Introduction Owner-managers who carry on business through corporations constantly face the dilemma of deciding whether to pay themselves by way of salaries or dividends. On the one hand, a salary is a deductible expense to the corporation and allows owner-managers to generate RSP contribution room. On the other hand, a dividend may provide tax deferral flexibility and is generally taxed at a lower personal income tax rate than a salary. The purpose of this article is to explain the concept of integration in the Canadian income tax system, which is an important concept to be considered when determining a remuneration strategy for owner-managers. This article will examine: i) various tax changes that may influence owner-managers viewpoints on what the most effective remuneration strategy may be, and ii) identify some considerations that owner-managers should keep in mind, when determining their optimal salary/dividend mix. Concept of integration Canada s corporate and individual income tax system is based on the concept of integration a concept that ensures that individuals will not be subject to double taxation and therefore are indifferent between earning income directly or indirectly through a corporation. This concept may sound fair and simple; however, full integration is only a theory built upon certain income tax rate assumptions (See Illustration 1 on Perfect Tax Integration). In practice, full integration is rarely attainable due to numerous combinations of corporate and personal tax rates at the federal and provincial/territorial levels and the fact that these rates are constantly changing over time. As a result of Canada s less than perfectly integrated income tax system, tax costs or savings exist. Consequently, owner-managers can minimize taxes by paying themselves the most tax effective salary/dividend mix, and therefore accumulate greater wealth for retirement.
Illustration 1: Perfect Tax Integration Earning income inside a corporation Corporation: Active business income $1,000.00 Corporate tax @ 20% combined rate* ($200.00) Net Corporate Cash Available for Distribution $800.00 Earning income personally Individual: Dividend income from corporation $800.00 Dividend gross-up @ 25% $200.00 Total Taxable Income $1,000.00 $1,000.00 Personal tax @ 43.5% combined rate** ($435.00) ($435.00) Less: Combined Dividend Tax Credit (DTC)*** $200.00 $- Net Personal Income Tax ($235.00) ($435.00) Net Cash to Individual: Active business income $1,000.00 $1,000.00 Less: Taxes paid at the corporate level ($200.00) $- $800.00 $1,000.00 Less: Taxes paid at the personal level ($235.00) ($435.00) Net Cash Flow $565.00 $565.00 * Assumes income is eligible for the Small Business Deduction ** Assumes federal tax rate at 29% and provincial tax rate at 14.5% (50% of federal rate) *** Combined Dividend Tax Credit Calculation: Dividend Gross-Up @ 25% $200.00 Federal DTC (2/3 x $200) $133.33 Provincial DTC (2/3 x $200 x 50%) $66.67 Combined DTC $200.00 Various tax changes and their impact on the remuneration strategy: Historically, owner-managers were advised to pay an adequate salary from their corporation to generate sufficient earned income to allow maximum contributions to their RSP. Taking a salary was preferred over a dividend payment because in the past the overall (combined federal and provincial/territorial) top marginal tax rate for individuals was higher than the rate that was used in the integration theory (combined federal and provincial/territorial personal tax rate of 43.5%). In addition, the overall small business corporate tax rates in most provinces/territories were lower than the corporate rate used in the integration theory (combined federal and provincial/territorial corporate tax rate of 20%). As a result, owner-managers were more likely to accumulate greater wealth by drawing a salary, making maximum annual RSP contributions (allowing for tax-free growth until the funds are withdrawn at retirement), investing the active business income (net of the small business tax) within the corporation, and withdrawing amounts from the corporation as dividend payments as required. 2
The Eligible Dividend and Non-eligible Dividend Tax Regime In 2006, the government of Canada introduced the concept of eligible and non-eligible dividends to correct some of the integration deficiencies that exist in the corporate and personal income tax systems. The tax treatment is different between these two types of dividends, in order to account for the fact that corporations pay different rates of tax on different types of income. For example, eligible dividends can be paid by corporations whose income is subject to the general (higher) corporate tax rate, and the more favorable tax treatment of these dividends to individual shareholders reflects this higher rate of tax already paid by the corporation. In this case, when an individual shareholder receives an eligible dividend, the cash dividend is subject to a gross-up (38% in 2014) and the shareholder receives an enhanced dividend tax credit which reduces the overall effective tax payable by the shareholder on this dividend. On the other hand, Canadian-controlled private corporations (CCPCs) are taxed at a lower corporate tax rate on their active business income up to the annual small business limit (for 2014, generally, the limit is $425,000 in Manitoba, $350,000 in Nova Scotia and $500,000 federally and in the remainder of the provinces/territories). When this after-tax corporate income is distributed to an individual shareholder as a dividend, the dividend is taxed less favorably to the individual shareholder to reflect the lower tax initially paid at the corporate level. That is, although the shareholder is subject to a lower gross-up (18% in 2014) on the dividend, the shareholder is entitled to a lesser dividend tax credit. The taxation of eligible and non-eligible dividends to an individual shareholder in Ontario is shown in Illustration 2. Illustration 2: 2014 Individual Tax on Dividends in Ontario Tax on Eligible Dividends Tax on Non-Eligible Dividends Cash Dividend Received $100.00 $100.00 Dividend gross-up (38% or 18% x $100) $38.00 $18.00 Taxable Income $138.00 $118.00 Federal Tax at 29% $40.02 $34.22 Dividend Tax Credit (6/11 x $38 or 13/18 x $18) ($20.73) ($13.00) Total Federal Tax $19.29 $21.22 Provincial Tax @ 13.16% $18.16 $15.53 Provincial Dividend Tax Credit (10% x $138 or 4.5% x $118) ($13.80) ($5.31) Provincial Surtax (56% of provincial tax) $10.17 $8.69 Total Provincial Tax $14.53 $18.91 Total Individual Tax on Dividend $33.82 $40.13 3
Corporate and Personal Income Tax Changes Over the past few years and in the current year, various tax changes at the federal and provincial/territorial levels have generally resulted in a reduction in corporate income tax rates as well as an increase in personal income tax rates with respect to both eligible and non-eligible dividends. The changing tax treatment to dividends is accomplished by adjusting both the gross-up and dividend tax credit amounts. Re-evaluation of the Traditional Remuneration Strategy These tax changes have not resolved the integration problem completely. However, these changes mean that owner-managers need to continue to re-evaluate with their professional tax advisor on an annual basis whether they should pay themselves a salary or dividend in order to optimize their remuneration as well as their personal and corporate after-tax cash flow. The tax changes noted above appear to suggest that owner-managers from corporations taking advantage of the small business tax rate may continue to be better off to accumulate wealth within their corporation, by retaining and reinvesting the excess funds in a diversified portfolio and extracting these funds from the corporation as dividends when income is needed, before and during retirement. The rationale for this view is that a tax deferral is achieved by retaining and reinvesting funds in the corporation since the small business tax rates on active business income in all provinces are significantly lower than the highest personal marginal tax rate in the corresponding provinces. In addition, there may be small tax savings in some provinces from paying dividends (from a corporation subject to the small business tax rate) over salaries to an owner-manager shareholder. Accordingly, the dividend-paying strategy may continue to be more beneficial, where pre-salary corporate income is eligible for the small business tax rate. Similarly, as a result of the tax changes noted above, in respect of active business income subject to the high general corporate tax rate, owner-managers in all provinces may find it more beneficial to retain income to be taxed in the corporation so as to achieve tax deferral, and only to pay a dividend to themselves to accommodate their personal needs as required. This is despite the fact that there may be small tax costs associated with paying a dividend over a salary in some provinces. Other factors to be considered in the determination of an appropriate remuneration strategy In addition to the income tax implications described above, other factors should be considered when deciding whether owner-managers should pay themselves a salary or dividend. The following table discusses some of these considerations: Control of Timing of Payment Salary Mandatory minimum withdrawals from an RIF (after an RSP matures, i.e., after age 71). Tax rules require RSP accounts to be wound up by the end of the year a taxpayer reaches age 71. Dividend / Retain Income in Corporation Greater ability to control the timing of dividends to be received since there are no mandatory withdrawals. 4
Control of Amount Creditor Protection Tax Treatment for an Individual Shareholder Tax Treatment for a Corporation Salary Payment of a salary and/or bonus to an active owner-manager shareholder of a corporation must generally be reasonable based on the services rendered to the corporation. RSPs as personal assets generally have greater protection from business creditors than corporate assets. A salary is fully taxable but creates RSP contribution room. Contributions to an RSP in the calendar year or within 60 days after yearend are tax deductible, subject to the contribution room available. The preferential tax treatment of capital gains (only 50% taxable) and Canadian portfolio dividends (eligible for the dividend tax credit) is not available when capital gains or dividends are earned inside an RSP or RIF. Upon withdrawal, all income is fully taxed at the same rate as interest income. Capital gains and dividends do not retain their income character when paid out of an RSP or RIF. Certain RSP and RIF income qualify for pension income splitting and the pension income credit (subject to age requirements), but dividend income does not. A salary is tax deductible to a corporation. A bonus accrued at the end of the corporation's taxation year and paid within 179 days of the corporation's year end are tax deductible to the corporation in the year of accrual. Dividend / Retain Income in Corporation Dividends can be paid at the discretion of the owner-manager shareholder, but subject to the share attributes and provisions/terms as set out in any shareholders agreement or imposed by a lending financial institution. Corporate income retained in a corporation has less protection from business creditors than RSPs held personally. A dividend does not create RSP contribution room for the owner-manager. Refer to the section on Eligible Dividends and Non-Eligible Dividends for a discussion on the tax treatment. Dividend income may decrease the cumulative net investment balance and may therefore increase the enhanced capital gains exemption claim. However, alternative minimum tax may apply in respect of dividend income. Income splitting can be achieved for a family business by having certain family members subscribe for shares of the corporation and receive income from the corporation as dividends. A dividend is not tax deductible to a corporation. 5
Additional Costs Capital Gains Exemption Salary There are additional payroll costs to a corporation associated with paying a salary to an owner-manager. These may include CPP, EI, and various health and workers compensation levies (e.g., EHT and WSIB in Ontario). However, these payroll costs may be deductible for income tax purposes by the corporation. Dividend / Retain Income in Corporation There are no payroll costs to a corporation associated with paying a dividend to an owner-manager or retaining income inside the corporation. The shares of a CCPC may not qualify as Qualified Small Business Corporation (QSBC) Shares if, among other conditions, 10% or more of the corporation s assets are not used principally in carrying on an active business primarily in Canada. Accordingly, the accumulation of substantial investment assets by a corporation needs to be monitored. Where an owner-manager sells his/her shares of the corporation but the shares are not considered QSBC shares, the $800,000 enhanced capital gains exemption will not be available to the owner-manager. This would result in greater personal tax payable by the ownermanager on the sale of the shares. The information contained herein has been provided by TD Wealth and is for information purposes only. The information has been drawn from sources believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate or complete. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, trading or tax strategies should be evaluated relative to each individual s objectives and risk tolerance. TD Wealth, The Toronto- Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. TD Wealth represents the products and services offered by TD Waterhouse Canada Inc. (Member Canadian Investor Protection Fund), TD Waterhouse Private Investment Counsel Inc., TD Wealth Private Banking (offered by The Toronto-Dominion Bank) and TD Wealth Private Trust (offered by The Canada Trust Company). The TD logo and other trade-marks are the property of The Toronto-Dominion Bank. Revised 15/08/2014 6