax cash
$46,470 $100,000 - $53,530

Source:  KPMG 2016 Personal Tax Rates

 

Scenario 2: Income earned through a corporation

As we reviewed in my last blog post, active business income eligible for the small business deduction is levied federal taxes of 10.5%. In Ontario, the combined federal and provincial corporate tax rate is 15% (or $15,000 on $100,000 of active business income). The after-tax business income of $85,000 can then be distributed to shareholders as a non-eligible dividend, which is taxed in their hands. A few adjustments are required to ensure the business owner is no better or worse off than if they had earned the income personally.

Totally grossed up

Once the dividend has been distributed to the shareholder, it must be grossed-up before being taxed. The gross-up is 17% for non-eligible dividends.

In our example, 17% of $85,000 is $14,450. These amounts are then added together to equal the taxable dividend of $99,450. (See what I mean about how $85,000 in non-eligible distributions approximately equals $100,000 of personal income?) Personal income taxes of 53.53% are then levied on the taxable dividend amount, resulting in a tax bill of $53,236.

Giving credit where credit is due

If we stopped right there, the corporate business owner would pay combined corporate and personal taxes of $68,236 ($15,000 corporate + $53,236 individual). Whoa, that’s significantly higher than the $53,530 of taxes payable by the individual in Scenario 1.

No fair! Luckily, federal and provincial dividend tax credits come to the rescue to help offset the corporate taxes already paid.  

First, there’s a federal dividend tax credit for non-eligible dividends. In 2016, that was 10.5217% of the grossed up personal income: $99,450 x 10.5217% = $10,464 credit.

Then there’s the Ontario dividend tax credit for non-eligible dividends, which was 4.2863% in 2016: $99,450 x 4.2863% = $4,263 credit.  

Combined, you get $10,464 + $4,263 = $14,727 in credits, which is mighty similar to the $15,000 of corporate income taxes already levied. After deducting these dividend credits from the personal taxes payable of $53,236, we end up with net personal taxes of $38,509.

Corporate personal combo

Our sausage-making is nearly complete: $15,000 of corporate taxes paid plus $38,509 of personal taxes due equals $53,509, with $46,491 of after-tax cash to stash. Voila! That’s almost identical to the $53,530 of personal taxes and $46,470 in remaining cash from our Scenario 1 taxpayer. Believe it or not, there’s usually a method to all that tax-planning madness.

Here’s a summary of the results.

Income earned through a corporation

General Formula Amount Calculation
Active business income $100,000  
Deduct:
Corporate tax payable
($15,000) $100,000 × 15% (Federal + Ontario)
Equals:
After-tax business income
$85,000 $100,000 - $15,000
Dividend distributed to shareholder $85,000  
Add:
Dividend gross-up (17% ineligible dividend rate)
$14,450 $85,000 × 17%
Equals: $99,450 $85,000 + $14,450
Taxable dividend    
Deduct:
Personal tax payable
($53,236) $99,450 × 53.53% (Federal + Ontario)
Add:
Federal dividend tax credit
$10,464 $99,450 × 10.5217% (Federal)
Add:
Provincial dividend tax credit
$4,263 $99,450 × 4.2863% (Ontario)
Equals:
Net personal tax payable
($38,509) $53,236 - $10,464 - $4,263
     
Equals:
After-tax cash
$46,491 $100,000 - $15,000 - $38,509

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

 

That was some fun, huh? Today’s post was all about earnings distributed to shareholders. What about those earnings that you put to work generating interest income within your corporation? These are also typically integrated, to level the playing field between business owners and individual taxpayers. In my next post, I’ll show you how that’s done.

Appendix:  2016 Provincial/Territorial Personal and Corporate Tax Integration

Example:  $100,000 of Active Business Income Eligible for the Small Business Deduction

Province or territory Top marginal tax rate (%) Top non-eligible dividend rate (%) Tax rate on small business active income (%) Corporate savings or (cost)
Alberta 48.00% 40.24% 13.50% ($313)
British Columbia 47.70% 40.61% 13.00% ($630)
Manitoba 50.40% 45.74% 10.50% ($1,038)
New Brunswick 53.30% 45.81% 14.12% ($164)
Newfoundland and Labrador 49.80% 41.86% 13.50% $91
Northwest Territories 47.05% 35.72% 14.50% $2,011
Nova Scotia 54.00% 46.97% 13.50% ($132)
Nunavut 44.50% 36.35% 14.50% ($1,079)
Ontario 53.53% 45.30% 15.00% $21
Prince Edward Island 51.37% 43.87% 15.00% ($917)
Saskatchewan 48.00% 39.91% 12.50% $579
Yukon 48.00% 40.17% 13.50% ($252)

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

 

By: Justin Bender | 4 comments
June-09-17

Corporate Taxation: Getting Proactive With Your Active Business Income

Albert Einstein once reportedly said something like, “The hardest thing in the world to understand is the income tax.” (His theory of relativity must have been a close second.) Al was likely just kidding around, but he wasn’t far off.  

It’s all relative. Your tax situation probably started out simple enough. (Remember the good old days when you only had a T4 slip to worry about?)  As your career took off, your accountant encouraged you to set up a corporation to defer taxes. But even as your corporate savings accumulated, you were hesitant to invest the cash. The tax implications of buying your favourite ETFs was hazy; you wanted to learn more before committing.

Next thing you know, several years have flown by. You’re working as hard as ever, but your corporate savings are still lazing about, earning next to nothing. Shouldn’t these assets be working at least as hard as you do toward your thriving business or eventual retirement? Whether the assets remain in your business or are distributed to shareholders, that often calls for tax-efficiently investing a portion of them in our capital markets.

But where to begin? In this next series of blog posts, I’ll explain the basics of corporate taxation. We’ll then discuss the different types of investment income and how they’re taxed within the corporation. Finally, we’ll look at some smart corporate investment strategies that will help reduce your tax bills.

We’ll kick off today’s lesson by getting proactive with the active business income taxed within your corporation.  

For our example, we’ll assume your corporation earned $100,000 of 2016 taxable income in Ontario. I’ll focus on Canadian-controlled private corporations (CCPCs), as these are the most common type (and likely relevant to most of you).

 

Back to basics

Most corporations are charged a basic federal tax rate of 38% on taxable income. That’s the base amount of Part I tax. In our example, $100,000 x 38% = $38,000.

Your corporation’s taxable income and base amount of Part I tax can respectively be found on line 360 and 550 of the T2 Corporation Income Tax Return.

T2 Corporation Income Tax Return (2016)

Source:  Corporate Taxprep – T2 Corporation Income Tax Return (2016)

 

Source: Corporate Taxprep – T2 Corporation Income Tax Return (2016)

Small potatoes

Canadian-controlled private corporations (CCPCs) are also eligible for a federal small business deduction of 17.5% on the first $500,000 of active business income earned in Canada.  In our example, you could use this deduction to reduce your taxes due by $17,500: $100,000 x 17.5% = $17,500.

The corporation’s active business income amount can be found on Schedule 7, or on line 400 of the T2 Corporation Income Tax Return. The small business deduction amount can be found on line 430 of the T2 Corporation Income Tax Return.  

Schedule 7 (2016)

Source: Corporate Taxprep - Schedule 7 (2016)

 

T2 Corporation Income Tax Return (2016)

Source: Corporate Taxprep – T2 Corporation Income Tax Return (2016)

Making a federal case out of it

Thanks to Canada’s federal tax abatement (to approximately offset provincial taxes), you can apply another 10% reduction in your basic federal tax rate for income earned in a Canadian jurisdiction.  In our example, that’s $100,000 x 10% = $10,000.

After the dust settles

After the small business deduction and federal tax abatement are subtracted from the basic federal tax rate, your remainder is called the Part I tax payable, and is 10.5% of taxable income, or $10,500 in our example.

T2 Corporation Income Tax Return (2016)

 Source:  Corporate Taxprep – T2 Corporation Income Tax Return (2016)

Provincial piece of the pie

Provincial taxes are then applied on line 760 of the T2 Corporation Income Tax Return.  Ontario adds 4.5% of taxable income to the corporate tax bill, increasing the total taxes payable to 15%, or $15,000 in our example (line 770).  

T2 Corporation Income Tax Return (2016)

Source:  Corporate Taxprep – T2 Corporation Income Tax Return (2016)

The big picture

Whew. Once you and your accountant are through, here’s what all this looks like in summary:

Corporate Taxation of Active Business Income: Summary

General Formula Amount Calculation
Base amount of Part I tax $38,000 $100,000 × 38%
Deduct:
Small business deduction
($17,500) $100,000 × 17.5%
Deduct:
Federal tax abatement
($10,000) $100,000 × 10%
Equals:
Part I tax payable
$10,500 $38,000 - $17,500 - $10,000
Add:
Provincial or territorial tax
$4,500 $100,000 × 4.5% (Ontario)
Equals:
Total tax payable
$15,000 $10,500 + $4,500
Remainder:
After-tax business income
$85,000 $100,000 – $15,000

 

This leaves your corporation with $85,000 of after-tax business income to retain and invest within the company, or distribute to shareholders such as yourself.

Circling back to the beginning, the next logical step is deciding how to make best use of this after-tax income. In my next post, I’ll explain how dividends from active business income can be distributed and how they’re taxed in the hands of the shareholder. At first glance, it may seem like they’re being hit by a double tax-whammy, but I’ll show you how the integration between business and personal income works, and why receiving dividends from your corporation can be managed as tax-efficiently as earning income personally.

I would like to thank Theresa Martin, CPA, Chair at Porter Hetu International for her assistance in writing this post. If you wish to engage Theresa for individual tax planning, she can be reached at tmartin@inbalance.org   

By: Justin Bender | 0 comments