Chapter 12

Integration for Business and Investment Income of the Private

Corporation

Problem 3

Problem 6

Problem 9

Today’s topics

• The concept of integration• Income from an active business of a

CCPC• Income from investments of a CCPC

Problems addressed

• A corporation is a separate legal entity and normally treated as such in tax

Object of integration

• Should cause total tax paid by a corporation and its shareholders to be equal to the total tax paid by an individual who carries on the same economic activity.

• Perfect integration relies on two factors:– Where corporation pays tax, the individual

gets credit– All after-tax income paid as dividends or taxed

by individual to avoid infinite deferral of tax

The Tool

• The major tool is the gross-up and tax credit procedure

• The gross-up is intended to approximate the pre-tax income of the corporation

Dividends

• Eligible dividends – dividends paid from income in excess of the SBD limit

• Ineligible dividends – paid from SBD income

The theoryTheoretical taxation of Dividends that demonstrate perfect integration

Corporation A B

Income 1,000 1,000

Theoretical tax ( 25% & 31%)

(200) (310)

After-tax earnings 800 690

Dividend paid 800 690

Gross-up 200 310

Taxable income 1,000 1,000

Personal tax 340 340

DTC (200) (310)

Net tax 140 30

Corporate tax paid 200 310

Shareholder 140 30

Total 340 340

If paid as salary (34%) 340 340

Concept application

• Works when corporate tax rate is 20%• Eligible and ineligible dividends attempt to

address the issues of different corporate tax rates

Eligible dividends

• Dividends paid by– Public corporations resident in Canada and

subject to general corporate tax rate– CCPC resident in Canada to the extent that

business income is subject to high rate• GRIP• Income over SBD level

Calculations

A (noneligible) B (eligible)

Calculation based on gross-up

Dividend gross up 200 310

Federal DTC

2/3 of GU 133

11/18 of GU 189

Provincial DTC

1/3 of GU 67

7/18 of GU 121

200 310

Calculations

A (noneligible) B (eligible)

Calculation based on grossed-up dividend

Grossed up dividend 1,000 1,000

Federal DTC

13 1/3% of GUD 133

19% of GUD 189

Provincial DTC

6 2/3% of GUD 67

12% of GUD 121

200 310

Summary of dividend

Cash amount received 1,000 1,000

Gross up par82(1)(b) 25%/45%

250 450

Grossed up taxable amount of dividend

1,250 1,450

Federal DTC 2/3 or 11/18 of GU

167 275

Federal DTC as percentage of GUTD

13.333% 18.97%

Eligibility

• 25% gross up– Dividends from active

business income of CCPC eligible for SBD

– Dividends from investment income of CCPC

• 45% gross up– Dividends from active

business income of CCPC not eligible for SBD

– Dividends from public CDN companies or CCPC with income subject to general corporate tax rate

Active Business Income

• SBD is a credit against tax otherwise payable

• Must meet certain criteria

Tax rates applicable

Federal tax rate 38.00%

Federal abatement for provincial taxes (10.00)

Net federal tax after abatement 28.00%

Small business deduction (17.00)

Total federal tax 11.00%

Provincial tax (assumed) 5.00%

Effective total tax 16.00%

Definition of active income

• Any business carried on by the corporation other than a specified investment business or a personal services business and includes an adventure or concern in the nature of trade

Specified investment income

• A business (other than a credit union or leasing property other than real property)

• The principal purpose is to derive income from property (including interest, dividends, rents and royalties)

• Unless the corporation employees MORE than 5 full-time employees

Personal services business

• Contractor vs employee discussion again

Personal services business

• A business of providing services where– An individual who performs services on behalf of the

corporation– Any person related to the incorporated employee– Is a specified shareholder (10% or more of shares)– The incorporated employee would reasonably be

regarded as an officer or an employee of the entity• Unless

– More than five full-time employees– Services are provided to an associated corporation

Discussion

• M Ltd provides management advisory services to ACC Ltd. And is not involved in any other business. M Mud is the sole shareholder and only employee. Mr Mud and his son each own 50% of ACC Ltd.

• PSB?• Specified investment income?• Active business?

Solution

• M is an active business. It is not a PSB as the services are provided to an associated corporation. M Ltd and ACC Ltd are associated. M Ltd is not specified investment business as the principal purpose is not to derive income from property.

Example

• XYZ Ltd owns an apartment building in downtown St Johns. The only employees of XYZ are the two shareholders. XYZ earns income from rents and has some interest income

• Is XYZ a specified investment business?• Would it matter if all apartments were on

leases and not month-to-month?• What if XYZ had 7 full time employees

Solution

• Specified invesment – YES – income is rent and less than 5 employees

• Leases vs mont to month – NO – leasing income is from leasing real property

• # of employees – YES – greater than 5 employees and there eligible for SBD

Incidental income

• Includes property income earned in conjunction with the activities of carrying on an active business.

Associated companies

• When two or more CCPCs are associated for tax purposes, the SBD is shared and is allocated annually.

Two corporations related where:

• Both corporations are owned by the same person (or common group)

• One corporation is controlled by one person who is related to a person or any member of a related group that controls the other corporation

• One corporation is controlled by one person or a related group and that person or one member is related to each member of an unrelated group which controls the other corporation

• Two corporations are controlled by unrelated groups and at least one member of one of the groups is related to each member of the other group

Related individuals

You

Parents and grandparents

SiblingsSpouses of siblingsSiblings of spouses

Children/children in lawadopted, children of spouse• Descendants

Siblings of your spouseSpouses of the siblings

of your spouse

Spouse Siblings

256(1)(c)

• Three conditions:– Control test:

• Each of the corporations must be controlled, directly or indirectly in any manner whatever by a person (includes corporation)

– Related test:• Person who controls one of the corporations must

be related to the person who controls the other one

– Cross-ownership test:• Either person owns not less than 25% of the issued

shares of any class other than a specified class

Specified class

• Shares are not convertible or exchangeable• Shares are non-voting• Dividends payable on the shares are fixed• Annual rate of dividends on shares does not

exceed prescribed rate of interest at the time shares were issued

• Redemption amount cannot exceed FMV of PUC plus unpaid dividends– Can’t make money on the sale

Illustration

• Group One Ltd: Mom and Dad• Group Two Ltd: Child of Mom and Dad

and Mom’s brother• Are Group One Ltd and Group Two Ltd

related?

Group One Ltd

Dad 50%

Mom 50%

Group Two Ltd

Child 50%

Brother 50%

Solution

• Group Two is controlled by unrelated group since it is uncle and child. Group One is controlled by related group (through marriage)

• Each member of related group that controls Group One is related to each member of unrelated group that controls Group Two.

• Corporations are related

Example

• Dad and Son (age 25) both own 100% of the common shares of their respective corporations Dadco and Sonco. Dad owns 100% preferred shares of Sonco (voting, 8% redeemable at $100,000)

• At issuance prescribed rate was 10% and FV was $100,000

• Are Dadco and Sonco associated?

Graph

Dad

Dadco Ltd (100%

common)

Son

Sonco Ltd (100%

common)

Solution

• Associated because:– Corporations are controlled directly– Dad and Son are related (parent-child)– Dad owns not less than 25% of Sonco (cross

ownership)– Preferred and common are not specified

classes because they are both voting

Example

• Mom owns 100% of common shares of Momco. Adult daughters 1 and 2 each own 35% of common shares of Sibco. Mom owns the remaining 30%

• Are Momco and Sibco associated?

Visual

Mom Daughter 1 Daughter 2

35% common

35% common

30% common

SibcoMomco

100% common

Solution

• Momco and Sibco are associated:– Mom controls Momco– Mom is related to each person who controls

Sibco– Mom owns not less than 25% of nonspecified

shares– Common shares of Sibco are not specified

shares (voting rights)

Example

• Alpha and Beta who are married each own 50% of the common shares of AB Ltd. Their son Alpha Jr and his wife own 40% and 30% respectively of Junior Ltd. Beta owns the other 30% of Junior.

• Are AB and Junior associated?

Visual

Alpha Alpha Jr Wife

30% common

40% common

50% common

Junior LtdAB Ltd

50% common

Beta

30% common

Solution

• Associated because:– AB is controlled by Alpha and Beta who are related

by marriage– Junior is controlled by any of

• Alpha Jr and Wife (marriage)• Beta and Alpha Jr (blood)• Beta and Wife (extended definition)• Alpha Jr, Wife and Beta are all related• All members of AB group are related to all members of

Junior group• One or more members of both groups must not own less

than 25%• Common shares are not specified

Concept of control

• Legal control– Ownership question

• Factual control– Lots of variables

Extended meaning of control

• A person or group of persons will be deemed to control a corporation when the person or group owns:– Shares representing more than 50% of FMV

of all issued and outstanding shares– Common shares representing more than 50%

of the FMV of all issued and outstanding common shares

• Rule ignores voting rights and looks at underlying value

Ownership of shares

• Look-through rules– Dilution of control through hierarchy

• Shares owned by a minor– Attribution and deeming rules apply

• Two other rules:– Rights to acquire shares or rights of a corporation

to redeem shares• Association with third company• Deemed association

– Need to demonstrate a non-tax reason for existence of corporations (hard to justify)

Example

Controller Ltd

Controlled Ont Ltd

Controlled Two Ltd

• Controller Ltd owns 60% therefore controls Controlled One.

• 60% of 55% is 33% therefore 256(1.2)(d) deems controlled by Controller Ltd.

60%

55%

Deemed association

• Where one of the main reasons for the separate existence of two corporations that are not otherwise associated is tax considerations, then they may be deemed to be associated

• SBD is shared within the associated group

M&P and the SBD

• Can have one or the other but not both• M&P is derived from the SBD calculation

therefore the calculation will exclude SBD income from M&P

Example

• During first year, Touchee-Feelee Ltd reported the following

• Corporation carries on business in Canada and is not associated

• All foreign tax recovered

• 96% of income earned is in a province

• What is the tax payable by the corporation?

M&P profits 80,000

Total active business income earned in Canada including M&P

105,000

Foreign ABI ($1,125 tax paid)

5,000

Taxable income 75,000

Division B income 110,000

Taxable dividends paid in the year

40,000

Solution

Taxable income 75,000

Basic federal tax (38%) 28,500

Abatement (10%) (7,200)

FBTC (1,125)

Small business deduction

17% of least of:

(1) ABI from Canada 105,000

(2) Taxable income 75,000

less 3X FBITC (3,375) 71,625

(3) business limit 400,000

(12,176)

M&P (all eligible for SBD) NIL

Part I tax payable 7,999

Provincial tax payable 3,600

Total payable 11,599

Incorporation

• Advantages and disadvantages

Advantages

• Limited liability• Tax savings if combined rate under 20%• Tax deferral at the higher personal income levels on income not

eligible for SBD• Income splitting potential• Estate planning advantages• Availability of ROO to owner as an employee• Separation of business and personal• Stabilization of individual income through salary or other

arrangements• Continuity issues• Deferral of capital gains on transfer of shares to spouse• Potential easier access to financing• Availability of capital gains exemption• Deferral of capital gains on sale of QSBCS

Disadvantages

• Tax cost if combined rate over 20%• Prepayment of tax at lower levels of

personal income• Additional costs of maintaining corporation• Loss of availability of losses to offset

personal income• Often the tax savings will outweigh the

disadvantages

Taxation of Active Business Income Not Eligible for SBD

Corporation

Income 1,000

Corporate tax 32.5%

(38% - 10% - 8.5% + 13%) (325)

Available for dividend 675

Individual

Dividend 675

Add gross up (45%) 304

Income subject to tax 979

25% 46%

Tax on dividend before credit 245 450

Total DTC (11/18 + 7/18) of 304 (304) (304)

Net tax (59) 146

Add tax paid by corporation 325 325

Total tax 266 471

Tax on income if unincorporated 250 460

Tax cost of incorporating on 1000 16 11

Deferral (prepayment) of tax in corp

(75) 135

Taxation of Active Business Income Eligible for SBD

Corporation

Income 1,000

Corporate tax 16%

(38% - 10% - 17% + 5%) (160)

Available for dividend 840

Individual

Dividend 840

Add gross up (45%) 210

Income subject to tax 1,050

25% 46%

Tax on dividend before credit 263 483

Total DTC (11/18 + 7/18) of 304 (210) (210)

Net tax 53 273

Add tax paid by corporation 160 160

Total tax 213 433

Tax on income if unincorporated 250 460

Tax cost of incorporating on 1000 (37) (27)

Deferral (prepayment) of tax in corp

(75) 300

Summary of costs

Average tax cost (saving)

Average tax deferral (prepayment)

Not eligible 1.4% 3.0%

Eligible (3.2)% 19.5%

Income from investments of a CCPC

• There are special rules to eliminate some biases between individual and corporation– Refundable tax (Part IV tax on portfolio

investments)– Dividend tax credit

Theory of perfect integration

Investment ABI

Federal rate 40% 40%

Abatement (10) (10)

Net federal tax 30 30

SBD (16)

RDT (20)

Net federal tax 10% 14%

Provincial tax 10% 6%

Effective tax 20% 20%

The reality

Investment ABI

Federal rate 38.00% 38.00%

Abatement (10.00) (10.00)

Net federal tax 28.00% 28.00%

Federal surtax 1.12 1.12

Additional RT 6.67 NIL

SBD (16.00)

Refundable DT (26.67)

Net federal tax 9.12% 13.12%

Provincial tax 14.50 5.00

Effective tax 23.62% 18.12%

Rates

• Effective tax rates are approximately the same when below $400,000

• Above $400,000 ABI rate is 36.62% vs 23.62% for investment income

Portfolio dividends

• Intercorporate dividends are deductible and therefore not subject to tax.

• Theoretically an individual could place high-yield investments into a corporation and defer tax

• Part IV tax is 33 1/3% on dividends from portfolios (not related)

• o/h

Additional refundable tax

• 6 2/3% x lesser of aggregate investment income and taxable income less amount on which SBD is based

Summarized as

Net TCG

Less NCL

Plus income from property

Less dividends deducted

Less losses from property

Refundable dividend tax on hand

• An account which accumulates all tax paid by a private company on its portfolio dividend income and a portion of Part I tax on other investment income

Summarized as

Refundable portion of Part I tax including ART paid on investment income

Amount of Part IV tax paid on taxable dividends

RDTOH balance at end of preceding year less dividend refunds of the previous year (arises when taxable dividends are paid)

Deeming rules

• Anti-avoidance provisions• Prevents associated companies from

creating losses or changing the nature of income

Deeming rules

Conditions Amount that would be income of the recipient company from property

Amount deductible in computing income from an active business of an associated payer company

Effect Amount not included in income from property

Amount deemed to be income of the recipient from active business

Application Eligible for the SBD to the extent that the associated group of companies has not exceeded the $400,000 limit

Why incorporate investment income?

• Advantages and disadvantages

Advantages

• Tax deferral if shareholders combined marginal tax rate is greater than combined corporate of 46 2/3%

• Negligible absolute tax saving as a result of the operation of the DTC in some provinces and a small tax saving where combined federal and provincial rate is less than 46 23%

• Greater flexibility in income payment• Estate planning advantages• Possible income splitting• Possible avoidance of foreign estate taxes by

placing foreign property in a Canadian corporation

Disadvantages

• Prepayment of tax if shareholders combined marginal tax rate is less than corporate tax rate

• Additional tax cost if combined corporate rates are over 46 2/3%

• Additional costs• Loss of availability of investment and

capital losses to the individual

Illustration of application

Taxable dividends paid 30,000

ABI 148,560

Investment income

Taxable CG 3,000

Net property

CDN source 2,000

Foreign (375) 2,500 7,500

112 dividends 13,000

Total net income 169,060

Deduct dividends 13,000

Deduct net capital losses 700

Taxable income 155,360

Part I tax on taxable income

Tax @ 38% on 155,360 59,037

Less federal abatement (10% x 155,360)

(15,536)

Net 43,501

Add refundable tax (6 2/3% x 6,800)

453

43,954

Less NBFT 375

SBD (17%) 25,255

Tax reduction NIL 25,630

Total Part I 18,324

Prov tax @ 10% 15,536

Total tax 33,860

Required

• Compute the refundable dividend tax on hand at the end of 2008 and the dividend refund for the 2008 tax year

Solution

• Part IV Tax payable Taxable dividends subject to Part IV

13,000

Part IV tax at 33.33% 4,333

RDTOHRefundable portion of Part I Tax

Least of

(a) 26 2/3% x AII ($6,800)

1,813

less NBFTC 375

minus 9 1/3% x FII ($2,500)

(233) (142) 1,671

(b) taxable income 155,360

less SBD amount (148,560)

25/9 x NBFTC ($375)

(1,042)

3 x BFTC NIL

26 2/3% x 5,758 1,535

(c) Part I tax 18,324

Refundable portion of Part I tax 1,535

Part IV tax payable 4,333

RDTOH 5,868

Dividend refund

Taxable dividends paid (30,000 x 1/3)

10,000

RDTOH at ye 5,868

Dividend refund (lesser of)

5,868

Summary of taxes payable

Part I tax (including provincial tax) 33,860

Part IV tax 4,333

38,193

Less dividend refund 5,868

Net taxes payable 32,325

Notes to solution

• If any of the dividends were from a connected corporation, then no Part IV tax is payable unless there is a dividend refund in the connected corporation

Problem 9

Analysis of income – step 1

ABI Investment DividendSource

Cdn. For’n. PSB Cdn. For’n. Conn. Port. TotalManufacturing $191,000 $191,000

Dividend $11,000 $20,000 31,000

Net taxable capital gains $17,000 17,000

Royalties 9,000 9,000

Recapture 4,000 4,000

Rental 14,000 14,000

Foreign $6,000 $23,000 29,000

Interest — A/R 5,000 5,000

Division B income $200,000 $6,000 Nil $40,000 $23,000 $11,000 $20,000 $300,000

Analysis of Division B Income

Part I taxTaxable income

$ 226,000Tax @ 38% of taxable income (38% of $226,000)

$ 85,880Less: Federal and provincial abatement

½

.91 $226,000 = $205,660

10% of $205,66020,566

Federal tax after abatement$ 65,314

Additional refundable tax: 62/3% of lesser of:

(a) Aggregate investment income ($40,000 + $23,000 – $7,000) $ 56,000

(b) Taxable income – SBD amount ($226,000 – $200,000) $ 26,0001,733

$ 67,047Deduct: Non-business foreign tax credit (given) $ 3,450

Business foreign tax credit (given) 1,800

Small business deduction (see Schedule 1) 34,000

General reduction (see Schedule 2) Nil39,250

Tax before investment tax credit$ 27,797

Deduct: investment tax credit (25% of capital cost of eligible child care space expenditures = 25% of $32,000)

8,000Part I tax payable (federal)

$ 19,797Provincial tax @ 5% of $226,000 .91

10,283Total tax

$ 30,080Summary of tax:

Part I tax payable (federal and provincial)$ 30,080

Part IV tax payable (see separate calculation)9,417

$ 39,497Less: dividend refund (see separate calculation)

11,985Net tax payable

$ 27,512

91.000,254$

000,238$

000,996,1$

000,776,1$

SBD and GRRIncome from active business carried on in Canada $200,000Taxable income $226,000

Less sum of:

(i) 10/3 foreign investment income tax credit (10/3 $3,450) (given)

$11,500(ii) 3.77 foreign business income credit (3.77 $1,800)

(given)6,786 18,286 $207,714

Business limit (agreed allocation of $200,000 leaving $300,000 for the subsidiary) $200,000Deduction: 17% of $200,000 $34,000

taxable income $226,000

less: 100/17 of the small business deduction $ 200,000

AII 56,000 (256,000)

net $ Nil

11.5% of Nil $ Nil

RDTOHNon-connected taxable Canadian corporations (portfolio dividends) (331/3% of

$20,000) $ 6,667Connected private corporation which triggered a dividend refund ($2,750 100%)

2,750 $ 9,417Refundable Portion of Part I TaxLeast of:

(a) 262/3% aggregate investment income(262/3% $56,000) $14,933Less: non-business foreign tax credit $3,450

minus: 91/3% foreign investment income91/3% $23,000) (2,147)

(1,303) $13,630(b) Taxable income $226,000

Less: Amount eligible for the SBD (200,000)25/9 non-business FTC ($3,450) (9,583)3.77 business FTC ($1,800) (6,786)

262/3% $9,631 = $ 2,568(c) Part I tax $19,797

Refundable portion of Part I tax: least of (a), (b) and (c) 2,568RDTOH as at December 31, 2011 $11,985Dividend RefundLesser of:

(i) 1/3 dividends paid (1/3 $72,000) $24,000(ii) RDTOH as at December 31, 2011 $11,985

Next week

• Read chapter 13• For inclass discussion: Chapter 12

Problems 14 & 15