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Corporate Taxation: The End of Refundable Taxes?

September 5, 2017 - 10 comments

By now, you’ve likely been bombarded by articles – shelling out nearly as many opinions – on the government’s proposed tax changes for private corporations of all size. Remember that dividend refund “magic act” I covered? Guess what – that’s one of the tax breaks targeted for elimination. As you might imagine, this is causing quite a stir in the business community, with outcries ranging from “Government extortion!” to “It’s about freaking time!”

To inject some objectivity into the emotionally charged debates, let’s take a look at the numbers. Conclude what you will, and if you’d like to weigh in on the matter, the Department of Finance is inviting comments through October 2, 2017.   

All’s fair in love, war … and tax codes

As I introduced in my dividend refund post, the federal government currently taxes 38.67% of a corporation’s passive interest income (plus provincial or territorial taxes). The corporation can then file for a 30.67% refund (with 8% non-refundable) once the taxable dividends are paid out to shareholders.

The government has proposed eliminating that refund entirely. Instead of just 8%, the entire 38.67% would become non-refundable.

What’s with the change in heart? Although the dividend refund mechanisms I described in my previous post allows integration to function reasonably well in theory (so everybody pays their fair tax share), it has tended to play out a little differently in reality. Small business owners are initially taxed at a much lower rate on their active business income than regular taxpayers incur on their personal income. In Ontario, the difference is 15% for small-business corporate taxes versus a top tax rate of 53.53% on personal taxes. This gives small businesses a big head start on the after-tax cash they’ve got left to invest in passive corporate investment portfolios. In industry jargon, they’re scoring an impressive tax deferral benefit.

To re-level the playing field, the government considered a few other ideas, but scrapped them as impractical for reasons I won’t inflict on you at this time. By settling on the current proposal – making all corporate taxes on passive investment income non-refundable – the goal is to make it a relatively moot tax point whether business owners invest their active business income in their corporate passive portfolio, or distribute the income to themselves (or other shareholders) for investing personally.  

That’s the theory. Will it work in reality? Keep reading to see how the numbers compare. (And if you’re really a glutton for punishment, here’s a spreadsheet with the background calculations.)

Two’s company, three’s a crowd

In the example below, I’ve compared three taxpayers:

  1. An individual taxpayer
  2. A corporation taxed under the current (refund) system
  3. A corporation taxed under the proposed (non-refund) system

All three start with $100,000 of income that’s initially taxed at the top Ontario tax rate of 53.53% for the individual or the small-business tax rate of 15% for the corporations. The after-tax proceeds are then invested in portfolios earning 3% annual interest, taxed again, and then reinvested each year. The corporations pay 50.17% tax on their investment income each year, while the individual pays tax at 53.53%. At the end of 10 years, the corporations’ active business income and investment income is distributed to the business owners and taxed in their hands.

Starting portfolio (Ontario)

  Individual Corporation: Current System Corporation: Proposed System
Income $100,000 $100,000 $100,000
Combined federal/provincial personal or corporate tax ($53,530) ($15,000) ($15,000)
Starting portfolio $46,470 $85,000 $85,000

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

 

On your marks … Get set … Get a head start

Under the current and proposed systems, the individual taxpayer’s starting portfolio is $38,530 less than either of the business owners’ portfolios ($85,000 - $46,470). The individual earns $1,394 of investment income in the first year ($46,470 × 3%) and pays $746 of federal/provincial taxes ($1,394 × 53.53%), leaving $648 of after-tax investment income after year-end ($1,394 - $746).

Both corporate portfolios earn $2,550 of interest in year one ($85,000 × 3%) and incur $1,279 in corporate taxes ($2,550 × 50.17%), leaving $1,271 of after-tax investment income ($2,550 - $1,279). The only difference is that the corporation under the current system designates $782 of the federal taxes as refundable ($2,550 × 30.67%), while the corporation under the proposed system makes no such distinction – all taxes are non-refundable.

Although this distinction initially makes no difference to the corporate taxes payable after year one ($1,279 either way), we’ll soon see how it paves the way for a dramatic impact on a business owner’s net worth once taxable dividends are distributed from the corporation to its shareholders after many years of investment growth.

After-tax investment income after 1 year (Ontario)

Return on investment in year 1 Individual Corporation: Current System Corporation: Proposed System
Starting portfolio $46,470 $85,000 $85,000
Earn: 3% interest $1,394 $2,550 $2,550
Deduct: Federal/provincial personal tax ($746) - -
Deduct: Part I federal tax – refundable - ($782) -
Deduct: Part I federal tax – non-refundable - ($204) ($986)
Deduct: Provincial taxes – non-refundable - ($293) ($293)
Equals after-tax investment income $648 $1,271 $1,271

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

 

The better part of a decade

After 10 years, the individual taxpayer (who has already paid taxes on the initial income, plus annual taxes on the 3% investment returns), has no additional taxes to fork over. Their portfolio is now worth $53,370.

Under the current corporate system, $8,368 of refundable taxes have accumulated, as well as $98,596 of active business income and after-tax investment earnings. The total taxable dividend amount of $106,965 ($8,368 + $98,596) is then distributed to shareholders and taxed in their hands as ineligible dividends – roughly 45.30% for an Ontario taxpayer in the top tax bracket. Once integration has supposedly done its job (so everyone ends up shouldering an equal tax burden), the business owner now has a net worth of $58,505. Whoops – that’s $5,135 more than the individual investor after 10 years ($58,505 vs. $53,370).

Enter the proposed corporate system, with its one tweak to eliminate refunds on all of a corporation’s passive investment income. Without the refundable taxes, that leaves only $98,596 (instead of $106,965) to distribute as taxable dividends to the shareholders. After they pay their personal taxes on the proceeds, they’re left with $53,928. That’s just $558 more than the individual investor ($53,928 vs. $53,370).

It would appear that the proposed system would come much closer to true integration between business owners’ and individual taxpayers’ investment interests.

After-tax portfolio value after 10 years (Ontario)

  Individual Corporation: Current System Corporation: Proposed System
Portfolio value after 10 years $53,370 $98,596 $98,596
Add: Refundable taxes - $8,368 -
Equals: Available dividends to distribute to shareholders - $106,965 $98,596
Deduct: Personal tax on dividends - ($48,460) ($44,669)
Net worth $53,370 $58,505 $53,928

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

 

Every decade counts

As you might guess, under the current system, the further out we extend our illustration, the bigger the gap grows between individual and corporate after-tax passive investment returns. Below, I illustrate the dramatic difference the proposed change would make after 30 years.

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

 

It ain’t over yet

As touched on above, everything I’ve just covered is still just a proposal, which means it is subject to change after the October 2, 2017 consultation period ends. That’s blog-job security for me, since I’ll want to take another look at it once the final results are in. Coming up next, we’ll see how capital gains are taxed within a corporation.

By: Justin Bender with 10 comments.
Comments
  25/10/2017 9:47:31 AM
Justin bender
@BobbyJoe: I’m glad you enjoyed the article. There’s more corporate taxation articles to come, so stay tuned!
 
  21/10/2017 10:27:33 AM
BobbyJoe
Great article. Thanks for writing this up and not taking sides. There seems to be a lot of misunderstanding with these reforms and more news outlets should focus on clarifying how the reforms mathematically function.
 
  26/09/2017 4:47:38 PM
Justin Bender
@Shahrukh Bakar: The assumption is that the $100,000 of additional income is after they have each earned $220,000 of other income (putting them in the highest marginal tax bracket in Ontario of 53.53% for income and 45.30% for ineligible dividends).
 
  26/09/2017 4:46:41 PM
Justin Bender
@Abhishek: The assumption is that the $100,000 personal income is taxed at the top marginal tax bracket in Ontario of 53.53%. It is also assumed that the business owner is taxed at the top marginal tax bracket for ineligible dividends in Ontario of 45.30% (this makes both calculations easier to follow) – these assumptions would indicate that both investors have already earned $220,000 of other income in their personal hands (so it is a fair comparison).
 
  26/09/2017 4:45:35 PM
Justin Bender
@Peter Fournier: It would be impossible to create the type of analysis you’re looking for.
 
  18/09/2017 4:09:23 PM
Justin Bender
@Martin Pergler: You’re already thinking out of the box, Martin J Yes, there still could be a benefit to investing within a corporation if the taxpayer’s marginal tax bracket on withdrawal (generally in retirement) is lower than during their working years.
 
  13/09/2017 10:53:36 PM
Abhishek
Your initial tax assessment on the $100K is seems to be incorrect. Based on 2017 tax tables, combined tax would be about $25k and left with $75k or so. Which then would change all other metrics you have listed.
 
  13/09/2017 10:46:13 PM
Shahrukh Bakar
Hi Justin, in your example you say, 'All three start with $100,000 of income that’s initially taxed at the top Ontario tax rate of 53.53% for the individual' and then show tax of $53,530 on the individual's $100k income.

Did you mean $100k of MARGINAL income assumed to be at the highest marginal tax rate? If not, the total federal/provincial tax burden will not be 53.53% because that is the marginal tax rate not the total combined federal/provincial tax rate...can you please correct the text?

Thanks.

SNB
 
  12/09/2017 12:06:01 PM
Peter Fournier
I don't understand how this proposed tax change is "fair". As a small business owner there are many benefits I do not have access to that RFT employees enjoy, for example:
=> Unemployment insurance
=> Good deals on regular insurance
=> Generous health benefits including dental, eyes and psychological couonseling
=> A corporate sponsored retirement plan with corporate contributions.
=> etc.

How does making the tax contribution equal make any sense without making the benefits equal as well, equal to say what is available for federal RFT employees or big corporation RFTs with access to even more benefits like stock options?
 
  07/09/2017 7:55:48 PM
Martin Pergler
Thank you for the clear explanation - actually the only one I've read and understood!
If I understand correctly, this essentially removes the benefit of investing inside the corp *if* one's personal tax bracket remains the same. It could still be quite advantageous to invest within one's corporation if one can arrange one's affairs so that the personal tax rate on the withdrawn dividends is lower, e.g. in retirement. Is that right?
 



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