The change may provide savings for small businesses, but it also has wider implications
Finance Minister Bill Morneau’s announcement of a Liberal plan to reduce the small-business tax rate to 9% by 2019 cooled outrage over earlier proposals to restrict tax benefits to Canadian corporations. But if the reductions push through as planned, they could lead to increases in other areas.
The problem arises from the taxation principle of integration. Under the Canadian tax system, the income that a corporation earns and distributes as a taxable dividend to an individual shareholder should be taxed to roughly the same degree as income earned directly by the individual.
“To achieve integration, corporations pay tax on the income they earn, and when a dividend is paid, the shareholder is required to include the dividend in the computation of his/her income plus a grossed-up amount,” David Malach and Saam Nainifard, tax lawyers at Aird & Berlis LLP, wrote in a piece on the Financial Post.
“The shareholder is then entitled to a claim a credit (known as the ‘dividend tax credit’) to offset the corporate tax payable by the corporation and avoid double taxation.”
According to the pair, unless marginal tax rates on individual taxpayers are reduced, a reduction in corporate tax rates must be offset with increased taxation on dividends. “[W]ith the coming small-business tax cut, the tax rate on dividends received by an individual resident in Ontario will increase from the current 45.3% tax rate to 46.75% in 2019,” they said.
Because of the increased dividend tax rate, the combined corporate/personal tax rate on active business income subject to the small business rate on a fully distributed basis will rise from 53.5% currently to 53.94% in 2019. As for passive income a corporation earns from interest and rent, the combined corporate and personal tax rate will increase from 55.97% to 57.13%.
Retained earnings are another concern. The rules governing the tax rate on dividend income of an individual shareholder don’t consider changes to historical corporate tax rates, Malach and Nainifard explained. Therefore, when corporate tax rates are lowered, the amount of combined corporate and personal tax payable on a corporation’s distributions of retained earnings accumulated from before the tax reduction will almost invariably be higher.
As an example, the two considered a corporation resident in Ontario that earns $500,000 of income in 2017 at the small-business rate of 15%, and then distributes the after-tax retained earnings to an individual shareholder in 2019. “[T]he combined corporate and personal tax paid on the dividend will be 54.95% compared to 53.5% before the corporate tax reduction,” they said.
Higher dividend tax rates will likely encourage shareholders of private corporations to convert dividend income into capital games, for which effective tax rates are lower. Such conversion was originally a major point in the proposed changes announced by Morneau, but he announced on Oct. 19 that proposals related to it would be dropped.
“We expect that a revised version of the proposals is likely forthcoming,” Malach and Nainifard said.
Related stories:
Will new passive income rules be beneficial to businesses?
Small businesses need a capital assist: IIAC head
The problem arises from the taxation principle of integration. Under the Canadian tax system, the income that a corporation earns and distributes as a taxable dividend to an individual shareholder should be taxed to roughly the same degree as income earned directly by the individual.
“To achieve integration, corporations pay tax on the income they earn, and when a dividend is paid, the shareholder is required to include the dividend in the computation of his/her income plus a grossed-up amount,” David Malach and Saam Nainifard, tax lawyers at Aird & Berlis LLP, wrote in a piece on the Financial Post.
“The shareholder is then entitled to a claim a credit (known as the ‘dividend tax credit’) to offset the corporate tax payable by the corporation and avoid double taxation.”
According to the pair, unless marginal tax rates on individual taxpayers are reduced, a reduction in corporate tax rates must be offset with increased taxation on dividends. “[W]ith the coming small-business tax cut, the tax rate on dividends received by an individual resident in Ontario will increase from the current 45.3% tax rate to 46.75% in 2019,” they said.
Because of the increased dividend tax rate, the combined corporate/personal tax rate on active business income subject to the small business rate on a fully distributed basis will rise from 53.5% currently to 53.94% in 2019. As for passive income a corporation earns from interest and rent, the combined corporate and personal tax rate will increase from 55.97% to 57.13%.
Retained earnings are another concern. The rules governing the tax rate on dividend income of an individual shareholder don’t consider changes to historical corporate tax rates, Malach and Nainifard explained. Therefore, when corporate tax rates are lowered, the amount of combined corporate and personal tax payable on a corporation’s distributions of retained earnings accumulated from before the tax reduction will almost invariably be higher.
As an example, the two considered a corporation resident in Ontario that earns $500,000 of income in 2017 at the small-business rate of 15%, and then distributes the after-tax retained earnings to an individual shareholder in 2019. “[T]he combined corporate and personal tax paid on the dividend will be 54.95% compared to 53.5% before the corporate tax reduction,” they said.
Higher dividend tax rates will likely encourage shareholders of private corporations to convert dividend income into capital games, for which effective tax rates are lower. Such conversion was originally a major point in the proposed changes announced by Morneau, but he announced on Oct. 19 that proposals related to it would be dropped.
“We expect that a revised version of the proposals is likely forthcoming,” Malach and Nainifard said.
Related stories:
Will new passive income rules be beneficial to businesses?
Small businesses need a capital assist: IIAC head
