ACC 522 Chapter 11 Notes: Corporations An Introduction

Relationship between the Corporation and Its ShareholdersCorporation Defined Shareholders are liable for the debts of the corporation only to the extent of their contributions to the contribution in the form of share capital. Shareholders provide equity capital, creditors provide borrowed capital, suppliers provide property and services, customers acquires G&S, employees provide HR, and lessors rent property Shareholder may have more than one relationship with the corporation. It can: (1) a creditor who loans fund; (2) a supplier who sells to the corporation; (3) a customer who buys property; (4) an employee who is paid for services, and (5) a lessor who rents property to the corporation.

Tax Impact of Shareholder/Corporate Relationships All corporate income ultimately flows to individuals. The corporations primary relationship is with the shareholder as the provider of equity capital to the corporation.The Primary Relationship Shareholder as an Equity Capital Provider Shareholder contributes cash or other property to the corporation in exchange for shares. Shares issued have various rights attached to them. Most commonly, they are entitled to the accumulated earnings of the corporation on a pro rata basis. Shareholders who provide share capital to a corporation can realize a ROI through dividends or through a capital gain when they sell their shares at a profit. Increased dividends reduce the potential for capital gains; reduced dividends increase the potential for capital gains. The undistributed profits belong to the participating shareholders, the value of the shares of increases to reflect the undistributed profits. Shareholder has the right to dispose of the shares to a new shareholder, at which point he/she recognizes a capital gain for tax purposes and a second level of tax occurs. The overall impact of the two levels of tax is diminished somewhat by the dividend tax credit and by the preferential treatment given to capital gains, only of which are taxable. Corporate profits are taxed a 2nd time at the shareholder level as either dividends or capital gains.The Secondary Relationships Secondary relationships are between the corporation and its creditors, suppliers, employees, customers, or lessors. In the primary relationship, dividends paid by the corporation are not deductible by the corporation for tax purposes but are taxable to the recipient shareholder. In secondary relationships, such payments as salaries, interest, and rents are deductible by the corporation and taxable to the recipient.

Determination of Taxable Income A corporations TI is determined by reducing NIFTP by a short list of special reductions. Corporation does not have a capital gain deduction. Also, it treats charitable donations as a reduction of taxable income, whereas the individual treats such donations as tax credit. The special reduction for dividends received from other Canadian corporations and from foreign corporations is of particular importance. NIFTP Special Reductions (donations, net capital losses, non-capital losses, dividends from taxable Canadian corporations, dividends from foreign affiliates, etc.) = TI

Loss Carry-Overs Loss carry-over provisions for corporations are the same, structurally, as they are for individuals. Net capital losses can be carried back 3 years and forward indefinitely to the extent of taxable capital gains realized in those years. Non-capital losses (business and property losses) incurred in a year can be carried back 3 years and forward 20 years as a special reduction against any other sources of income. Non-capital losses arising from ABIL can be carried back 3 years and forward 10 years against any source of income.Change in Control Whenever a new shareholder or group of shareholders acquires control of a corporation, the unabsorbed losses being carried forward may be restricted as to use or entirely eliminated. In general terms, a change in control will affect the unabsorbed loss carry-over as follows:1. The net capital losses that exist in the corporation at the time of change in control are deemed to have expired. They will hold the assets that have appreciated in value and that will create capital gains in the future when a disposition occurs.2. Non-capital losses that resulted from a business operation continues to be carried forward but can be utilized only against income generated from the business that incurred the loss. Further, the business that incurred the loss must be carried on at a profit or with a reasonable expectation of profit throughout the taxation year in which the losses are deducted. Any losses incurred by the corporation after the change in control can be carried forward in the normal manner against any other sources of income. The fact that business loss carry-overs can be utilized against income from a similar business opens up a narrow opportunity with respect to business sales and acquisitions. These restrictions relate to the treatment of losses that have already occurred but have not been absorbed by later, profitable operations. After a change in control, the new owners can sell assets that they owned previously and create a terminal loss; but these losses would not fall under the restrictions. To ensure that unrealized losses do not escape the restrictions, the corporations year end is deemed, for tax purposes, to end immediately before the control change. Depreciable property, eligible capital property, and other capital property are all deemed to have been sold at their market value if that value is below the tax cost. These restrictions do not apply when a related party acquires control. Acquisition of Control Summary of Rules Occurs when control over the voting rights of a corporation (more than 50%) is acquired by an unrelated person or group. The tax implications: Year-End: Taxation year-end is deemed to occur immediately prior to the date of the acquisition of control. If the period is less than 365 days any tax rules relating to short taxation years will apply such as the prorating of CCA. Choose a new taxation year-end. Inventory: At the deemed year-end, inventory is valued at the lower of cost or market and any resulting loss is recognized for tax purposes. Account Receivable: The normal reserve for bad debts is not permitted. Instead, the corporation must examine each A/R and claim any uncollectible amount as a bad debt. Amounts written off that are subsequently received will be added to income. Depreciable Property: Extent that the FMV of property in each class is less than the UCC of the class at the end of the deemed year (after the CCA deduction for that year), the difference is deemed to be a deduction of CCA of that class for the year reducing the UCC accordingly. For capital gains purposes the original ACB is retained. Cumulative Eligible Property (CEC): Extent that 3-quarters of the FMV the eligible capital property is less than the balance of the CEC account (after CECA deductions for the deemed year), the balance is written down by that difference. Non-Depreciable Capital Property: Extent that the FMV of each non-depreciable property is less than the ACB of that property, the difference is deemed to be a capital loss for the period and a reduction to the ACB. The loss can be offset against any capital gains in the period or carried back; however, it cannot be carried forward. If recapture occurs, it can only be offset by current non-capital loss carryovers. Loss Carry-Overs: On acquisition of control net capital losses and ABIL expire and cannot be used after the deemed year-end. Also, any unused donations cannot be carried forward. Read the Situation and Analysis on Page 424-425 to understand the rules.Loss Utilization in Corporate Groups The profits and losses of the various corporations can be combined if the operations of each corporation are formally merged and housed in a single corporate entity. If the new venture is going to incur losses in the initial years, a branch structure would permit the losses to be used immediately against the profits of other operations; the subsidiary structure, on the other hand, would separate the profits of the existing operations from the losses incurred by the expansion activity.

Dividends from Other Canadian Corporations Corporation includes dividends received from other corporations as property income when determining NIFTP. In order to avoid multiple taxation on the distribution of corporate after-tax income, a corporations taxable income is reduced by the amount of dividends received from other taxable Canadian corporations and are not subject to a second level of tax until they are received by the ultimate shareholder. Corporate profits, once taxed by the initial corporation, can be shifted to other corporations via dividends without further taxation. In certain cases, private corporations may be subject to a temporary tax on dividends received from other corporations. However, for most business structures, Canadian intercorporate dividends flow tax-free. Canadian corporations that receive dividends from a foreign affiliate corporation are also not taxable on such dividends as a result of the special reduction in arriving at taxable income. To qualify as a foreign affiliate, the Canadian corporation must have equity percentage in the foreign corporation that is at least 10%. Read Situation and Analysis on Page 427

Calculation of Corporate Tax Three basic categories for tax purposes: (1) public, (2) private, and (3) CCPC. Resident of Canada whose shares are traded on a stock exchange. Resident of Canada and which are not public or controlled by public corporations. Resident of Canada, do not qualify as public, and are not controlled by non-residents of Canada. Provincial taxes are expressed as a percentage of taxable income, and as a result, it is easy to determine the basic marginal tax rates. Study Exhibit 11-5 on Pg. 429 for Determination of Tax for Corporations

Federal Tax Primary federal tax is calculated by applying a flat-rate tax of 38% to the corporations TI. To provide room for the provinces to impose a tax, the federal rate of 38% is reduced by 10% as a federal abatement for provincial taxes. So the rate of federal tax is 28%.General Tax Reduction Public Corporations: Federal tax is reduced by 13% of the corporations TI other than its income from manufacturing and processing activities (M&P), which is a separate reduction. CCPC: Federal tax is reduced by 13% on active business income that is above the annual limit to which small business deduction applies. This restriction does not apply to the tax on its investment income or personal service business income.

Refundable Tax on Investment Income Special tax is applied only to the investment income (not active business income) of CCPC. The rate of tax is 6% of the corporations investment income and is fully refundable to the corporations when dividends are paid to its shareholder(s).Small Business Deduction Only available to CCPC. This deduction permits the normal federal tax rate to be reduced by 17% so that the net federal tax rate is 11%; this applies only to the first $500,000 of annual active business income of the corporation or to its taxable income, whichever is lower.Manufacturing and Processing Deductions Profits that result from M&P activities are subject to a rate reduction of 13% for all public corporations. CCPC are entitled to the same reduction, but only on annual manufacturing profits in excess of the $500,000 small business deduction limit. The net federal rate of tax on manufacturing activities (expect those eligible for the small business deduction) is 15% (28% - 13%). Most corporate income will be subject to a net federal tax rate of 15%. Following arbitrary formula is used to determine the manufacturing profits subject to the rate reduction. Formula MC = Manufacturing Capital; ML = Manufacturing Labour; TC = Total Capital; and TL = Total Labour If the activities are divided between two corporations, the maximum profit eligible for the 13% federal and some provincial manufacturing reduction is the manufacturing corporations profits. If the activities are combined, the profit for manufacturing is based on the arbitrary formula and is governed by the capital wages employed in each operation.Full-Rate Taxable Income and GRIP When full-rate taxable income, less the related income tax, is paid to shareholders as a dividend, the dividend qualifies as an eligible dividend that is subject to a higher gross-up and dividend tax credit. CCPC keep track of this type of after-tax income by maintaining a General Rule Income Pool (GRIP). A corporations GRIP is increased annually by 72% of its full-rate taxable income. Public corporations may receive non-eligible dividends from a CCPC. These dividends cannot be classified as full-rate taxable income. Instead, they are tracked in a tax account called the Low Rate Income Pool (LRIP) which, when paid as a dividend, maintains its non-eligible status. Public corporations and non-CCPCs are subject to a penalty if they have a LRIP balance at the time eligible dividends are paid. To avoid the penalty, public corporations must pay dividends first from the LRIP before designating other dividends as eligible dividends.

Provincial Tax Certain provinces apply a reduced rate of tax to the first $500,000 of active business profits of CCPC, and some reduce the rate for manufacturing profits. Ontario, the primary rate of 11% is reduced to 4.5% for active business profits that qualify for the federal small business deductions and to 10% for manufacturing. A corporation incorporated or based in a particular province will be taxed entirely in that province unless it carries on business in another province through a permanent establishment. If that exists, the profits attributable to that locations are based on the ratio of sales in the province to total sales, and the ratio of wages paid in the province to total wages, multiplied by the total business profits of the whole corporation.

The Integration of Corporate and Individual Taxation Annual business income in excess of $500,000 is subject to a higher rate of corporate tax; consequently, that income is subject to double taxation, much like income from public company.