Advisors have to understand the needs for a client’s investment capital in order to recommend the most appropriate investment solution. When considering a corporate client’s investments, advisors have two additional aspects to consider, namely:
- An additional layer of tax – the corporation and its shareholders are separate taxpayers; and
- What is the most tax-efficient manner to pay out income to individual shareholders when the need arises?
How is investment income taxed in a corporation?
Corporate tax rates are determined largely by the nature of income reported for tax purposes, while an individual is subject to a marginal tax rate system and, to a certain extent, to the nature of income being reported.
Investment income (interest, other income, dividends, capital gains) earned by a corporation is passive in nature and attracts a higher corporate tax rate than active business income. The higher corporate tax rates are due to:
- Refundable income tax; and
- The inability to claim the small business tax deduction or general rate reduction.
When working with a corporate client, advisors should consider the following:
- Determine if distributions are needed from the corporate investments to support ongoing corporate operations or for a shareholder who requires funds for personal lifestyle needs.
If distributions from the corporate investments are not required for ongoing operations or for shareholders, consider investing on account of capital, namely using CI’s Corporate Class funds, which seek to minimize income distributed to investors. Unnecessary income generates unnecessary income tax, which represents tax leakage from investment capital.
If the corporation does require distributions for ongoing operations, consider CI’s Corporate Class T-Class or CI’s trust pools, which distribute return of capital (ROC) or income on a regular basis. Recognize that ROC is cash flow and is not taxable, whereas income is taxable receipt.
Corporate Class T-Class funds are useful in a limited set of circumstances for a corporate client. T-Class funds result in ROC payments, where cash is transferred from the corporation’s investment capital to its bank account. Where the corporation itself requires regular cash flow for operations or to fund a particular corporate expense, i.e. life insurance premiums, a bank interest payment or the repayment of a shareholder loan, T-Class funds generate tax-free cash flow at the corporate level.
Where the personal shareholder needs to access the corporate investments to support personal lifestyle needs, there are a variety of ways a shareholder can realize income or extract funds as cash flow from a corporation, namely:
- Compensation (salary) – generally, where the corporation is an operating company, generating active income
- Dividends from shares – either eligible, ineligible or capital dividends
- Capital gains – from the redemption or disposition of a share of the corporation; or
- Cash flow – repayment of a shareholder loan.
- What role do dividends play in distributing from a corporation tax efficiently? What means, if any, are available to reduce the overall taxes paid by the two taxpayers – the corporation and its shareholder(s)?
When considering the payment of taxable dividends, advisors and their clients should consider the corporation’s Refundable Dividend Tax on Hand Account (RDTOH). The premise behind RDTOH is to prevent a tax deferral on investment income at the corporate level, or gain a tax advantage by incorporating a corporation to hold investments.
As mentioned above, corporate investment income is passive in nature and is subject to refundable tax. For example for every $1 a Canadian corporation reports of:
- Interest or other investment income, it will pay 30.67% Part I refundable tax;
- Capital gains, it will pay 15.34% Part I refundable tax; or
- Canadian dividends, it will pay 38.33% Part IV refundable tax.
If an individual shareholder anticipates the need to access corporate investments, creating RDTOH, to generate a dividend refund when paying taxable dividends can be tax advantageous. To create RDTOH, the corporation needs to generate and report passive income. This can be achieved by realizing capital gains in the corporate portfolio, receiving dividends or other income distributions from either CI Corporate Class or trust pools. To the extent the corporation does not have a RDTOH balance, no dividend refund nor other form of tax relief to the corporation for declaring and paying dividends is realized, and thus, a double tax scenario occurs.
Corporate investment decision tree