Module 9: Taxable income and tax payable Corporations Part 2

Transcription

1 Module 9: Taxable income and tax payable Corporations Part 2 Overview This module explores the special provisions regarding tax payable that apply when a corporation earns investment income, and how to determine a corporation's liability for Part IV tax when it receives dividends. In certain circumstances, corporations that pay dividends may obtain a partial refund of the taxes paid on investment income and a total refund on dividend income. This tax treatment respects the principle of integration. While studying this module, you should refer often to the T2 Corporation income tax return. This will help you to integrate the tax elements. This material is supplied as reference material only. Forms are not supplied on the exam. The forms do not apply to all situations, but only to the most common ones. In your role as a professional accountant, you will encounter situations that go beyond the common forms. Other corporate tax concepts covered include whether it is advantageous to incorporate a business and determining appropriate shareholder-manager remuneration. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Module Refundable tax on CCPC's investment income 9.2 Part IV tax 9.3 Integration principle and distribution of corporate surpluses 9.4 Capital dividend account 9.5 Incorporated and unincorporated businesses 9.6 Shareholder-manager remuneration 9.7 Computer illustration 9.7-1: Using a T1 tax planner program Learning objectives 9.1 Compute Part I tax payable on investment income and explain the principles underlying the taxation of aggregate investment income. (Level 1) 9.2 Compute Part IV tax payable, the balance in the refundable dividend tax on hand (RDTOH) account, and a dividend refund. (Level 1) 9.3 Describe the principle of integration and the effects of the distribution of corporate surpluses. (Levels 1 and 2) 9.4 Compute the capital dividend account balance. (Levels 1 and 2) 9.5 Evaluate the tax advantages and disadvantages of incorporating a business and justify the decision to incorporate or not. (Level 1) 9.6 Determine an appropriate shareholder-manager remuneration plan. (Level 1) file:///f /Courses/ /CGA/TX1/06course/m09intro.htm[11/10/2010 4:45:07 PM]

2 9.7 Perform comparative analysis using the Cantax tax planner to make decisions. (Level 1) Assignment reminder: Assignment #3 is due this week (see Course Schedule). Please allocate time to complete and submit the assignment by the deadline. Module summary Print this module file:///f /Courses/ /CGA/TX1/06course/m09intro.htm[11/10/2010 4:45:07 PM]

3 9.1 Refundable tax on CCPC's investment income Learning objective Compute Part I tax payable on investment income and explain the principles underlying the taxation of aggregate investment income. (Level 1) Required reading Optional reading LEVEL 1 Text: 12,310 to 12, (Level 1) ITA: (Level 1) ITA: Definitions, 129(4): aggregate investment income, eligible portion, income or loss (Level 1) IT: 269R4 The Canadian tax system s principle of integration refers to ensuring that the combined corporate and personal tax on income earned through, and distributed by, a corporation is equal to the tax that would be paid if the income were earned directly by the individual taxpayer. Text section 12,310 explains the concept of integration for income from investments of a Canadian controlled private corporation (CCPC). Under section 123.3, there is a refundable tax for CCPCs on aggregate investment income. This refundable tax is equal to 6 2/3% of the lesser of: a. aggregate investment income as defined under subsection 129(4), and b. taxable income less the amount on which the SBD is calculated, if any Aggregate investment income The definition of aggregate investment income (AII) in subsection 129(4) takes the income calculated under paragraph 3(b), adds the passive sources of income used in paragraph 3(a), and then deducts property losses used in paragraph 3(d). For a private corporation, the distinction between AII and other types of income is important because a private corporation is not entitled to the SBD or the general rate reduction on investment income, and therefore pays a high rate of tax on this type of income. However, there is a mechanism in place for a private corporation to claim a partial refund of the Part I tax that it pays on AII if it pays a taxable dividend. Activity Refundable tax In this activity, you calculate Part I tax for a corporation, including the refundable tax. file:///f /Courses/ /CGA/TX1/06course/m09t01.htm[11/10/2010 4:45:08 PM]

4 9.2 Part IV tax Learning objective Compute Part IV tax payable, the balance in the refundable dividend tax on hand (RDTOH) account, and a dividend refund. (Level 1) Required reading Optional reading LEVEL 1 Text: 12,345 to 12,380 (Level 1) ITA: 129(1), (3), (4), and (6), 186(1), (2), and (4) (Level 1) ITA Definition: 186(3): assessable dividend (Level 1) IT: 269R4 Connected corporation Under subsection 186(4), corporations are connected if: the dividend-paying corporation is controlled by the dividend-receiving corporation, or the dividend-receiving corporation owns more than 10% of the voting shares of the dividendpaying corporation and those represent more than 10% of the fair market value of all the issued share capital. Refer to text section 12, (including Exhibit 12-14) for the definition of a connected corporation. The concept of connected corporations is important in the determination of Part IV tax as you will see below. Taxable dividends and computation of Part IV tax With certain exceptions, taxable dividends received by a corporation are deductible under section 112 in computing taxable income. In such cases, no Part I tax is payable, but Part IV tax could be payable and refundable under certain conditions. Were it not for Part IV tax, dividends would be completely tax free to the recipient corporation, whereas individual investors would pay personal tax on dividends received. However, this Part IV tax is refundable (in the form of a dividend refund) when the corporation in turn pays a taxable dividend out to its shareholders. A tax account called the Refundable Dividend Tax On Hand (RDTOH) account is used to keep track of various taxes that are refundable such as the Part IV tax. Under paragraph 186(1)(a), any private corporation must pay Part IV tax on an assessable dividend received unless it is received from a connected corporation [subsection 186(4)]. This tax is 1/3 of taxable dividends received. Under paragraph 186(1)(b), Part IV tax is payable on an assessable dividend received from a connected corporation if payment of the dividend enabled the connected corporation to obtain a dividend refund. This tax is based on the recipient's portion of the payer's dividend refund. Dividend refund A private corporation paying a dividend may be eligible for a dividend refund, which is a refund of a portion of the tax it paid on its investment income. file:///f /Courses/ /CGA/TX1/06course/m09t02.htm[11/10/2010 4:45:08 PM]

5 The dividend refund is the lesser of two amounts: 1/3 of taxable dividends paid and the balance in the refundable dividend tax on hand (RDTOH) account. Refundable dividend tax on hand Only private corporations are required to compute the RDTOH provided for in subsection 129(3). This computation is important because the RDTOH represents an amount of tax that the corporation has paid but that it can recover if it pays dividends. The definition of RDTOH given in subsection 129(3) is quite complex. Review text section 12,345 and know how to determine the RDTOH in straightforward situations. Overview of taxes payable by a corporation The following table summarizes corporate tax payable by a corporation. Basic rate 38% (taxable income) Provincial abatement 10% (taxable income earned in a province) Small business deduction (SBD) General rate reduction Refundable tax for CCPCs M&P deduction Part IV tax Dividend refund Where the corporation was a CCPC throughout the taxation year 17% (lesser of 3 amounts) 1. Active business income (ABI) 2. Taxable income (TI) 3. Business limit ($500,000 for 2010 and 2009) 10% for 2010 and 9% for 2009 (taxable income not eligible for preferential treatment) +6 2/3% (lesser of 2 amounts) 1. Aggregate investment income (AII) 2. TI income amount that qualifies for the SBD 10% for 2010 and 9% for 2009 (lesser of 2 amounts) 1. M&P profits earned in Canada minus amount qualifying for the SBD 2. TI aggregate of income qualifying for SBD minus AII +1/3 (dividends received) if corporation not connected If corporation connected + dividend refund of payer corporation dividend received by recipient total dividend paid by payer (lesser of 2 amounts) 1. RDTOH balance at end of year 2. 1/3 (dividends paid) Refundable dividend tax on hand (RDTOH) Balance at beginning of year + (lesser of 3 amounts) + Part IV tax /3% (TI income amount that qualifies for SBD) 2. Part I tax /3% (AII) file:///f /Courses/ /CGA/TX1/06course/m09t02.htm[11/10/2010 4:45:08 PM]

6 = Balance end of year Activity Part IV tax In this activity, you calculate a company's Part IV tax under various scenarios. file:///f /Courses/ /CGA/TX1/06course/m09t02.htm[11/10/2010 4:45:08 PM]

7 9.3 Integration principle and distribution of corporate surpluses Learning objective Describe the principle of integration and the effects of the distribution of surpluses. (Levels 1 and 2) Required reading LEVEL 1 Text: 11,020 to 11,025.30; 12,010 to 12,045 (Level 1) ITA: 52(2), 52(3), 82(1) (Level 2) ITA: Definitions, 89(1): taxable dividend (Level 1) ITA: 248(1): amount, dividend, stock dividend (Level 2) Principle of integration As noted previously, one of the basic principles of the ITA is to achieve integration when the income earned by a private corporation is subsequently paid to shareholders who are individuals. Integration is achieved if the total tax paid, by the corporation and by the shareholders, on income distributed as a dividend or salary is equal to the tax that would have been paid by the shareholder if the business income subject to the small business deduction (SBD) had been earned personally. The ITA allows a private corporation that pays a taxable dividend to obtain a partial refund of the taxes it has paid on its investment income. The dividend refund is intended to integrate corporate and individual taxation. LEVEL 2 Concept of dividend for purposes of the ITA A corporation usually distributes its surpluses in the form of dividends to its shareholders. For purposes of the ITA, the concept of dividends includes cash dividends, dividends in kind, and stock dividends. Cash dividends are the most common and need no further comment. Dividends in kind are dividends that are paid not in cash but by distributing property of the corporation such as an automobile, a building lot, or an investment to the shareholder. In the case of such a distribution: the corporation is deemed to have disposed of the property at its FMV [subsection 52(2)]; the shareholder is deemed to have acquired the property at its FMV [subsection 52(2)]; and the shareholder is taxed on a dividend equal to the FMV of the property received [subsection 82(1) and subsection 248(1), definition of "amount"]. Stock dividends are included in the definition of "dividend" in subsection 248(1). A stock dividend is a dividend paid by the issuance of shares of any class of the capital stock of the corporation. The amount of a stock dividend is determined according to the definition of "amount" given in subsection 248(1). The amount of the dividend is generally equal to the increase in the paid-up capital (PUC) of the corporation resulting from the payment of the dividend. (The concept of PUC is covered extensively in TX2.) Under subsection 52(3), the amount of the stock dividend constitutes the price paid for the share. file:///f /Courses/ /CGA/TX1/06course/m09t03.htm[11/10/2010 4:45:09 PM]

8 Example Keith Duncan is the sole shareholder of Amico Ltd., a Canadian corporation. In the current year, Amico Ltd. reported a dividend paid to Keith in the form of a public corporation bond, the FMV of which was $10,000 at the time of payment of the dividend. Amico Ltd. had acquired this bond 10 years ago for $8,000. What are the tax consequences for both Amico Ltd. and Keith? Solution file:///f /Courses/ /CGA/TX1/06course/m09t03.htm[11/10/2010 4:45:09 PM]

9 Topic 9.3 solution For Amico Ltd.: Deemed disposition [at FMV per subsection 52(2)] POD $ 10,000 ACB (8,000) Capital gain $ 2,000 Taxable capital gain (1/2) $ 1,000 For Keith: Taxable dividend received $ 10,000 44% gross-up [paragraph 82(1)(b)] 4,400 Taxable amount of dividend $ 14,400 Dividend tax credit [section 121] 10/17 $4,400 $ 2,588 Cost of bond [subsection 52(2)] $ 10,000 file:///f /Courses/ /CGA/TX1/06course/m09t03sol.htm[11/10/2010 4:45:09 PM]

10 9.4 Capital dividend account Learning objective Compute the capital dividend account balance. (Levels 1 and 2) Required reading Optional reading LEVEL 1 Text: 12,316 to 12,319 (Level 1) ITA: 83(2), (3), and (4) (Level 1) ITA Definitions, 89(1): taxable dividend (Level 1) ITA Definitions, 89(1): capital dividend account (Level 2) Forms: T2054 CDA Election (found on the CRA website) (Level 2) REG: 2101 (Level 2) IT: 66R6 Non-taxable dividend and capital dividend account Until now you have been dealing only with taxable dividends. In subsection 89(1), a dividend is taxable unless a capital dividend election has been made under subsection 83(2). As explained in text section 12,316, the capital dividend account (CDA) allows private corporations to distribute the non-taxable portion of capital gains and other non-taxable earnings, such as life insurance proceeds, to shareholders as tax-free dividends or capital dividends. The intent of the CDA is to preserve the concept of integration, ensuring the tax result to the shareholder is the same as if the shareholder has earned or received the income directly. Distributing a capital dividend in cash, or in kind or in the form of shares may occur as long as a balance exists within the CDA. A capital dividend will be non-taxable to the shareholder if it is paid by a private corporation and an election is made under subsection 83(2). If an election is made to pay a capital dividend in excess of the balance in the CDA, a tax equal to 60% of the excess will be assessed. This, however, will not affect the tax-free nature of the dividend to the recipient. LEVEL 2 The calculation of the CDA is made in accordance with the rules set out in the definition of the CDA in subsection 89(1). The example problem in text section 12,319 illustrates the rules concerning the inclusion in the CDA of the untaxed portion of gains on the disposition of eligible capital property (ECP). Activity Capital dividend account In this activity, you calculate the balance of a company's capital dividend account. file:///f /Courses/ /CGA/TX1/06course/m09t04.htm[11/10/2010 4:45:10 PM]

11 9.5 Incorporated and unincorporated businesses Learning objective Evaluate the tax advantages and disadvantages of incorporating a business and justify the decision to incorporate or not. (Level 1) Required reading LEVEL 1 Text: 12,270 to 12, (Level 1) Where an individual is personally carrying on a business, some of the resulting income is often taxed at the higher personal tax rates because of the graduated tax rates that apply to individuals. Incorporation may enable the deferral or reduction of tax on this income. However, before incorporating, an individual must analyze the tax and any other consequences that may arise from such a decision. For example, a person engaged in a profession should consult the provincial laws governing his profession, since, in some provinces professionals are prohibited from practising a profession through the medium of a corporation. The main tax advantage of incorporating a business is the possibility of deferring a significant portion of the tax payable on the income that remains in the corporation, due to the lower income tax rate from claiming the small business deduction. file:///f /Courses/ /CGA/TX1/06course/m09t05.htm[11/10/2010 4:45:11 PM]

12 9.6 Shareholder-manager remuneration Learning objective Determine an appropriate shareholder-manager remuneration plan. (Level 1) Required reading LEVEL 1 Text: 13,010 to 13,065.10; 13,090 to 13,210 (Level 1) Remuneration planning A company may remunerate an employee exclusively by way of salary or offer a package including salary and other fringe benefits, such as: employer's contributions to a pension plan, group health insurance plan, group term life insurance plan, the use of a company car, payment of club dues, and so on. When an employee is offered a remuneration package, a comparison of the net disposable income between the present situation and the proposed situation must be made in order to make a decision. Note that the issue is not how much an employee is paid, but the difference in disposable income after tax that is important. Exhibit 13-4 in text section 13,100 presents an example showing the possible advantage of the company providing a car subject to the standby charge versus the individual providing herself with the same car. Remuneration of the owner manager When an employee is also a shareholder, it is useful to explore whether it is preferable to pay salary or dividends. This choice between salary and dividends is mainly relevant for private corporations that have few shareholders. If the integration system operated perfectly, there would be no difference between a salary and a dividend paid by a private corporation on the income subject to the small business deduction, except for the additional social security taxes payable on salaries (for example, employer's contributions to CPP, EI, and any medical plan premiums). However, the integration system does not operate perfectly, largely because the provinces do not impose a taxation rate equal to the rate assumed by the model. Also, integration does not work on active business income in excess of the business limit as such income is not subject to the small business deduction. It may therefore be more advantageous in certain cases to pay a salary rather than a dividend, and vice versa. Text section 13,210 discusses the basic trade-off between paying salary or dividends. There are other factors to consider when deciding whether to pay a salary or a dividend where the corporation s income is taxed at the lower rate, such as: the possibility of making larger contributions to an RPP or RRSP if a salary is paid, since a salary unlike a dividend, is included in computing earned income the possibility of maximizing CPP benefits by making the maximum contribution each year the additional costs to the corporation in the form of fringe benefits and employer portions of CPP and EI contributions if a salary is paid file:///f /Courses/ /CGA/TX1/06course/m09t06.htm[11/10/2010 4:45:11 PM]

13 the possibility of deferring the payment of taxes by paying a dividend, since dividends are not subject to deductions at source the requirement to pay dividends to all shareholders of a class file:///f /Courses/ /CGA/TX1/06course/m09t06.htm[11/10/2010 4:45:11 PM]

14 9.7 Computer illustration 9.7-1: Using a T1 tax planner program Learning objective LEVEL 1 Perform comparative analysis using the Cantax tax planner to make decisions. (Level 1) The Cantax tax planner is a simplified schedule that estimates the tax payable by an individual when considering various tax situations. Even though the planner will not provide exact figures, it is sufficiently precise to be a very useful tool in evaluating the possible tax savings of certain decisions. Description Harry Davidson is a sole proprietor who is considering incorporating his non-manufacturing business. His business averages $550,000 of active business income a year. Harry would like to retain capital within the business for future expansion. He understands that his business can benefit from the small business deduction if he incorporates as a Canadian-controlled private corporation (CCPC). If he were to incorporate, Harry would need $50,000 in salary. Required Solution 1. Manually calculate the Part I tax payable by a corporation on $500,000 of income for the 2010 taxation year. 2. Based only on the amount of tax payable, should Harry incorporate his business or not? Assume provincial taxes for the corporation are 5% of taxable income. 3. Ignoring corporate tax, if Harry needed an extra $50,000 in remuneration, would you suggest salary or dividend? file:///f /Courses/ /CGA/TX1/06course/m09t07.htm[11/10/2010 4:45:12 PM]

15 Computer illustration 9.7-1: Suggested solution Part (a) Basic rate 500,000 38% 190,000 Abatement 500,000 10% (50,000) Small business deduction 500,000 17% (85,000) Part I tax payable 55,000 Part (b) Part (c) 1. Open file TX1M9P1, which is Harry Davidson's income tax return for Save the file under your own initials. 2. At the Index, select "PLAN: 2010 Tax planner" from the "Wealth Planners" folder. 3. The current information is entered as "Current Non Incorp." Scroll through the first column of each of the four tabbed pages of the "Summary of Projected Income Receipts and Tax-Deductible Expenditures for 2010." Note that total payable for the year (PLAN-3) of $224, is based on his income of $550, Go back to the top of PLAN-1 and enter If Incorp in the header box above the second column. 5. Move down to the first line and enter 50000, his expected employment income if he incorporates. 6. Click the Plan 3 tab and under the "Total federal and provincial amounts payable" heading, view the "Total payable for the year" and note that the total outlay is now $11, To the amount of $11, that Harry must pay in tax you must add the $55,000 that his corporation would have to pay (from Part a), and the $25,000 ($500,000 5%) assumed in provincial taxes. The total taxes payable by Harry and his corporation would be $91,090.53, well below the $224, Harry pays now. Based on these figures, Harry should incorporate. 1. Change the first line of the second column from to to account for the extra $50,000 of employment income. 2. Enter If Incorp Sal +Div in the header box above the third column. 3. Enter on the first line to account for the expected employment income Harry is to receive. 4. Enter on the fourth line to account for the expected dividend income. Notice the gross-up is calculated automatically. 5. Click the Plan 3 tab and under the "Total federal and provincial amounts payable" heading, view file:///f /Courses/ /CGA/TX1/06course/m09t07sol1.htm[11/10/2010 4:45:12 PM]

16 the "Total payable for the year" and note the total outlay is now $27, for the salary option and $22, for the salary-dividend option. 6. By subtraction, you can determine that Harry's tax savings on the salary-dividend option are $5, or $5,371 ($27, $22,400.32). If you had any difficulties, open file TX1M9P1S. If checking part (b), ensure $50,000 appears in Column 2 of PLAN-1, print PLAN-1, PLAN-2, and PLAN-3, and compare your results. If checking part (c), ensure $100,000 appears in Column 2 of PLAN-1, print PLAN-1, PLAN-2, and PLAN-3, and compare your results. Conclusion The Cantax tax planner is a useful tool when considering the tax implications of various transactions. It does not, however, compare and analyze the results of various alternatives to determine what is the best solution. The accountant/tax practitioner must understand and interpret the information provided by the planner in order to complete the final analysis. In arriving at the best solution, non-quantitative factors need to be considered as well. This is the case for both the decision to incorporate and remuneration planning. file:///f /Courses/ /CGA/TX1/06course/m09t07sol1.htm[11/10/2010 4:45:12 PM]

17 Module 9 Self-test Question 1 Discuss the legislative intent underlying the following tax rules: Solution Question 2 a. When a CCPC earns dividend income from portfolio investments, it must pay a refundable "Part IV tax." b. The capital dividend account allows corporations to pay tax-free dividends to its shareholders. How does the government protect against indefinite deferral of tax when a taxpayer incorporates a chain of holding corporations in order to manipulate income as if it was dividend income? Solution Question 3 Except for $50,000 in pension income, Jack's income is predominantly from investments. He earns dividends from a portfolio of shares in taxable Canadian corporations, taxable capital gains from the purchase/sale of marketable securities, and interest from term deposits. Jack's marginal tax rate on the dividends is 30% and on the taxable capital gains and interest it is 45%. He has heard that holding his investments in a corporation would give him some tax relief. Is that true? Prepare a comparison for Jack. Use $50,000 as the income from each source (dividends, capital gains, and interest). Assume a provincial corporate tax rate of 15%. Solution Question 4 Jay is the sole shareholder of Blue Jay Ltd., a Canadian-controlled private corporation. He has an immediate need for $50,000, which he will take out of Blue Jay. The company is expected to have taxable income of $215,000 for the current taxation year, all of which is business income. Its tax rate is 25% on business income that qualifies for the small business deduction (SBD) and 45% on business income that does not qualify for the SBD. Blue Jay has a CDA balance of $18,000. Jay receives an annual salary of $100,000 and has a marginal tax rate of 50%. Determine how the extra $50,000 amount from Blue Jay should be distributed to Jay (either salary or dividends) in order to provide the lowest tax cost for Jay and Blue Jay. Solution Question 5 A business owner can leave $50,000 of pre-tax income invested in her business. The after-tax profit retention under two possibilities is as follows: Corporate organization Sole proprietorship Income $50,000 Income $50,000 file:///f /Courses/ /CGA/TX1/06course/m09selftest.htm[11/10/2010 4:45:13 PM]

18 Tax $10,500 (including SBD & 10% Tax $25,000 (at 50%) provincial tax) After-tax income $39,500 After-tax income $25,000 Assume that the after-tax income under the corporate organization is distributed as a taxable dividend (noneligible) to the individual shareholder, and is taxed at 33 1/3% in the individual's hands. Compare the after-tax dividend amount to the after-tax income amount under the sole proprietorship. What can you conclude from your findings? Solution Question 6 Dr. Donald DeBig incorporated in order to manage his professional practice better. He submitted the following statement of his income and expense items to his accountant for the 2010 taxation year: Professional fees rendered and billed $95,000 Salaries to assistants (20,000) Supplies (4,500) Interest expense on bank overdraft (19,000) Money withdrawn for living expenses (30,000) a. Compute both the corporate and personal income tax payable, assuming a provincial corporate tax rate of 8% and a personal provincial tax of 50% of the federal tax. b. Compute the personal income tax payable, assuming Dr. DeBig operated as a sole proprietor (same 50% provincial tax). c. Comment on the difference in total tax, if any. For your calculations, use: Solution Question 7 15% personal income tax rate for income up to and including $40,970 22% personal income tax rate for income over $40,970 15% personal tax credit on the basic personal amount of $10,382 Your client, Golf & Ski World Ltd., is a private corporation that re-organized its business in the past year. The principal change was the addition of a line of ski products, which necessitated additions to its retail store. The client provided you with the following statement of income, prepared in accordance with generally accepted accounting principles, for the year ended December 31, Golf & Ski World Ltd. Statement of Income For the 12 months ended December 31, 2010 Revenue: Sales revenue $903,400 Cost of goods sold 480,000 Gross profit $ 423,400 Dividend income from portfolio investments 4,200 Total revenue $427,600 file:///f /Courses/ /CGA/TX1/06course/m09selftest.htm[11/10/2010 4:45:13 PM]

19 Expenses: Structural renovation for ski division (Note a) $ 30,000 Depreciation and amortization (Note b) 22,000 Meals and lift tickets for promoters and clients 13,200 Interest expense for renovation and expansion 55,000 Interest penalty for late filing of income tax 2,400 Legal fees for tax re-assessment 980 Charitable donations (Note c) 3,600 Reserve for warranty expense (Note d) 900 RRSP contributions to group plan (Note e) 14,000 Rent 44,000 Wages and salaries 150,000 Total expenses 336,080 Income before income taxes $ 91,520 Notes: a. The structural renovation for the ski division involved the following: Addition to building $19,000 Furniture and fixtures 6,400 Outside landscaping costs 4,600 b. The UCC of the various classes of assets, as of the end of the prior year, was as follows: Class 1 (4%) $118,000 Class 8 16,000 Class 9 5,000 Class 10.1 (van) 22,000 Golf Shop Leasehold 3,800 The building was expanded to house the ski division. All of the structural changes are permanent. The van is a class 10.1 asset. It is used most of the time for business transportation to golf and ski events. The van is also used as a promotional tool because advertising covers all four sides of the vehicle. The owner/employee-manager, Hans den Ham, drove the vehicle 350 kilometres per month for personal use. Total kilometres driven last year were 18,400 kilometres. The corporation paid all automobile operating expenses. The leasehold interest at a warehouse expired this year. The balance in the pool represents the remaining amount. On January 20 last year, the company sold some of its furniture and fixtures for $5,800. The original cost of these fixtures was $9,500. The balance in class 9 represents radio communications equipment that was sold for scrap value of $800. $12,400 was spent on a new truck. file:///f /Courses/ /CGA/TX1/06course/m09selftest.htm[11/10/2010 4:45:13 PM]

20 c. The company donated new ski equipment to the War Amps of Canada. The cost to the corporation was $3,600. A charitable donation receipt of $7,000 was received from War Amps because it represented the fair market value of the goods transferred. d. The company did not incur any actual warranty expenses during the year. e. Contributions were made to a group RRSP for the company president, controller, and employees. f. Golf & Ski World Ltd. had a non-capital loss carryforward of $44,000 and a net capital loss carryforward of $23,000. Approximately 40% of the company's net income resulted from the resale of ski equipment. For the year ended December 31, compute Golf & Ski World's: a. net income from a business and net income for tax purposes b. taxable income c. federal and provincial tax liability for 2010 (assume a provincial tax rate of 15%) Solution file:///f /Courses/ /CGA/TX1/06course/m09selftest.htm[11/10/2010 4:45:13 PM]

21 Self-test 9 solution 1 a. Integration and equity among taxpayers. If the government did not institute Part IV tax, an individual could incorporate and earn dividend income tax free as a result of the dividend deduction pursuant to section 112 of the ITA. This would cause unequal treatment between individuals who earn dividend income directly and those who hold investments in holding corporations, since the latter could benefit from the deferral of tax as long as the dividend income is retained in the corporation. Part IV tax overcomes this inequity by charging corporations a tax on the dividends they receive from other corporations. This tax is refundable when the dividends are actually paid out to the shareholders. b. Integration and equity among taxpayers. The intent of the capital dividend account (CDA) is to make the amount of tax paid in a corporation the same as the amount of tax that would have been paid if a gain had been earned directly by an individual. The CDA permits the nontaxable portion of the capital gain (net of capital losses) to flow out to shareholders tax free, thus preserving equity among taxpayers. file:///f /Courses/ /CGA/TX1/06course/m09selftestsol1.htm[11/10/2010 4:45:13 PM]

22 Self-test 9 solution 2 Part IV tax was implemented to motivate corporations to pay out the dividends they receive from other corporations to their own shareholders. It essentially charges the corporation a holding fee (Part IV tax) of 33 1/3% of the dividend income. This tax is refunded only when dividends are actually distributed to the shareholders. Through this tax, the government receives its share of cash flow, even if the dividends are held indefinitely in a corporation. file:///f /Courses/ /CGA/TX1/06course/m09selftestsol2.htm[11/10/2010 4:45:14 PM]

23 Self-test 9 solution 3 $50,000 dividends When received by Jack personally, dividends attract tax at the rate of 30%, or $15,000. In a corporation, these dividends would be subject to Part IV tax at 33 1/3%, or $16,667. While this tax is refunded when the corporation pays a taxable dividend to Jack, the tax in his personal hands will be 30%. There is no advantage to receiving dividends through/in a corporation. The initial tax is more inside the corporation than to Jack personally ($16,667 versus $15,000). $50,000 interest When received by Jack personally, the interest attracts tax at the rate of 45%, or $22,500. In a corporation, interest would be taxed at the rate of 49 2/3% (28% federal + 6 2/3% refundable federal tax + 15% provincial tax). That results in an initial tax inside the corporation of $24,833. This is more than the tax to Jack personally. Of the initial federal tax, 26 2/3% is refundable when the corporation pays a taxable dividend to Jack. Flowing the net after-tax interest (that is, after the dividend refund) to Jack as a taxable dividend results in $11,550 personal tax. The net after-tax cash to Jack can be determined as: Corporate tax on $50,000 (net of refundable tax) $ 11,500 Tax to Jack on taxable dividend of $38,500 11,550 Total Tax $ 23,050 The total tax of $23,050 is more than the $22,500 tax Jack pays personally on the interest. $50,000 capital gains The analysis is identical to that for interest, except the amounts are halved. Conclusion There is no tax advantage to receiving investment income through a corporation. Jack would also incur additional costs, including legal and accounting fees, maintaining the corporation. This assumes that no other business or legal reasons require Jack to incorporate. file:///f /Courses/ /CGA/TX1/06course/m09selftestsol3.htm[11/10/2010 4:45:14 PM]

24 Self-test 9 solution 4 To achieve a distribution of funds at the lowest tax cost for Jay and Blue Jay Ltd., Blue Jay should first elect and pay out a dividend of $18,000 to Jay from its CDA. This dividend is not taxable and triggers no tax consequences. Next, Blue Jay Ltd. should pay an additional salary (bonus) of $64,000 to Jay. This bonus will be included in Jay's income and taxed at 50%, leaving $32,000 net of taxes. A salary is preferable to a taxable dividend because the tax rate of Blue Jay is higher than 20%. If Blue Jay was taxed on its business income, subject to the SBD at a rate lower than 20%, a bonus of $15,000 to reduce the taxable income to the small business limit and a taxable dividend could be suggested. file:///f /Courses/ /CGA/TX1/06course/m09selftestsol4.htm[11/10/2010 4:45:15 PM]

25 Self-test 9 solution 5 After-tax corporate income $ 39,500 Personal income tax on dividend at 33 1/3% 13,167 After-tax cash to shareholder $ 26,333 After-tax cash to proprietorship $ 25,000 There is a difference in the tax of $1,333 that the individual pays. The small business deduction provides only a deferral of tax for profits retained in the business; it is not an absolute savings of tax. This is the purpose of integration $1 of income earned through a corporation should not bear more or less tax than the same $1 earned personally. There is some "leakage" in integration (in this situation of $1,333) because of the provincial corporate tax rate. The optimum rate is 12%, but most provinces/territories have a small business rate substantially less than that. To the extent the provincial/territorial rate is less than 12%, there is an absolute tax savings on small business income earned first through a corporation and then distributed to the shareholders. file:///f /Courses/ /CGA/TX1/06course/m09selftestsol5.htm[11/10/2010 4:45:15 PM]

26 Self-test 9 solution 6 Dr. DeBig is better off to incorporate because of a tax deferral of $1,860 ($10,359 8,499). file:///f /Courses/ /CGA/TX1/06course/m09selftestsol6.htm[11/10/2010 4:45:16 PM]

27 Self-test 9 solution 7 RDTOH Balance beginning of year $ 0 Part IV tax payable $1,400 file:///f /Courses/ /CGA/TX1/06course/m09selftestsol7.htm[11/10/2010 4:45:17 PM]

28 Note 1 file:///f /Courses/ /CGA/TX1/06course/m09selftestsol7.htm[11/10/2010 4:45:17 PM]

29 Module 9 summary Taxable income and tax payable Corporations Part 2 This module examines taxable income and tax payable of corporations, specifically refundable tax, Part IV tax, and aggregate investment income. The topics of the integration principle and the distribution of corporate surpluses are also covered. Under section 123.3, there is a refundable tax for CCPCs on aggregate investment income. This refundable tax is equal to 6 2/3% of the lesser of: the aggregate investment income as defined under subsection 129(4), and, the taxable income less the amount on which the SBD is calculated, if any. A corporation effectively pays a higher rate of tax on aggregate investment income than on ABI, given there are no further reductions, such as the SBD. A CCPC also pays an additional tax on aggregate investment income (AII). However, it is entitled to claim a partial refund of Part I tax paid on investment income. Generally, no Part I tax is payable on taxable dividends received; however, Part IV tax may be payable and refundable under certain conditions. There are two formulas to calculate Part IV tax, based on the relationship between the payer of the dividend and the recipient corporation: Where the corporations are not connected, the Part IV tax is 1/3 of the assessable dividend. Where the corporations are connected, the Part IV tax is the dividend refund of the connected corporation times the assessable dividends received from the connected corporation divided by the taxable dividends paid by the connected corporation. A dividend refund is available to private corporations. This refund is the lesser of: 1/3 times the taxable dividends paid RDTOH balance at the end of the taxation year The refundable dividend tax on hand (RDTOH) calculation accumulates a pool of high rated tax paid under Part I and all the Part IV tax. The RDTOH represents a pool of taxes that may be refundable to a corporation as it pays taxable dividends to its shareholders. The ITA achieves integration if the total tax paid, by the corporation and by the shareholders, on income distributed as a dividend or salary is equal to the tax that would have been paid by the shareholder if the business income subject to the small business deduction (SBD) had been earned personally. A corporation may distribute its surpluses to its shareholders in the form of cash dividends, dividends in kind, and stock dividends. Dividends are taxable dividends unless the taxpayer files an election to pay out tax-free dividends out of its capital dividend account (CDA) [subsection 83(2) election]. The CDA represents a pool of non-taxed funds received by the corporation. It allows these nontaxed amounts to flow tax free to the company's shareholders. The CDA is composed of: file:///f /Courses/ /CGA/TX1/06course/m09summary.htm[11/10/2010 4:45:17 PM]

30 the non-taxable portion of capital gains and losses, the non-taxable portion of gains on the disposition of ECP, the proceeds of life insurance policies less any non-deductible premiums paid, and any capital dividends received. The incorporation of an active business may be good tax planning if all the income earned by the corporation is not distributed yearly, by way of salary or dividend, to the owners of the business. There are non-tax considerations that may also motivate taxpayers to incorporate a business, such as the shareholders' limited liability. Remuneration planning should be considered for the following reasons: increase the after-tax cash flow to employee receipt of non-taxable versus taxable benefits It is possible to take a reduction in salary and have the employer pay or provide items that may or may not constitute a taxable benefit and be further ahead in the end. file:///f /Courses/ /CGA/TX1/06course/m09summary.htm[11/10/2010 4:45:17 PM]