Taxation of investment income earned in a corporation

When there is surplus cash in your corporation, the first step is to determine if the business will need the funds in the near future. Perhaps your corporation will need the excess cash to make tax instalments or a major business acquisition. If you decide to invest the surplus cash in your corporation, the income generated might be considered incidental to your business and may be taxed as active business income (ABI).

If the income generated from investing the surplus cash is not incidental to your business, it would be taxed as passive investment income, regardless of whether  it’s earned in your operating company or holding company. Passive investment income includes interest income, foreign dividend income, rental income,
royalty income and taxable capital gains. Although the taxation of passive investment income earned in a corporation may be complex, the following provides an
overview of some concepts you may find helpful.

In BC, the (flat) tax rate on active business income is 12%. On passive (investment) income the (flat) tax rate rises to 50.67% for 2024.

Tax on Capital Gains

In its spring budget, the federal government announced four big capital gains changes:

  1. For corporations, a hike in the inclusion rate from 50% to 66.7% for all capital gains, with no lower rate on the first $250,000. This applies when the business itself has capital gains on investments or property. Owners selling their businesses have the benefits described in this note.
  2. A significant bump in the Lifetime Capital Gains Exemption (LCGE) to $1.25 million: The $1 million LCGE for sales of small business shares or assets for fishers and farmers will rise to $1.25 million as of June 25, 2024. It will be indexed to inflation starting in 2026. This was a high priority recommendation from CFIB for many years.
  3.  new Canada Entrepreneurs’ Incentive (CEI) to lower capital gains taxes on the next $2 million upon sale of qualifying small business shares: This new incentive will start at $200,000 in 2025 and rise by $200,000 each year over the next 10 years before it reaches $2 million in 2034. Qualifying entrepreneurs will pay income taxes on 33.3% of their capital gains rather than the new 66.7% inclusion. Sadly, many business sectors will not qualify (restaurants, hotels, arts, entertainment, recreation, personal services, finance, insurance, real estate firms and professional corporations).

Previous and Current Capital Gains Tax in Canada

Under the previous system, 50% of the capital gains realized were included in taxable income. For example, if you had a capital gain of $100,000, $50,000 of this gain would be added to your taxable income for the year.

Starting June 25, 2024, the inclusion rate increased to 66.67% for capital gains realized by a corporation. For the same $100,000 gain, $66,670 is now included in taxable income.

Calculation Example: If a corporation realizes a capital gain of $300,000 in a year: 

  • Under the old system: $150,000 (50% of $300,000) would be taxable.
  • Under the new system: $200,010 (66.67% of $300,000) would be taxable.

This change significantly impacts the after-tax returns on investments, making it more crucial than ever to employ tax-efficient strategies and seek professional advice from a corporate tax lawyer.

Impact on Corporate Taxation

The new capital gains tax affects corporate taxation in several ways. Corporations may face higher tax liabilities, impacting their profitability and cash flow. Corporations will need to adopt strategic planning measures, revise investment strategies, and potentially increase their reliance on tax advisory services to navigate the new tax landscape effectively.

High-level Strategies to Mitigate Capital Gains Tax

  1. Tax-Efficient Investment Planning: Review and adjust your investment portfolio to maximize tax efficiency. Consider holding investments for longer periods to delay triggering capital gains.
  2. Utilize Tax Shelters and Exemptions: Take advantage of tax shelters and exemptions available to individuals from a Canadian tax perspective, such as the Lifetime Capital Gains Exemption (LCGE) for qualifying small business corporation (QSBC) shares. This can significantly reduce taxable gains.
  3. Incorporate Strategic Timing: Plan the timing of asset sales to optimize tax outcomes. Selling assets in a lower-income year can reduce the overall tax burden.
  4. Engage in Tax Loss Harvesting: Offset capital gains with capital losses by strategically selling underperforming assets. This can help reduce taxable gains and manage your tax liability.
  5. Seek Professional Tax Advice: The complexities of the new capital gains tax require expert guidance. Consulting with a corporate tax lawyer ensures you receive tailored advice and strategies to minimize tax impacts

The new capital gains tax presents challenges, but with the right strategies and professional guidance, you can effectively manage its impact. By prioritizing tax-efficient investment planning, corporate tax strategies, utilizing available exemptions, and engaging in strategic timing, you can navigate the complexities of the new tax landscape.

Tax on investment income (excluding Canadian dividends)

When a corporation earns passive investment income  (excluding Canadian dividends), it’s subject to a federal tax of 28% and an additional refundable tax of 10 2⁄3% on this investment income for a total federal tax of 38 2⁄3%. A portion of the tax paid is refundable to the corporation when taxable dividends are paid out to its shareholders. The refundable portion is equal to 30 2⁄3% of the investment income earned. The refundable portion is reduced if the corporation earns foreign investment income and claims a foreign tax credit for the non-resident withholding tax paid

The purpose of this refundable tax is to achieve an important principle in the Canadian tax system commonly referred to as “integration”. When a tax system is perfectly integrated, an individual will be indifferent to earning investment income in a corporation versus earning it personally. Without the refundable tax on investment income, a corporation would pay less tax on investment income earned than an individual in a high marginal tax bracket; this advantage would encourage individuals to earn investment income in a corporation as a way to defer tax.

Tax on Canadian dividends

Canadian dividends earned in a corporation are not subject to regular corporate tax. Instead, they may be subject to a refundable tax depending on whether the dividends are received from a connected corporation or non-connected corporation.

A payer corporation is connected to the recipient corporation if:
● The recipient corporation owns more than 10% of the voting shares and more than 10% of the fair market value
of all the issued shares of the payer corporation; or
● The recipient corporation controls the payer corporation. For the purposes of determining whether two corporations are connected, the normal concept of control is expanded and provides that one corporation is controlled by another if more than 50% of its shares (that have full voting rights) belongs to the other corporation, persons who do not deal at arm’s length with the other corporation, or a combination of the other corporation and persons who do not deal at arm’s length with the other corporation.

Dividends received from Canadian corporations that are not connected are subject to a refundable tax of 381⁄3%. This tax is refundable to the corporation when taxable dividends are paid out to the shareholders. Dividends received from connected corporations are generally not subject to this refundable tax unless the paying corporation received a refund of its taxes when it paid the dividends. Speak to your qualified tax advisor for more information about the tax implications of inter-corporate dividends. Unlike dividends received by individuals, there’s no gross-up or dividend tax credit for dividends received by a corporation.

Capital dividend account

No money is actually paid into the CDA. It’s a notional account that includes the non-taxable portion of all capital gains. Corporations can elect to pay a capital dividend, up to the balance in the CDA, and the shareholder receives the dividend tax free. This is very attractive to shareholders.

Refundable dividend tax on hand account

The RDTOH account is also a notional account. It includes all the 38.33% tax on dividends received from a taxable Canadian corporation. For all other investment income (i.e., interest, foreign income, and taxable capital gains), 30.67% of that income is also added to the RDTOH account. When the corporation pays a taxable dividend to shareholders, it’ll receive a tax refund of $1 for every $2.61 of dividends paid, up to the balance of the RDTOH account. The taxable dividend received by the shareholder is included on their tax return and will be subject to a dividend gross-up and dividend tax credit.

This topic is quite complex requiring consideration of your investment alternatives and the tax implications. This article is not intended to be a comprehensive guide to taxation of investment income earned in a BC corporation.

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