Aug 16th, 2023
Aug 7th, 2018
By Robert Korne
Owners of holding companies need to know that the new federal passive investment income tax rules are coming into force on January 1, 2019. This is significant because important planning may need to be undertaken by them before the new year. Why?
In its February 27, 2018 budget, the Liberal government introduced two initiatives affecting business owners: (i) reducing the small business deduction limit for companies within an associated group based on the combined amount of passive income earned for tax years beginning after 2018 and (ii) limiting the ability to recover refundable dividend tax on hand (RDTOH) when an eligible dividend is paid.
The government is of the view that corporate after-tax capital used to make passive investments rather than invested back in a business is a “significant tax deferral advantage […] relative to an individual investor”. As such, these rules are meant to penalize those who are using such after-tax capital for investment purposes above a certain threshold.
In terms of (ii) above, the tax system in Canada generally allows for a refund of a portion of taxes paid by a corporation on its earned investment income when taxable dividends are paid out to shareholders. The amount available to be refunded is called the RDTOH account. A corporation is entitled to a refund equal to 38 1/3 % of the taxable dividends paid to shareholders, up to the existing RDTOH balance.
The concept of RDTOH was introduced in our tax system as a mean of integration which was intended to ensure that tax payable on investment income is the same whether earned by a corporation or earned personally.
“Eligible dividends” are those taxed at lower dividend rates (highest marginal rate is approx. 40% in 2018) which are derived from active income earned in the corporation and taxed at the general active business rate. This is in contrast to “non-eligible dividends” which are taxed at higher rates (marginal rate of approx. 44% in 2018) derived from the first $500,000 of net active income taxed at the small business rate and investment income.
The current system allows for eligible dividends to be paid out where the RDTOH was created from investment income. However, had the investment income been paid out, it would have instead been taxed as a non-eligible dividend at a marginal rate of 44%. The current dividend refund system does not distinguish between eligible and non-eligible dividends.
The aim of the new tax rule referred to in (ii) above is, according to the government, to “align the refund of taxes paid on passive income with the payment of dividends sourced from passive income”. It is estimated that for all of this new complexity and vast array of additional rules surrounding these proposals, the amount of extra taxes to be collected by the government on the passive earnings in a corporation will only amount to 1.6% for capital gains and 3.3% for interest income.
These new rules propose to create two pools of RDTOH – (a) the eligible RDTOH pool whereby eligible dividends will only enable a dividend refund from the company’s eligible RDTOH balance and (b) the more general non-eligible RDTOH pool whereby only non-eligible dividends will enable a dividend refund of the company’s non-eligible RDTOH and once this pool is exhausted will enable a refund of the company’s eligible RDTOH. In practice, these rules will limit the amount of RDTOH available where eligible dividends are paid.
Important planning needs to be considered and implemented, if warranted, before the end of 2018. This is because the transitional rules provided for in the Budget create the opening eligible RDTOH and non-eligible RDTOH balances as at January 1, 2019. The eligible RDTOH opening balance will be equal to the lesser of (x) the existing RDTOH balance at the transition time and (y) 38 1/3% of any balance of corporate income that has been taxed at the general active business corporate rate (i.e. not the small business rate – and otherwise known as GRIP). Any RDTOH remaining that is not added to the eligible RDTOH balance will be added to the non-eligible RDTOH opening balance.
So let’s quickly look at few general examples to make the point.
Mr. A owns 100% of an investment corporation (Investco) which, in turn, owns 100% of an operating company (Opco). If Opco has GRIP of say ($3,000,000) but no RDTOH (which makes sense because it does not earn passive income) and Investco has no GRIP but does have RDTOH (say $1,000,000 - because it only earns passive investment income), then without any tax planning there is a mismatch between these companies. As such, without planning, in order to recover all of the non-eligible RDTOH in 2019, a non-eligible dividend of $2,608,922 is paid in that year by Opco to Investco and in turn up to Mr. A. The net personal after-tax retention to Mr. A will be $1,402,295.
Same facts as Example 1 however planning is undertaken in 2018 whereby Opco pays an eligible dividend up to Investco. Now, Investco has both the GRIP account of $3,000,000 and the eligible RDTOH account. As such, in 2019 when Investco pays an eligible dividend of $2,608,922 to Mr. A to recover the eligible RDTOH, the net personal after-tax retention to Mr. A will be $1,565,353 or a tax savings of more than $163,058 (6.25%).
Investco owns an asset which it is intending to sell in early 2019. If Investco has a large GRIP balance but no RDTOH at the beginning of 2019, then it will pay roughly 2.5% more tax if the asset is sold in 2019 rather than accelerating the sale in 2018. This is because when dividends sourced from this 2019 sale are paid out of Investco in 2019, the dividends will be considered non-eligible whereas if the sale occurs in 2018, Investco will create an RDTOH balance in 2018 and as a result, such dividends paid out will be treated as eligible. For larger assets, the taxes created between the rate on eligible dividends and non-eligible dividends may well be significant.
It is recommended that your holding corporation’s tax situation is reviewed in 2018 to determine if tax planning should be completed before the end of this year. Given that August has already begun, this work should not be delayed. The tax specialists at Spiegel Sohmer would be pleased to assist you.