chapter 12 integration for business and investment income of the private corporation
TRANSCRIPT
Chapter 12
Integration for Business and Investment Income of the Private
Corporation
Problem 3
Problem 6
Problem 9
Today’s topics
• The concept of integration• Income from an active business of a
CCPC• Income from investments of a CCPC
Problems addressed
• A corporation is a separate legal entity and normally treated as such in tax
Object of integration
• Should cause total tax paid by a corporation and its shareholders to be equal to the total tax paid by an individual who carries on the same economic activity.
• Perfect integration relies on two factors:– Where corporation pays tax, the individual
gets credit– All after-tax income paid as dividends or taxed
by individual to avoid infinite deferral of tax
The Tool
• The major tool is the gross-up and tax credit procedure
• The gross-up is intended to approximate the pre-tax income of the corporation
Dividends
• Eligible dividends – dividends paid from income in excess of the SBD limit
• Ineligible dividends – paid from SBD income
The theoryTheoretical taxation of Dividends that demonstrate perfect integration
Corporation A B
Income 1,000 1,000
Theoretical tax ( 25% & 31%)
(200) (310)
After-tax earnings 800 690
Dividend paid 800 690
Gross-up 200 310
Taxable income 1,000 1,000
Personal tax 340 340
DTC (200) (310)
Net tax 140 30
Corporate tax paid 200 310
Shareholder 140 30
Total 340 340
If paid as salary (34%) 340 340
Concept application
• Works when corporate tax rate is 20%• Eligible and ineligible dividends attempt to
address the issues of different corporate tax rates
Eligible dividends
• Dividends paid by– Public corporations resident in Canada and
subject to general corporate tax rate– CCPC resident in Canada to the extent that
business income is subject to high rate• GRIP• Income over SBD level
Calculations
A (noneligible) B (eligible)
Calculation based on gross-up
Dividend gross up 200 310
Federal DTC
2/3 of GU 133
11/18 of GU 189
Provincial DTC
1/3 of GU 67
7/18 of GU 121
200 310
Calculations
A (noneligible) B (eligible)
Calculation based on grossed-up dividend
Grossed up dividend 1,000 1,000
Federal DTC
13 1/3% of GUD 133
19% of GUD 189
Provincial DTC
6 2/3% of GUD 67
12% of GUD 121
200 310
Summary of dividend
Cash amount received 1,000 1,000
Gross up par82(1)(b) 25%/45%
250 450
Grossed up taxable amount of dividend
1,250 1,450
Federal DTC 2/3 or 11/18 of GU
167 275
Federal DTC as percentage of GUTD
13.333% 18.97%
Eligibility
• 25% gross up– Dividends from active
business income of CCPC eligible for SBD
– Dividends from investment income of CCPC
• 45% gross up– Dividends from active
business income of CCPC not eligible for SBD
– Dividends from public CDN companies or CCPC with income subject to general corporate tax rate
Active Business Income
• SBD is a credit against tax otherwise payable
• Must meet certain criteria
Tax rates applicable
Federal tax rate 38.00%
Federal abatement for provincial taxes (10.00)
Net federal tax after abatement 28.00%
Small business deduction (17.00)
Total federal tax 11.00%
Provincial tax (assumed) 5.00%
Effective total tax 16.00%
Definition of active income
• Any business carried on by the corporation other than a specified investment business or a personal services business and includes an adventure or concern in the nature of trade
Specified investment income
• A business (other than a credit union or leasing property other than real property)
• The principal purpose is to derive income from property (including interest, dividends, rents and royalties)
• Unless the corporation employees MORE than 5 full-time employees
Personal services business
• Contractor vs employee discussion again
Personal services business
• A business of providing services where– An individual who performs services on behalf of the
corporation– Any person related to the incorporated employee– Is a specified shareholder (10% or more of shares)– The incorporated employee would reasonably be
regarded as an officer or an employee of the entity• Unless
– More than five full-time employees– Services are provided to an associated corporation
Discussion
• M Ltd provides management advisory services to ACC Ltd. And is not involved in any other business. M Mud is the sole shareholder and only employee. Mr Mud and his son each own 50% of ACC Ltd.
• PSB?• Specified investment income?• Active business?
Solution
• M is an active business. It is not a PSB as the services are provided to an associated corporation. M Ltd and ACC Ltd are associated. M Ltd is not specified investment business as the principal purpose is not to derive income from property.
Example
• XYZ Ltd owns an apartment building in downtown St Johns. The only employees of XYZ are the two shareholders. XYZ earns income from rents and has some interest income
• Is XYZ a specified investment business?• Would it matter if all apartments were on
leases and not month-to-month?• What if XYZ had 7 full time employees
Solution
• Specified invesment – YES – income is rent and less than 5 employees
• Leases vs mont to month – NO – leasing income is from leasing real property
• # of employees – YES – greater than 5 employees and there eligible for SBD
Incidental income
• Includes property income earned in conjunction with the activities of carrying on an active business.
Associated companies
• When two or more CCPCs are associated for tax purposes, the SBD is shared and is allocated annually.
Two corporations related where:
• Both corporations are owned by the same person (or common group)
• One corporation is controlled by one person who is related to a person or any member of a related group that controls the other corporation
• One corporation is controlled by one person or a related group and that person or one member is related to each member of an unrelated group which controls the other corporation
• Two corporations are controlled by unrelated groups and at least one member of one of the groups is related to each member of the other group
Related individuals
You
Parents and grandparents
SiblingsSpouses of siblingsSiblings of spouses
Children/children in lawadopted, children of spouse• Descendants
Siblings of your spouseSpouses of the siblings
of your spouse
Spouse Siblings
256(1)(c)
• Three conditions:– Control test:
• Each of the corporations must be controlled, directly or indirectly in any manner whatever by a person (includes corporation)
– Related test:• Person who controls one of the corporations must
be related to the person who controls the other one
– Cross-ownership test:• Either person owns not less than 25% of the issued
shares of any class other than a specified class
Specified class
• Shares are not convertible or exchangeable• Shares are non-voting• Dividends payable on the shares are fixed• Annual rate of dividends on shares does not
exceed prescribed rate of interest at the time shares were issued
• Redemption amount cannot exceed FMV of PUC plus unpaid dividends– Can’t make money on the sale
Illustration
• Group One Ltd: Mom and Dad• Group Two Ltd: Child of Mom and Dad
and Mom’s brother• Are Group One Ltd and Group Two Ltd
related?
Group One Ltd
Dad 50%
Mom 50%
Group Two Ltd
Child 50%
Brother 50%
Solution
• Group Two is controlled by unrelated group since it is uncle and child. Group One is controlled by related group (through marriage)
• Each member of related group that controls Group One is related to each member of unrelated group that controls Group Two.
• Corporations are related
Example
• Dad and Son (age 25) both own 100% of the common shares of their respective corporations Dadco and Sonco. Dad owns 100% preferred shares of Sonco (voting, 8% redeemable at $100,000)
• At issuance prescribed rate was 10% and FV was $100,000
• Are Dadco and Sonco associated?
Graph
Dad
Dadco Ltd (100%
common)
Son
Sonco Ltd (100%
common)
Solution
• Associated because:– Corporations are controlled directly– Dad and Son are related (parent-child)– Dad owns not less than 25% of Sonco (cross
ownership)– Preferred and common are not specified
classes because they are both voting
Example
• Mom owns 100% of common shares of Momco. Adult daughters 1 and 2 each own 35% of common shares of Sibco. Mom owns the remaining 30%
• Are Momco and Sibco associated?
Visual
Mom Daughter 1 Daughter 2
35% common
35% common
30% common
SibcoMomco
100% common
Solution
• Momco and Sibco are associated:– Mom controls Momco– Mom is related to each person who controls
Sibco– Mom owns not less than 25% of nonspecified
shares– Common shares of Sibco are not specified
shares (voting rights)
Example
• Alpha and Beta who are married each own 50% of the common shares of AB Ltd. Their son Alpha Jr and his wife own 40% and 30% respectively of Junior Ltd. Beta owns the other 30% of Junior.
• Are AB and Junior associated?
Visual
Alpha Alpha Jr Wife
30% common
40% common
50% common
Junior LtdAB Ltd
50% common
Beta
30% common
Solution
• Associated because:– AB is controlled by Alpha and Beta who are related
by marriage– Junior is controlled by any of
• Alpha Jr and Wife (marriage)• Beta and Alpha Jr (blood)• Beta and Wife (extended definition)• Alpha Jr, Wife and Beta are all related• All members of AB group are related to all members of
Junior group• One or more members of both groups must not own less
than 25%• Common shares are not specified
Concept of control
• Legal control– Ownership question
• Factual control– Lots of variables
Extended meaning of control
• A person or group of persons will be deemed to control a corporation when the person or group owns:– Shares representing more than 50% of FMV
of all issued and outstanding shares– Common shares representing more than 50%
of the FMV of all issued and outstanding common shares
• Rule ignores voting rights and looks at underlying value
Ownership of shares
• Look-through rules– Dilution of control through hierarchy
• Shares owned by a minor– Attribution and deeming rules apply
• Two other rules:– Rights to acquire shares or rights of a corporation
to redeem shares• Association with third company• Deemed association
– Need to demonstrate a non-tax reason for existence of corporations (hard to justify)
Example
Controller Ltd
Controlled Ont Ltd
Controlled Two Ltd
• Controller Ltd owns 60% therefore controls Controlled One.
• 60% of 55% is 33% therefore 256(1.2)(d) deems controlled by Controller Ltd.
60%
55%
Deemed association
• Where one of the main reasons for the separate existence of two corporations that are not otherwise associated is tax considerations, then they may be deemed to be associated
• SBD is shared within the associated group
M&P and the SBD
• Can have one or the other but not both• M&P is derived from the SBD calculation
therefore the calculation will exclude SBD income from M&P
Example
• During first year, Touchee-Feelee Ltd reported the following
• Corporation carries on business in Canada and is not associated
• All foreign tax recovered
• 96% of income earned is in a province
• What is the tax payable by the corporation?
M&P profits 80,000
Total active business income earned in Canada including M&P
105,000
Foreign ABI ($1,125 tax paid)
5,000
Taxable income 75,000
Division B income 110,000
Taxable dividends paid in the year
40,000
Solution
Taxable income 75,000
Basic federal tax (38%) 28,500
Abatement (10%) (7,200)
FBTC (1,125)
Small business deduction
17% of least of:
(1) ABI from Canada 105,000
(2) Taxable income 75,000
less 3X FBITC (3,375) 71,625
(3) business limit 400,000
(12,176)
M&P (all eligible for SBD) NIL
Part I tax payable 7,999
Provincial tax payable 3,600
Total payable 11,599
Incorporation
• Advantages and disadvantages
Advantages
• Limited liability• Tax savings if combined rate under 20%• Tax deferral at the higher personal income levels on income not
eligible for SBD• Income splitting potential• Estate planning advantages• Availability of ROO to owner as an employee• Separation of business and personal• Stabilization of individual income through salary or other
arrangements• Continuity issues• Deferral of capital gains on transfer of shares to spouse• Potential easier access to financing• Availability of capital gains exemption• Deferral of capital gains on sale of QSBCS
Disadvantages
• Tax cost if combined rate over 20%• Prepayment of tax at lower levels of
personal income• Additional costs of maintaining corporation• Loss of availability of losses to offset
personal income• Often the tax savings will outweigh the
disadvantages
Taxation of Active Business Income Not Eligible for SBD
Corporation
Income 1,000
Corporate tax 32.5%
(38% - 10% - 8.5% + 13%) (325)
Available for dividend 675
Individual
Dividend 675
Add gross up (45%) 304
Income subject to tax 979
25% 46%
Tax on dividend before credit 245 450
Total DTC (11/18 + 7/18) of 304 (304) (304)
Net tax (59) 146
Add tax paid by corporation 325 325
Total tax 266 471
Tax on income if unincorporated 250 460
Tax cost of incorporating on 1000 16 11
Deferral (prepayment) of tax in corp
(75) 135
Taxation of Active Business Income Eligible for SBD
Corporation
Income 1,000
Corporate tax 16%
(38% - 10% - 17% + 5%) (160)
Available for dividend 840
Individual
Dividend 840
Add gross up (45%) 210
Income subject to tax 1,050
25% 46%
Tax on dividend before credit 263 483
Total DTC (11/18 + 7/18) of 304 (210) (210)
Net tax 53 273
Add tax paid by corporation 160 160
Total tax 213 433
Tax on income if unincorporated 250 460
Tax cost of incorporating on 1000 (37) (27)
Deferral (prepayment) of tax in corp
(75) 300
Summary of costs
Average tax cost (saving)
Average tax deferral (prepayment)
Not eligible 1.4% 3.0%
Eligible (3.2)% 19.5%
Income from investments of a CCPC
• There are special rules to eliminate some biases between individual and corporation– Refundable tax (Part IV tax on portfolio
investments)– Dividend tax credit
Theory of perfect integration
Investment ABI
Federal rate 40% 40%
Abatement (10) (10)
Net federal tax 30 30
SBD (16)
RDT (20)
Net federal tax 10% 14%
Provincial tax 10% 6%
Effective tax 20% 20%
The reality
Investment ABI
Federal rate 38.00% 38.00%
Abatement (10.00) (10.00)
Net federal tax 28.00% 28.00%
Federal surtax 1.12 1.12
Additional RT 6.67 NIL
SBD (16.00)
Refundable DT (26.67)
Net federal tax 9.12% 13.12%
Provincial tax 14.50 5.00
Effective tax 23.62% 18.12%
Rates
• Effective tax rates are approximately the same when below $400,000
• Above $400,000 ABI rate is 36.62% vs 23.62% for investment income
Portfolio dividends
• Intercorporate dividends are deductible and therefore not subject to tax.
• Theoretically an individual could place high-yield investments into a corporation and defer tax
• Part IV tax is 33 1/3% on dividends from portfolios (not related)
• o/h
Additional refundable tax
• 6 2/3% x lesser of aggregate investment income and taxable income less amount on which SBD is based
Summarized as
Net TCG
Less NCL
Plus income from property
Less dividends deducted
Less losses from property
Refundable dividend tax on hand
• An account which accumulates all tax paid by a private company on its portfolio dividend income and a portion of Part I tax on other investment income
Summarized as
Refundable portion of Part I tax including ART paid on investment income
Amount of Part IV tax paid on taxable dividends
RDTOH balance at end of preceding year less dividend refunds of the previous year (arises when taxable dividends are paid)
Deeming rules
• Anti-avoidance provisions• Prevents associated companies from
creating losses or changing the nature of income
Deeming rules
Conditions Amount that would be income of the recipient company from property
Amount deductible in computing income from an active business of an associated payer company
Effect Amount not included in income from property
Amount deemed to be income of the recipient from active business
Application Eligible for the SBD to the extent that the associated group of companies has not exceeded the $400,000 limit
Why incorporate investment income?
• Advantages and disadvantages
Advantages
• Tax deferral if shareholders combined marginal tax rate is greater than combined corporate of 46 2/3%
• Negligible absolute tax saving as a result of the operation of the DTC in some provinces and a small tax saving where combined federal and provincial rate is less than 46 23%
• Greater flexibility in income payment• Estate planning advantages• Possible income splitting• Possible avoidance of foreign estate taxes by
placing foreign property in a Canadian corporation
Disadvantages
• Prepayment of tax if shareholders combined marginal tax rate is less than corporate tax rate
• Additional tax cost if combined corporate rates are over 46 2/3%
• Additional costs• Loss of availability of investment and
capital losses to the individual
Illustration of application
Taxable dividends paid 30,000
ABI 148,560
Investment income
Taxable CG 3,000
Net property
CDN source 2,000
Foreign (375) 2,500 7,500
112 dividends 13,000
Total net income 169,060
Deduct dividends 13,000
Deduct net capital losses 700
Taxable income 155,360
Part I tax on taxable income
Tax @ 38% on 155,360 59,037
Less federal abatement (10% x 155,360)
(15,536)
Net 43,501
Add refundable tax (6 2/3% x 6,800)
453
43,954
Less NBFT 375
SBD (17%) 25,255
Tax reduction NIL 25,630
Total Part I 18,324
Prov tax @ 10% 15,536
Total tax 33,860
Required
• Compute the refundable dividend tax on hand at the end of 2008 and the dividend refund for the 2008 tax year
Solution
• Part IV Tax payable Taxable dividends subject to Part IV
13,000
Part IV tax at 33.33% 4,333
RDTOHRefundable portion of Part I Tax
Least of
(a) 26 2/3% x AII ($6,800)
1,813
less NBFTC 375
minus 9 1/3% x FII ($2,500)
(233) (142) 1,671
(b) taxable income 155,360
less SBD amount (148,560)
25/9 x NBFTC ($375)
(1,042)
3 x BFTC NIL
26 2/3% x 5,758 1,535
(c) Part I tax 18,324
Refundable portion of Part I tax 1,535
Part IV tax payable 4,333
RDTOH 5,868
Dividend refund
Taxable dividends paid (30,000 x 1/3)
10,000
RDTOH at ye 5,868
Dividend refund (lesser of)
5,868
Summary of taxes payable
Part I tax (including provincial tax) 33,860
Part IV tax 4,333
38,193
Less dividend refund 5,868
Net taxes payable 32,325
Notes to solution
• If any of the dividends were from a connected corporation, then no Part IV tax is payable unless there is a dividend refund in the connected corporation
Problem 9
Analysis of income – step 1
ABI Investment DividendSource
Cdn. For’n. PSB Cdn. For’n. Conn. Port. TotalManufacturing $191,000 $191,000
Dividend $11,000 $20,000 31,000
Net taxable capital gains $17,000 17,000
Royalties 9,000 9,000
Recapture 4,000 4,000
Rental 14,000 14,000
Foreign $6,000 $23,000 29,000
Interest — A/R 5,000 5,000
Division B income $200,000 $6,000 Nil $40,000 $23,000 $11,000 $20,000 $300,000
Analysis of Division B Income
Part I taxTaxable income
$ 226,000Tax @ 38% of taxable income (38% of $226,000)
$ 85,880Less: Federal and provincial abatement
½
.91 $226,000 = $205,660
10% of $205,66020,566
Federal tax after abatement$ 65,314
Additional refundable tax: 62/3% of lesser of:
(a) Aggregate investment income ($40,000 + $23,000 – $7,000) $ 56,000
(b) Taxable income – SBD amount ($226,000 – $200,000) $ 26,0001,733
$ 67,047Deduct: Non-business foreign tax credit (given) $ 3,450
Business foreign tax credit (given) 1,800
Small business deduction (see Schedule 1) 34,000
General reduction (see Schedule 2) Nil39,250
Tax before investment tax credit$ 27,797
Deduct: investment tax credit (25% of capital cost of eligible child care space expenditures = 25% of $32,000)
8,000Part I tax payable (federal)
$ 19,797Provincial tax @ 5% of $226,000 .91
10,283Total tax
$ 30,080Summary of tax:
Part I tax payable (federal and provincial)$ 30,080
Part IV tax payable (see separate calculation)9,417
$ 39,497Less: dividend refund (see separate calculation)
11,985Net tax payable
$ 27,512
91.000,254$
000,238$
000,996,1$
000,776,1$
SBD and GRRIncome from active business carried on in Canada $200,000Taxable income $226,000
Less sum of:
(i) 10/3 foreign investment income tax credit (10/3 $3,450) (given)
$11,500(ii) 3.77 foreign business income credit (3.77 $1,800)
(given)6,786 18,286 $207,714
Business limit (agreed allocation of $200,000 leaving $300,000 for the subsidiary) $200,000Deduction: 17% of $200,000 $34,000
taxable income $226,000
less: 100/17 of the small business deduction $ 200,000
AII 56,000 (256,000)
net $ Nil
11.5% of Nil $ Nil
RDTOHNon-connected taxable Canadian corporations (portfolio dividends) (331/3% of
$20,000) $ 6,667Connected private corporation which triggered a dividend refund ($2,750 100%)
2,750 $ 9,417Refundable Portion of Part I TaxLeast of:
(a) 262/3% aggregate investment income(262/3% $56,000) $14,933Less: non-business foreign tax credit $3,450
minus: 91/3% foreign investment income91/3% $23,000) (2,147)
(1,303) $13,630(b) Taxable income $226,000
Less: Amount eligible for the SBD (200,000)25/9 non-business FTC ($3,450) (9,583)3.77 business FTC ($1,800) (6,786)
262/3% $9,631 = $ 2,568(c) Part I tax $19,797
Refundable portion of Part I tax: least of (a), (b) and (c) 2,568RDTOH as at December 31, 2011 $11,985Dividend RefundLesser of:
(i) 1/3 dividends paid (1/3 $72,000) $24,000(ii) RDTOH as at December 31, 2011 $11,985
Next week
• Read chapter 13• For inclass discussion: Chapter 12
Problems 14 & 15