Income earned in a corporation is taxed depending on its source and nature. The discussion in this GreenLearning article will be limited to those corporations which would be considered to be a Canadian Controlled Private Corporation (“CCPC”).
Before the T2 Return can be properly prepared, it is necessary to identify and distinguish one source of income from another; for instance, active business income (“ABI”) from specified investment business income (“SIBI”).
This GreenLearning article will focus on describing what constitutes a particular source of income, and how it is taxed within the corporation.
Active Business Income (ABI) earned by a CCPC is eligible for the Small Business Deduction (“SBD”) and is afforded the lowest corporate tax rate in Canada on the first $500,000 of taxable income annually (within an associated group of companies).
Active business is defined in Section 248(1) of the Income Tax Act (Canada) to include “any business carried on by the taxpayer other than a specified investment business or a personal services business”.
In determining active business for a corporation, for tax reporting purposes, expenses or outlays relating to or in connection with active business earned would be deductible and “matched” against the active business source income.
The definitive test in determining whether an outlay or expense is deductible against active business income is whether the amount was laid out or incurred for the purpose of earning such income.
Effective federal/provincial tax rates vary from province to province. Tax rates for ABI (eligible for the SBD) for selected provinces are highlighted below (2015 tax rates):
Manitoba11.0% up to $425K
Examples of active business income earned by a corporation would include for instance (not exhaustive):
Active Business Income earned for a taxation year in excess of $500,000 would not be eligible for the Annual SBD Limit and would be subject to a higher corporate tax rate. Such income forms the basis of income added to the corporation’s General Rate Income Pool (“GRIP”) – see Schedules 53 and 55 on the corporate T2 Return.
The $500,000 Annual Small Business Deduction (SBD) is available to a CCPC. If there are two or more corporations associated with each other, the $500,000 Annual Limit must be allocated amongst the group of associated corporations. In effect, there is only one Annual SBD Limit for a corporation or a group of associated corporations.
Also, the Annual $500,000 SBD Limit is pro-rated for a “short” fiscal year, falling into the particular taxation year. Consequently, where there are 2 or more corporations in the associated group and one of the corporations has a “short” fiscal year end (meaning less than 365 days), any portion of the $500,000 Annual SBD Limit allocated to that corporation would be pro-rated, based on the number of days in the fiscal period, that such amount is, of 365 days in that year.
Not all ABI of a CCPC is taxed at the lower rate. Active Business Income earned by a corporation will not be eligible for the SBD for:
It is important to identify a corporation’s access to the Annual SBD Limit, since ABI reported under the General Rate, is subject to a higher overall corporate tax rate.
Effective federal/provincial tax rates vary from province to province. Some provincial general corporate rates (ABI not eligible for the SBD) are highlighted below (2015 tax rates).
Alberta27.0% after July 1, 2015
Specified Investment Business Income (“SIBI”) of a corporation is defined in subsection 125(7) of the Income Tax Act (Canada). SIBI includes “a business (other than a business carried on by a credit union or a business of leasing property other than real property), the principal purpose of which is to derive income (including interest, dividends, rents and royalties) from property but – does not include a business carried
on by the corporation in the year where the corporation employs in the business throughout the year more than 5 full time employees”
SIBI is not eligible for the $500,000 Annual SBD and therefore, corporate tax rates are considerably higher than corporate tax rates for ABI. However, income taxed as SIBI can benefit from Refundable Dividend Tax on Hand (“RDTOH”), which is a mechanism designed to maintain integration and tax fairness between corporate and personal taxes on investment income. The RDTOH can be viewed as an account that accumulates refundable tax paid by a private company on its investment and dividend income. Investment income (including interest, rents, royalties, and the taxable portion of capital gains) earned by a Canadian Controlled Private Corporation (“CCPC”) is taxed at a higher rate of tax than ABI. A portion of this tax (calculated as 26.67% of taxable investment income – net of ABI) is added to the RDTOH account, limited by the corporation’s taxable income. In other words, corporations create RDTOH accounts to track the “extra” tax they pay on investment income, and to preserve their right to claim a tax credit when they pay a taxable dividend to a shareholder. Why do they do this, and why do they get a tax credit? In a word, integration. This is in place to ensure that the corporation and its shareholders are not both taxed on the same income. Integration is discussed in further detail in our GreenLearning article “Corporate Tax Integration”.
In addition, taxable dividends or “portfolio dividends” received by a CCPC are subject to a refundable tax (Part IV tax) at a rate of 33.33%. The full amount of Part IV tax is also added to the RDTOH account. Dividends received from connected corporations can, in certain instances, also attract Part IV tax. Amounts in the RDTOH account are refundable to the corporation when a taxable dividend is paid to a shareholder at the rate of $1 of refund for every $3 of taxable dividends paid.
Example - RDTOH
YOUR Co. Inc. buys, as a passive investment, Canadian Investment Co. stock using retained earnings. Canadian Investment Co. distributes a quarterly dividend of $2000. The stock is sold for a $2,000 capital gain in the current fiscal year. Canadian Investment Co. dividend:$2,000 Tax at 33.3% (equals RDTOH credit): $667 Net after tax income: $1,333 Canadian Investment Co. dividend:$2,000 Taxable Capital Gain:$1,000 Tax at 49%: $490 Net after tax income:$1,510 RDTOH (25 2/3%) $267TOTAL RDTOH Credits: $930
Effectively, SIBI constitutes “property” income and would include income from the following sources:
There are some exceptions to the above. For example, property income earned that is incidental to the earning of active business income may not be considered SIBI if the principal purpose was not to earn such income or where the income earned is ancillary to the earning of active business income. For instance, where a contracting company is required to set aside a sum of money to be held as a “bid bond”, and interest earned on the funds set aside, is incidental to the principal purpose for holding the cash. This interest would be considered ABI. Similarly, interest earned or paid into a current bank account maintained by a company to facilitate its business transactions would be ancillary to the purpose for maintaining the account. This interest income would also be considered to be part of the corporation’s active business income for the taxation year.
However, where a corporation does have surplus cash and has set aside and invested funds separately, any interest or similar income earned on this would be considered to be income from property and taxed as SIBI. Where this is the case, it is important to “match” expenses related to the earning of such SIBI, and to determine the net income from property of the corporation.
An example would be property tax, insurance and repairs and maintenance directly related to a rental property. Such amounts are reported on Schedule 7 of the T2 Return. This schedule differentiates SIBI from the ABI of the corporation.
Other expenses and outlays pertaining to and incurred in connection with the earning of SIBI might include:
These expenses should also be reported on Schedule 7.
Conversely, expenses and outlays that relate strictly to the earning of active business income in the corporation should not be allocated against SIBI of the corporation. Sometimes however, there can be certain expenses which pertain to the corporation’s ABI and SIBI, such as accounting or bookkeeping fees. For these, allocate each cost in a reasonable manner accordingly, matched to the purpose of the expense.
Income earned by a corporation from real estate (including rental and leasing income) will be subject to tax as SIBI, including real estate rents from residential or commercial property, unless the corporation has more than 5 full time employees in that business throughout the year.
There is also one other exception to this rule. Where a corporation rents or leases real estate from another corporation with which it is associated, subsection 129(6) of the Act deems the income of the recipient corporation to be from an active business carried on by it in Canada. Note: A professional corporation is not included in this exception as specific limitations apply to these corporations.
In addition, the same tax rules pertaining to individuals who own and rent 2 or more real estate properties, apply equally to a corporation. There is a requirement for a corporation to account separately for each rental property and to determine the income or loss for each particular property. Capital Cost Allowance (“CCA”) can then only be applied or claimed by the corporation to reduce rental income to NIL. The corporation must also maintain a separate CCA class for each rental property, in a manner that would be required for an individual taxpayer.
While losses realized (prior to any CCA claim) by a corporation on one or more real estate properties can be offset against profits reported from its ABI, the corporation (similar to an individual) cannot claim CCA to increase rental losses.
Property held principally for the use of the corporation’s shareholders and persons related thereto, may be considered to be “non-business” personal use assets even where the corporation charges a rent to the shareholder for personal use. The determining factor is the evidence that would point to the corporation’s principal purpose of acquiring the property. CRA looks to evidence or support that the property has been used for bona-fide rental purposes and that the property is available for rent by other non-related persons. The tax preparer should assess tax risk to the corporation, where a company acquires a rental property and it is used or available for use by a shareholder or related persons.
Significant adverse tax consequences can arise if CRA determines that the principal purpose or use of the property is for the shareholder’s benefit.
Combined 2015 corporate tax rates for SIBI (interest, rental income) for selected provinces are as follows:
Alberta46.7% after July 30
While Canadian source dividend income is considered income from property for tax purposes, it is subject to tax separately under Part IV of the Income Tax Act (Canada) at a flat rate of 33 1/3%.
If the Canadian source dividend income is received from a “connected” payor corporation, then the 33 1/3% Part IV tax will not apply, unless the payor corporation received a dividend refund on the payment to the “connected” recipient corporation, and then only to the extent of its proportional share of the dividend received.
If the Canadian source dividend income is received from a non-connected private or public corporation the Part IV tax payable by the recipient corporation is added to the company’s RDTOH account. RDTOH is available as a dividend refund when dividends are paid to shareholders of private corporations.
Foreign source dividend income is taxed as SIBI and is not included in Part IV tax calculations. However, if the dividend is received from a “foreign affiliate”, the dividend is essentially non-taxable and can be deducted under the provisions of subsection 113(1) of the Act, so that no amount is included or subject to tax under Part I of the Act.
However, be aware that if a Canadian corporation holds an interest in a “foreign affiliate”, there is an additional filing requirement. The Canadian Corporation must prepare and file Form T1134 disclosing information relating to its investment in a foreign affiliate. If the Canadian Corporation holds shares in a “controlled foreign affiliate”, then additional disclosures will be required in regard to the corporate structure and financial operations of the foreign corporation. Form T1134 must be filed within 15 months of the taxation year of the Canadian Corporation, which includes the fiscal year end of the foreign affiliate. Failure to file on a timely basis can result in significant penalties.
From a practical perspective, it is important for the corporation to account properly for its dividend income received from Canadian versus U.S portfolio investments. Canadian source portfolio dividend income can benefit from the Part IV, 33 1/3% refundable tax, while U.S source portfolio dividend income will be taxed as SIBI at rates of approximately 48 to 54%, depending on provincial jurisdiction.
Dividend income from a “connected” or “associated” corporation should be identified separate and apart from Canadian portfolio dividend income, as this income flows up to the recipient corporation free of Part I tax.
Schedule 7 Reporting: Dividends that are deductible under ITA sect. 112 & 113 are as follows:
A capital gain (loss) is realized by a corporation upon the disposition of a capital property. The meaning of a capital gain (loss) is defined in Subsection 39(1) of the Income Tax Act (Canada). A capital property is generally property held by the corporation and used in connection with earning income from its business. In contrast, an asset acquired principally for the purpose of being re-sold at a profit, would be
considered to be inventory of the corporation and any resulting profit (loss) realized thereon, would be considered to be ordinary income (loss) of the corporation. The primary distinguishing factor between “capital” and “inventory” is the purpose or use to which the asset is put.
The taxable portion of a capital gain (1/2) realized by a corporation is taxed in the same manner as SIBI. This is added to RDTOH.
The non-taxable portion (1/2) of the capital gain is added to the corporation’s capital dividend account (“CDA”). The CDA is a cumulative “point-in-time” calculation; subject to a requisite election in prescribed form T2054. The CDA can be paid out to the corporation’s shareholders on a tax-free basis.
PSBI is defined in subsection 125(7) of the Act to include income earned by a corporation that, but for the existence of the corporation, would effectively constitute employment income of an individual, providing services to another entity or person. An exception to the PSBI rules is provided where the corporation employs throughout the year, more than 5 full time employees.
Draft legislation was released on October 31, 2011 which would amend the Act to significantly change the way PSBI is taxed within a corporation. Under the “old” rules, PSBI was eligible for the “general rate reduction percentage” and effectively taxed as ABI, subject to the GRIP. Consequently, corporate income taxed as PSBI also increased the corporation’s GRIP, for purposes of the payment of an eligible dividend.
Under the proposed legislation, PSBI will no longer be available for the “general rate reduction percentage”, which will essentially increase the tax rate by approximately 13%, for taxation years beginning after October 31, 2011. One of the best examples of the current application of a PSB would be a professional athlete.
In addition, PSBI can no longer be added to a corporation’s GRIP (General Rate Income Pool) for purposes of calculating the amount of an “eligible dividend” that a corporation can pay.
These amendments effectively place a prohibitively high tax burden on earning PSBI through a corporation. Continued restrictions on the deductibility of expenses will also apply, such as the ability for a corporation to deduct only salaries or wages paid to the specified “incorporated employee”.
As a planning point, there is no benefit whatsoever in a person incorporating and earning income which would otherwise be viewed as “income from employment”. Many small business persons who have less than 6 employees and perform services for only one customer are in danger of being re-classified as a PSB. From an Audit Defense prospective, CRA appears to be taking an active approach in identifying
corporations that may be a PSB and implement the higher tax rate in the future.
In the course of determining a corporation’s income from a business or property, the company may report a business or an investment loss. For tax purposes, this loss would be considered to be a non-capital loss, as it arises in connection with an undertaking of carrying on a business with the purpose of earning a profit from business or property.
The term non-capital loss is defined in subsection 111(8) of the Act.
A non-capital loss incurred in the current taxation year of a corporation can be carried back and applied to reduce taxable income of the company in any of the 3 immediately preceding taxation years. To the extent that the loss is not carried back to a prior taxation year, it can be carried forward for a period of 20 taxation years.
Non-capital losses are reported on Schedule 4 of the T2 Return and the application to carry back all or a portion of a loss to a prior taxation year, is also reported on Schedule 4.
If a non-capital loss is not utilized within the time frames specified above it is simply extinguished.
Also, the ability for a corporation to claim a non-capital loss can be affected or denied where there is an “acquisition of control” in the corporation by another arm’s length person. There are rules in the Act which would require the corporation to carry on the same or similar business that it operated prior to control changing, in order for these non-capital losses to be available to be applied against income earned by the corporation in future taxation years. Such tax rules were introduced to limit or restrict “loss-trading” amongst corporations and arm’s length persons.
In order to complete a T2 Return correctly and allocate the proper tax rates to the proper types of business transactions, it is important to separate the different types of income and expenses that relate to each other. As mentioned in earlier GreenLearning articles, well established procedures and accurate bookkeeping will assist in creating an accurate T2 Return. The maintenance of the year-end tax file from day 1 also provides a proper audit trail to be established.
Active Business Income (ABI) is simply the main source of business profit of the corporation. Using an example of a Variety Store, the sales realized less the expenses incurred to operate the variety store creates Active Business Income.
Therefore determining what expenses relate to which income will allow the tax professional to clearly determine the ABI so that the corporation can pay the lowest tax rate which is eligible for the Small Business Deduction (SBD). The first $500,000.00 of net ABI earned by a corporation, or a group of corporations, is eligible for the lower tax rate by claiming the SBD.
Specified Investment Business Income (SIBI) is income that comes from interest, rental property, dividends & royalties. As shown in the chart earlier in this GreenLearning article, the tax rate is considerably higher for this type of income. Because of this it becomes important to identify expenses that are incurred to earn SIBI and allocate the expenses against SIBI in order to reduce the tax owing. Keeping track of these types of income and expenses separately will be a challenge if they are all lumped together with the ABI expenses by the bookkeeper, so planning and communication with clients and bookkeepers is important.
When an individual taxpayer owns and controls shares in more than one Canadian Controlled Private Corporation the ITA requires that the “associated” corporations only have one Small Business Deduction (SBD) to share among them.
It is important to understand the corporate structure of every corporation because an “associated” corporation will use up some of the $500,000.00 SBD amount and could increase the tax rate considerably. There is only ONE $500,000.00 SBD to all associated companies, NOT each company has $500,000.00 SBD. This cannot be stressed enough. A review of the corporate structure, preferably with the client’s lawyer is important and a CRA ruling could be required if the relationship between corporations is unclear, in order to avoid costly mistakes.
We can assist you with advice and reporting as it relates to income earned in a corporate environment. Here at Green Quarter Consulting - Accounting and Bookkeeping Services for Small Businesses in White Rock South Surrey, Vancouver, Langley and Surrey BC, we assist Small Business Owners with analyzing transactions, sources of income and your tax risks and how they relate to your specific business strategy. Learn more about our Greenstamp CFO Services here.