My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, December 19, 2011

Should your Investment Income be Earned in a Corporation

Many people often ask should they own their investments in a corporation to avoid and/or defer income taxes. Although there may be reasons to utilize a corporation for liability purposes or to save on U.S. estate taxes if you own U.S. securities, there are currently no income tax savings or benefits to utilizing a corporation to earn investment income.

The overriding principle of taxation in Canada is that an individual should be indifferent between earning investment income through a corporation and earning that same income personally. This concept is known as integration. To achieve integration on investment income, Canada imposes a refundable tax on Canadian controlled private corporations that earn investment income.

If investment income earned in a corporation was subject to an income tax rate that was lower than the highest marginal personal income tax rate, it would be possible to have an indefinite deferral of income tax so long as the after-corporate tax funds were left in the corporation.

In order to ensure taxpayers do not defer income tax on investment income by using a corporation, the Income Tax Act imposes an income tax rate that is essentially the same as the highest marginal personal income tax rate. Thus, an investment corporation in Ontario would currently pay 46.41% on all its investment income earned, which by coincidence is the exact same rate as the highest personal marginal income tax rate in Ontario. In order to ensure that double tax is not incurred, when corporate funds are distributed out to an individual by a dividend, the high rate of corporate income tax is partially refunded.  This refundable tax prevents the corporation from having more after-tax dollars available to reinvest than the individual would have had if he or she had earned the money personally.

This may be more than you want to know, but the way the refundable tax system works is as such: the 46.41% corporate income tax rate is split into two components, the income tax component which is 19.74% and the refundable tax component which is 26.67%. The refundable component goes into a notional account called the Refundable Tax On Hand (“RDTOH”) account. Where a corporation has paid refundable tax, it will receive a refund of this tax when it pays a dividend to its shareholder(s) who will then pay the personal tax on the dividends. The corporation receives a $1 refund for every $3 in dividends it pays to a shareholder.

It is probably best to think of the refundable taxes as a prepayment of the eventual personal taxes to be paid on the investment income. Below is a model of how the investment income integration system works (this is theoretical not actual; see below for a discussion of the realities of integration in Ontario). As demonstrated by the examples, theoretically where investment income is earned through a corporation there should be no deferral of tax and no tax savings where the individual shareholder pays tax on the dividends at the highest marginal tax rate.




Integration model


Interest


Eligible Dividend


Other Than Eligible Dividend
A:
Investment income earned personally
100.00
100.00
100.00
Personal tax (2011)
46.41
28.19
32.57
Net cash for investment
53.59
71.81
67.43
B:
Investment income earned in a corporation
100.00
100.00
100.00
Corporate tax
20.00
-
-
80.00
100.00
100.00
Refundable tax
26.67
33.00
33.00
Net cash for investment
53.33
67.00
67.00
Corporation declares dividend to shareholder
and recovers $1 of refundable tax for every
$3 of dividends paid to the shareholder(s)
Dividend refund
26.67
33.00
33.00
Cash to pay dividend
80.00
100.00
100.00
Personal tax to shareholder on dividend
26.41
28.19
32.57
Net cash for personal investment
53.59
71.81
67.43


In reality, integration is not perfect. For example, in Ontario there is a ½ point of absolute income tax benefit to use a corporation when earning interest income, a ¼ point of savings if earning capital gains and no tax savings when earning dividends; however, based on the professional fees and administration, one would almost never use a corporation for such a small benefit.

The refundable income tax system is a somewhat nefarious concept; hopefully I have provided some insight into the concept above and not confused you further. However, the key take-away point is; there is no income tax benefit to incorporate your investment income.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.