Chapter 15 Corporate Taxation And Management Decisions

The Decision To Incorporate Tax Reduction Tax Reduction Tax Deferral Tax Deferral Income Splitting Income Splitting Other Considerations Other Considerations © 2010, Clarence Byrd Inc. 2

Incorporation: Other Advantages Limited Liability Limited Liability Shareholders’ liability to creditors limited to amounts invested Shareholders’ liability to creditors limited to amounts invested For smaller corporations, personal guarantees almost always required to obtain significant financing For smaller corporations, personal guarantees almost always required to obtain significant financing Protection from other types of liabilities (e.g., product liability) Protection from other types of liabilities (e.g., product liability) © 2010, Clarence Byrd Inc. 3

Incorporation: Other Advantages Lifetime capital gains deduction Lifetime capital gains deduction Flexibility on timing and character of income Flexibility on timing and character of income Foreign taxes Foreign taxes Estate planning Estate planning © 2010, Clarence Byrd Inc. 4

Incorporation: Disadvantages Loss deductions Loss deductions Tax credits Tax credits Charitable donations (deduction, not credit) Charitable donations (deduction, not credit) Cost of maintaining corporation Cost of maintaining corporation Winding-up procedures Winding-up procedures © 2010, Clarence Byrd Inc. 5

Tax Reduction See Paragraph (Based on $100,000 of income) See Paragraph (Based on $100,000 of income) Save $1,100 for CCPC with SBD Save $1,100 for CCPC with SBD Neutral with respect to dividends Neutral with respect to dividends All other cases involve tax cost All other cases involve tax cost $1,040 for public company $1,040 for public company $1,040 for CCPC on non-eligible income $1,040 for CCPC on non-eligible income $1,360 for CCPC investment income $1,360 for CCPC investment income © 2010, Clarence Byrd Inc. 6

Tax Deferral See Paragraph See Paragraph Neutral on non-eligible dividends Neutral on non-eligible dividends Prepay Prepay CCPC investment income CCPC investment income Eligible dividends subject to Part IV Eligible dividends subject to Part IV Deferral in other cases Deferral in other cases $16,000 for public company or CCPC without SBD $16,000 for public company or CCPC without SBD $30,000 for CCPC earning ABI $30,000 for CCPC earning ABI © 2010, Clarence Byrd Inc. 7

CCPC Income > Small Business Limit The The Problem If If over $500,000 ABI Flow Flow through rate can be near 50% The The Solution Bonusing Bonusing Down © 2010, Clarence Byrd Inc. 8

Imperfections In Integration System Provincial dividend tax credits – non-eligible dividends Provincial dividend tax credits – non-eligible dividends DTC  1/3 (33-1/3%) Gross Up – Favours use of corporation DTC  1/3 (33-1/3%) Gross Up – Favours use of corporation DTC < 1/3 (33-1/3%) Gross Up – Favours not incorporating DTC < 1/3 (33-1/3%) Gross Up – Favours not incorporating Actual range (2010): 10.5% to 40.0% Actual range (2010): 10.5% to 40.0% © 2010, Clarence Byrd Inc. 9

Imperfections In Integration System Provincial dividend tax credits – eligible dividends Provincial dividend tax credits – eligible dividends DTC  7/17 (41.2%) Gross Up – Favours use of corporation DTC  7/17 (41.2%) Gross Up – Favours use of corporation DTC < 7/17 (41.2%) Gross Up – Favours not incorporating DTC < 7/17 (41.2%) Gross Up – Favours not incorporating Actual range: 20.9 to 38.9% Actual range: 20.9 to 38.9% © 2010, Clarence Byrd Inc. 10

Imperfections In Integration System Different federal/provincial combined tax rates Different federal/provincial combined tax rates Combined rates for CCPC on ABI range from 12% to 19% As all rates are less than 20%, they favour incorporation © 2010, Clarence Byrd Inc. 11

Tax Free Dividends Basic Concepts Basic Concepts $1 Non-Eligible Dividend Received $1 Non-Eligible Dividend Received $1.25 Increase In Taxable Income [($1)(125%)] $1.25 Increase In Taxable Income [($1)(125%)] Individuals In Lowest Federal Tax Bracket Individuals In Lowest Federal Tax Bracket Taxes Are $ [($1.25)(15%)] Taxes Are $ [($1.25)(15%)] Federal Dividend Tax Credit = $ [($0.25)(2/3)] Federal Dividend Tax Credit = $ [($0.25)(2/3)] © 2010, Clarence Byrd Inc. 12

Tax Free Dividends Tax on first $1 of non-eligible dividends is $ ($ $.1667) Tax on first $1 of non-eligible dividends is $ ($ $.1667) First $1 of non-eligible dividends uses up available credits of $ ($.0208 ÷ $.15) First $1 of non-eligible dividends uses up available credits of $ ($.0208 ÷ $.15) © 2010, Clarence Byrd Inc. 13

Use Of Tax Credits $1 of salary uses $1 of credits $1 of salary uses $1 of credits $1 of non-eligible dividends uses $ of credits $1 of non-eligible dividends uses $ of credits Dividends are a better until credits are used Dividends are a better until credits are used © 2010, Clarence Byrd Inc. 14

Amounts Available Tax Free Single Individual $40,844 Non-Eligible $ 66,625 Eligible With Dependent Spouse $28,051 Non-Eligible $80,096 Eligible © 2010, Clarence Byrd Inc. 15

Amounts Available Tax Free Don’t forget the alternative minimum tax (AMT) © 2010, Clarence Byrd Inc. 16

Income Splitting Splitting income a very powerful tool Splitting income a very powerful tool Corporations very effective here Corporations very effective here Few limits for spouses and adult children Few limits for spouses and adult children Problems with minor children (tax on split income) Problems with minor children (tax on split income) © 2010, Clarence Byrd Inc. 17

Shareholder Benefits The owner-manager environment Not arm’s length Few constraints on use of corporate resources Sometimes difficult to separate business and personal use Travel Automobiles © 2010, Clarence Byrd Inc. 18

Shareholder Benefits Automobiles Automobiles Standby charge Standby charge Operating cost benefit Operating cost benefit See Chapter 3, Employment Income See Chapter 3, Employment Income © 2010, Clarence Byrd Inc. 19

Shareholder Benefits Benefits other than loans Benefits other than loans Included in shareholders’ income Included in shareholders’ income Not deductible for corporation Not deductible for corporation Should be avoided! Should be avoided! © 2010, Clarence Byrd Inc. 20

Shareholder Benefits Loans - ITA 15(2) Loans - ITA 15(2) General Requirements General Requirements Principal amount must be added to shareholder’s income Principal amount must be added to shareholder’s income No imputed interest under ITA 80.4(2) No imputed interest under ITA 80.4(2) Can be deducted under ITA 20(1)(j) when it is repaid Can be deducted under ITA 20(1)(j) when it is repaid © 2010, Clarence Byrd Inc. 21

Shareholder Loans Exceptions Exceptions Corporation In Lending Business: ITA 15(2.3) Corporation In Lending Business: ITA 15(2.3) Loan repaid prior to second balance sheet date Loan repaid prior to second balance sheet date Not Specified Shareholder Not Specified Shareholder If not in income – imputed interest under ITA 80.4(2) If not in income – imputed interest under ITA 80.4(2) © 2010, Clarence Byrd Inc. 22

Shareholder Loans Exceptions Exceptions Loans Loans To Shareholder/Employee: ITA 15(2.4) To To acquire personal residence acquire shares of the company acquire an automobile to be used in employment duties © 2010, Clarence Byrd Inc. 23

Management Compensation General Principle: Salary is Benchmark General Principle: Salary is Benchmark Fully taxable to shareholder Fully taxable to shareholder Fully deductible to corporation Fully deductible to corporation © 2010, Clarence Byrd Inc. 24

Management Compensation Tax effective solutions Tax effective solutions RPPs RPPs DPSPs DPSPs Private health care Private health care Stock options Stock options © 2010, Clarence Byrd Inc. 25

Salary Vs. Dividends © 2010, Clarence Byrd Inc. 26 Example: Ms. Olney has $100,000 of corporate income and is subject to a tax rate of 45 percent SALARY: No corporates taxes – personal taxes of $45,000 – retention of $55,000. Like direct receipt of income. Dividends: Retention will depend on type of corporation and type of income (see Paragraph 15-66). Better retention only in the case of a CCPC earning active business income.

Salary vs. Dividends – Other Considerations Provincial rates and credits Provincial rates and credits Tax rates on individuals are not an issue Tax rates on individuals are not an issue High dividend tax credit rates encourage the use of dividends High dividend tax credit rates encourage the use of dividends High corporate tax rates encourage the use of salary High corporate tax rates encourage the use of salary © 2010, Clarence Byrd Inc. 27

Salary vs. Dividends – Other Considerations Income splitting Income splitting Some family members with no income Some family members with no income Can receive substantial amounts of tax free earnings Can receive substantial amounts of tax free earnings © 2010, Clarence Byrd Inc. 28

Salary vs. Dividends – Other Considerations RRSP Contributions (2009*) RRSP Contributions (2009*) $22,000  18% = $122,222 = required 2009 earned income $22,000  18% = $122,222 = required 2009 earned income Dividends  Earned Income Dividends  Earned Income RRSP RRSP CPP CPP *2010 Not Available Yet *2010 Not Available Yet © 2010, Clarence Byrd Inc. 29

Salary vs. Dividends – Other Considerations Cumulative net investment loss (CNIL) Cumulative net investment loss (CNIL) CNIL reduces available lifetime capital gains deduction CNIL reduces available lifetime capital gains deduction Receipt of dividends reduces CNIL Receipt of dividends reduces CNIL Added costs of salary Added costs of salary CPP and EI premiums CPP and EI premiums Payroll taxes (in some provinces) Payroll taxes (in some provinces) © 2010, Clarence Byrd Inc. 30

Salary vs. Dividends – Other Considerations Added benefits of salary Added benefits of salary CPP and EI tax credits CPP and EI tax credits Canada employment credit Canada employment credit Corporate tax payable Corporate tax payable If distributions exceed income If distributions exceed income No tax savings with salary No tax savings with salary © 2010, Clarence Byrd Inc. 31

Dividends - Problem Problem - All Dividend Approach Problem - All Dividend Approach Use up tax credits at a slow rate Use up tax credits at a slow rate May leave unused tax credits May leave unused tax credits Solution Solution Pay a lesser amount of dividends Pay a lesser amount of dividends Sufficient additional salary to absorb tax credits Sufficient additional salary to absorb tax credits © 2010, Clarence Byrd Inc. 32

Basic Data Corporate Taxable Income = $29,500 Corporate Taxable Income = $29,500 Combined Corporate Tax On ABI = 16% Combined Corporate Tax On ABI = 16% Provincial Tax On First $40,970 Of Personal Taxable Income = 10% Provincial Tax On First $40,970 Of Personal Taxable Income = 10% Individual Has Combined Tax Credits Of $3,920 Individual Has Combined Tax Credits Of $3,920 Provincial Dividend Tax Credit = 1/3 Of Gross Up Provincial Dividend Tax Credit = 1/3 Of Gross Up © 2010, Clarence Byrd Inc. 33

All Salary No Corporate Tax Payable No Corporate Tax Payable Salary Received = $29,500 Salary Received = $29,500 Taxes At 25% (15% + 10%)($7,375) Personal Tax Credits 3,920 Tax Payable( 3,455) After Tax Cash Retained $26,045 © 2010, Clarence Byrd Inc. 34

All Dividends Maximum Dividend Maximum Dividend Corporate Income$29,500 Corporate Tax At 16% ( 4,720) Available For Dividends$24,780 Taxable Dividends Taxable Dividends Dividends Received$24,780 Gross Up (25%) 6,195 Taxable$30,975 © 2010, Clarence Byrd Inc. 35

All Dividends Personal Taxes On Dividends Personal Taxes On Dividends Tax At 25 Percent [(25%)($30,975)] $7,744 Personal Tax Credits( 3,920) Dividend Tax Credit(Equal Gross Up)( 6,195) Tax Payable (Negative $2,371) Nil After Tax Cash Retained After Tax Cash Retained Dividends Received$24,780 Tax Payable Nil Cash Retained$24,780 © 2010, Clarence Byrd Inc. 36

All Dividends The All Dividend Approach Leaves $2,371 In Unused Personal Tax Credits The All Dividend Approach Leaves $2,371 In Unused Personal Tax Credits A Combination Of Salary And Dividends May Provide A Better After Tax Retention A Combination Of Salary And Dividends May Provide A Better After Tax Retention © 2010, Clarence Byrd Inc. 37

Dividend/Salary Combination Consider: Consider: For For Each $1,000 Of Additional Salary Paid Dividends Dividends Are Reduced $ [($1,000)( )] Increase In Salary$1, Decrease In Dividends( ) Decrease In Gross Up ( ) Change In Taxable Income ($ 50.00) © 2010, Clarence Byrd Inc. 38

Dividend/Salary Combination Decrease In Dividend Tax Credit$ Each $1,000 Increase In Salary Results In An Increase Of Tax Payable Of $ [$ – (25%)($50)] Each $1 Increase In Salary Increases Tax Payable By $ To Use Up $2,371 In Credits, Need Additional Salary Of $12,005 ($2,371/$0.1975) © 2010, Clarence Byrd Inc. 39

Dividend/Salary Combination Pre-Salary Taxable Income$29,500 Salary ( 12,005) Corporate Taxable Income$17,495 Corporate Tax At 16 Percent ( 2,799) Available For Dividends$14,696 © 2010, Clarence Byrd Inc. 40

Dividend/Salary Combination Dividends Received$14,696 Gross Up (25%) 3,674 Taxable Dividends$18,370 Salary 12,005 Taxable Income$30,375 © 2010, Clarence Byrd Inc. 41

Dividend/Salary Combination Personal Tax At [(25%)($30,375)]$7,594 Personal Tax Credits ( 3,920) Dividend Tax Credit (Gross Up) ( 3,674) Personal Tax Payable Nil © 2010, Clarence Byrd Inc. 42

Dividend/Salary Combination Dividends Received$14,696 Salary Received 12,005 Personal Tax Payable Nil After Tax Retention$26,701 © 2010, Clarence Byrd Inc. 43

Dividend/Salary Combination All Salary Approach$26,045 All Salary Approach$26,045 All Dividend$24,780 All Dividend$24,780 Dividend/Salary$26,701 Dividend/Salary$26,701 © 2010, Clarence Byrd Inc. 44

Conclusions All Dividends Ineffective Doesn’t use all credits Need minimum salary of $12,005 to use credits (in this example) © 2010, Clarence Byrd Inc. 45

Conclusions Combination salary/dividend improves on all dividend and all salary Combination salary/dividend improves on all dividend and all salary Reflects the fact that the 16 percent corporate rate is below the 20 rate built into the dividend gross up and tax credit procedures. Reflects the fact that the 16 percent corporate rate is below the 20 rate built into the dividend gross up and tax credit procedures. © 2010, Clarence Byrd Inc. 46

© 2010, Clarence Byrd Inc. 47