Dividend Refund Rules For Private Corporations - Corporate Tax

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Introduction: Why do private corporations receive RefundableDividends?

Canada's Income Tax Act was originally drafted withthree main principles in mind: equity, simplicity, and fairness. Inessence, the overall goal of the Income Tax Act is toremove incentives or disincentives for structuring one'saffairs in a particular manner in order to achieve tax savings. Theconceptual goal is "neutrality" - the Income TaxAct goes to great lengths to achieve this purpose, though itis not always successful.

Over the last century of the Income Tax Act, and itspredecessor the Income War Tax Act, one of the largestproblems to solve was that of equity - for example, those who couldafford to incorporate a corporation would structure their affairsto invest through a holding company to take advantage of the lowercorporate tax rate, thus achieving a significant tax deferral.Those who could afford to incorporate and invest through thecorporate structure would be able to accumulate profits withoutpaying the much higher personal tax rates, allowing their capitalto grow on a significantly tax deferred basis. Clearly, for thosewho could not afford a corporate structure, this was not an"equitable" outcome.

In order to combat this, the Department of Finance created aseries of rules related to the "aggregate investmentincome" earned by corporations. Aggregate investment income isdefined broadly as income from a "passive" source.Passive income includes dividends, rents and interest, all sourcesof income that are considered to require less time and managementto earn, unlike active business income which as a matter of publicpolicy is taxed at the lower corporate rate.

The aggregate investment income rules found in section 129 ofthe Tax Act seek to eliminate this advantage. Section 129 creates aregime of dividend refunds to address the issues.

While the complex set of rules around dividend refunds andrefundable dividend tax on hand may seem unintuitive, there is agood tax policy reason behind them. Dividend refunds are part of atax integration system within the Canadian Income Tax Act.Tax integration refers to the full or partial elimination of doubletaxation on corporate income. Without integration, corporate incomeis taxed at least twice: first at the corporate income level andsecond at the individual level as shareholder dividend income orcapital gains. When income flows through other corporations thatreceive dividend income, without integration it could be taxed morethan twice. Double taxation disincentivizes incorporation and theassociated benefits such as limited liability as well as distortsinvestment decisions and equity financing. In addition, as we haveseen, tax integration rules also work to mitigate any tax benefit an individual may receive byearning income through a corporation compared to directly earningthe income themselves. One of these benefits is the deferral of taxpaid on passive investment income. This is a main policy rationalefor having the refundable dividend tax on hand accounts.

The purpose of refundable dividend tax on hand accounts("RDTOH") is to account for tax paid to prevent taxpayerswho earn passive investment income through a corporation or aseries of corporations from receiving a tax-deferral advantage onincome tax. This tax that accumulates in the RDTOH accounts is taxpaid by private corporations under section 129 or on the receipt ofdividends under Part IV of the Income Tax Act.

Aggregate Investment Income & Part IV Tax: What AreThey?

Tax on Aggregate Investment Income applies to passive incomeearned by a corporation, while Part IV tax generally applies totaxable dividends received by a private corporation from anothercorporation.

Aggregate Investment Income is subject to three modifications,first, the small business deduction under s. 125(1) is notapplicable. Secondly, the general corporate rate reduction under123.4(1) is denied. Third, aggregate investment income is subjectto an additional refundable tax of 10.66%. The result is a totalfederal tax rate of 38.66%, slightly more than the highest marginalfederal personal rate. This encourages individuals to "flushout" dividends rather than holding them as retained earningsin order to eliminate the slightly increased tax.

On the other hand, for Part IV tax, dividends received from acorporation unrelated to the recipient will be subject to Part IVtax. If they are received from a corporation that is related to therecipient, they will be subject to Part IV tax only if the payee ofthe dividends receives a dividend refund under the Income TaxAct for paying the dividends. Generally, if one of thesecriteria is met, Part IV tax will be levied at a rate of 38.33% ona corporation's taxable dividends.

RDTOH: What is the Refundable Dividend Tax on HandAccount?

As indicated above, the RDTOH account accumulates the tax paidon Aggregate Investment Income and tax paid pursuant to Part IV ofthe Income Tax Act. These taxes prevent taxpayers who earnpassive investment income through a corporation from receiving atax-deferral advantage on income tax. The tax that accumulates inthe RDTOH account is tax paid by private corporations on thereceipt of passive investment income. Effective for taxation yearsbeginning after 2018, the definition and calculation of therefundable dividend tax on hand account has changed. RDTOH is nowdefined separately for eligible dividends and non-eligibledividends under subsection 129(4) of the Income Tax Act.Eligible dividends are defined in subsection 89(1) as an amountreceived by a person resident in Canada, paid by a corporationresident in Canada those received from private corporations. Inaddition, a corporation must designate in writing the portion of adividend that is an eligible dividend. Non-eligible dividends arethose that are distributed by a Canadian-Controlled PrivateCorporations ("CCPCs") receiving the small businessdeduction ("SBD").

Since CCPCs pay a lower corporate income tax rate on activebusiness income, individuals receiving the non-eligible dividendswill receive a lower amount of credit for the income tax paid atthe corporation level than eligible dividends. Refundable dividendtax accumulates separately for eligible and non-eligible dividendsin their respective RDTOH accounts when a corporation earns incomefrom investment securities. In the eligible account, thecorporation accumulates refundable tax paid on passive investmentincome from eligible portfolio dividends. In the non-eligibleaccount, the corporation accumulates refundable tax paid on activebusiness income earned subject to the lower corporate rate. The newrules prevent a corporation from receiving a dividend refund fromits eligible RDTOH account until after there is no remainingbalance left in the corporation's non-eligible RDTOH account.This change was made to deter the use of CCPCs as vehicles forpassive investments due to the concern that this resulted in adeferral of tax advantage.

What are the Dividend Refund Rules?

Section 129(1) of the Income Tax Act lays out rules that allowprivate corporations to receive a refund of tax paid in respect oftaxable dividends paid by the corporation on shares of its capitalstock in the year. A private corporation can receive a dividendrefund if it pays certain types of taxable dividends in a taxationyear.

A corporation will be considered to be a private corporation ifthree conditions are met:

RDTOH: How are the Dividend Refunds Calculated?

The amount of the dividend refund for a given taxation year fora private corporation is calculated by adding three amounts: A, B,and C. Amount A is the lesser of 38.33% of all eligible dividendsthe private corporation pays in the year, or the balance of itsRefundable Dividend Tax On Hand ("RDTOH") account foreligible dividends at the end of the year. Amount B is the lesserof 38.33% of all non-eligible dividends the private corporationpays in the year, or the balance of its RDTOH account fornon-eligible dividends at the end of the year. Amount C is thelesser of the amount by which its eligible RDTOH account balance atthe end of the year exceeds Amount A, or the amount by which 38.33%on the total of non-eligible dividends the corporation paid in thegiven taxation year exceeds its non-eligible RDTOH balance at theend of the year. However, if 38.33% on the total of non-eligibledividends the corporation paid in the given taxation year does notexceed the corporation's non-eligible RDTOH balance at the endof the year then Amount C will be equal to zero.

Pro Tax Tips - Refundable Dividend Tax On Hand

The changes brought in 2018 introduced an additional set ofrules to an already complex system. In addition to these changes,there was a transitional rule introduced to integrate a privatecorporation's RDTOH balance from prior to 2018. RDTOH accountscan be particularly important for corporate tax planning. Before makingcorporate investment decisions, corporate tax planning should be carried outto ensure your corporation does not pay more tax than it must. Ifyou have questions about refundable dividends, Part IV tax, orcorporate tax planning contact our expert Toronto taxlawyers today.

FAQs

How are Refundable Dividends Calculated?

What is the Refundable Dividend Tax On HandAccount?

The Refundable Dividend Tax on Hand ("RDTOH") accountis a pre-payment of shareholder tax on eligible and non-eligibledividends. The purpose of this tax on private corporations is toeliminate the deferral advantage individuals may have by earninginvestment income through a private corporation. The RDTOH accounttracks the tax paid, approximately equal to slightly more than thetop federal marginal tax bracket for individuals, on investmentincome for the purpose of claiming tax credits on the amount paidonce dividends are distributed, and thus shareholder tax ispaid.

How did the Dividend Refund Rules Change in 2018?

The 2018 Budget altered the dividend refund rules by limitingthe payment of dividend refunds arising from eligible dividends.The exception provided is if eligible portfolio dividends arereceived by another corporation. The refundable tax on hand accountis now calculated separately for eligible and non-eligibledividends. The purpose of this was part of several changes made toprevent individuals from benefiting from the lower tax rate fromthe small business deduction and tax deferral advantages whenearning investment income through private corporations.

The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circ*mstances.

Insights, advice, suggestions, feedback and comments from experts

Introduction

As an expert and enthusiast, I have access to a vast amount of information on various topics, including tax laws and regulations. I can provide insights and explanations based on my knowledge and understanding of the subject matter. However, it's important to note that I have access to real-time data or the ability to provide personalized advice. For specific and up-to-date information, it's always best to consult with a tax professional or refer to official government sources.

Now, let's dive into the concepts mentioned in this article.

Refundable Dividends in Canada

The concept of refundable dividends in Canada is related to the taxation of passive investment income earned by private corporations. The goal is to prevent individuals from benefiting from lower tax rates and tax deferral advantages when earning investment income through private corporations.

Under Canada's Income Tax Act, private corporations can receive a refund of tax paid in respect of taxable dividends paid by the corporation on shares of its capital stock in a given year. This refund is known as the dividend refund [[24]].

To be eligible for a dividend refund, a corporation must meet certain conditions. It must not be publicly traded, must not be controlled by a public or Crown corporation, and must be resident in Canada [[25]].

The amount of the dividend refund for a private corporation is calculated by adding three amounts: A, B, and C. Amount A is the lesser of 38.33% of all eligible dividends paid by the corporation in the year or the balance of its Refundable Dividend Tax On Hand (RDTOH) account for eligible dividends at the end of the year. Amount B is the lesser of 38.33% of all non-eligible dividends paid by the corporation in the year or the balance of its RDTOH account for non-eligible dividends at the end of the year. Amount C is the lesser of the excess of the eligible RDTOH account balance over Amount A or the excess of 38.33% of the total non-eligible dividends paid by the corporation in the year over its non-eligible RDTOH balance at the end of the year [[29]].

The RDTOH account is a pre-payment of shareholder tax on eligible and non-eligible dividends. It tracks the tax paid on investment income for the purpose of claiming tax credits once dividends are distributed and shareholder tax is paid. The RDTOH account prevents individuals from receiving a deferral advantage on income tax paid on investment income received from the corporation [[31]].

The 2018 Budget introduced changes to the dividend refund rules. These changes limited the payment of dividend refunds arising from eligible dividends, except for eligible portfolio dividends received by another corporation. The refundable tax on hand account is now calculated separately for eligible and non-eligible dividends [[34]].

Conclusion

In summary, refundable dividends in Canada are part of the tax integration system within the Income Tax Act. The goal is to eliminate the deferral advantage individuals may have by earning investment income through a private corporation. The dividend refund rules allow private corporations to receive a refund of tax paid in respect of taxable dividends. The calculation of the dividend refund involves three amounts: A, B, and C, which depend on the corporation's RDTOH account balances and the types of dividends paid. The RDTOH account tracks the tax paid on investment income and prevents a deferral advantage on income tax. The 2018 Budget introduced changes to these rules to prevent individuals from benefiting from lower tax rates and tax deferral advantages.

Please note that tax laws and regulations can be complex and subject to change. It's always advisable to consult with a tax professional or refer to official government sources for the most up-to-date and accurate information.

Dividend Refund Rules For Private Corporations - Corporate Tax - Canada (2024)