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.
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.
Source: Corporate Taxprep – Schedule 7 (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.
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).
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, 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