Executive summaryOn 9 December 2015, Bill C-2, An Act to amend the Income Tax Act, received first reading in the House of Commons. This bill includes a number of the majority Liberal Government’s election platform personal income tax proposals, including the proposed 4% increase in the top marginal personal income tax rate on income in excess of $200,000.

The bill also includes amendments to the taxation of investment income of private corporations, including Canadian-controlled private corporations (CCPCs), by imposing an additional 4% refundable tax on such investment income and an additional 5% refundable tax on portfolio dividends. Consequential amendments have also been made to the refundable dividend tax refund mechanism and the gross-up factor that applies to foreign non-business income. These measures are considered substantively enacted for tax accounting purposes as of 9 December 2015.

These consequential amendments are intended to prevent any incremental deferral advantage associated with earning investment income through a corporation, but introduce new complexities with respect to the integration of the tax system on future income and moreover to the future taxation of existing retained earnings.

Affected taxpayers should discuss with their tax advisor before 31 December 2015 the implications to their private corporation’s current retained earnings and their dividend policies.

14 December 2015

Global Tax AlertNews from Americas Tax Center

Canada amends taxation of investment income earned through a private corporation

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2 Global Tax Alert Americas Tax Center

Detailed discussionSummary of the changesAs a result of the proposed increase in the top marginal personal income tax rate from 29% to 33% on an individual’s taxable income in excess of C$200,000, the Government has announced consequential amendments to the refundable Part I tax, Part IV tax and the refundable dividend tax on hand (RDTOH) mechanism:• Increase in the portion of Part I tax on investment income

earned by a CCPC that is refundable, from 26.67% to 30.67% — the Part I tax rate on investment income for CCPCs being increased from 34.67% to 38.67%

• Increase in the refundable Part IV tax rate on portfolio dividends received by a private corporation from 33.33% to 38.33%

• Increase in the rate at which dividend refunds are paid out of a private corporation’s RDTOH balance from 33.33% to 38.33%

• Other consequential amendments related to the calculation of the RDTOH balance

These amendments generally apply for taxation years that end after 2015 (prorated for taxation years that straddle 1 January 2016), except that the increase in Part IV tax applies to dividends received after 2015.

The intent of these changes is to eliminate the incremental tax-deferral advantage for individuals earning investment income through a corporation that would otherwise have resulted from the 4% increase in the top marginal personal income tax rate.

Background on integration of investment incomeIntegration is a fundamental concept of the Canadian federal income tax system. The theory of integration is that the total tax paid on investment income (such as interest, capital gains and dividends) is the same whether the income is earned by an individual directly or through a corporation and paid to the individual as a dividend.

As corporate tax rates are generally lower than personal rates, this is accomplished through refundable taxes, which are also designed to eliminate the deferral aspect of earning

such income through a corporation. However the concept of integration generally assumes that the top marginal rate is being paid on a dividend distribution, which may not always be the case. Moreover, the effectiveness of integration is influenced by year-over-year rate changes and by varying top marginal rates by province.

Similarly, dividends are permitted to pass between taxable Canadian corporations on a tax-free basis. However, this may result in an unintended deferral of personal tax when an individual arranges for his or her investments in shares to be held by a corporation (which would otherwise receive dividends on the shares tax free). Part IV tax reduces or eliminates any deferral that may be achieved.

Implications of the changes Due to the significant increase in the top marginal personal income tax rate, the above-noted changes need to be considered in the context of both existing retained earnings balances (i.e., prior years’ earnings) and future earnings (in 2016 and later years).

Prior years’ earnings Although the integration of future earnings (as described below) has not changed significantly on a current-year basis as a result of the federal changes, what has changed significantly is the pure tax cost of keeping prior years’ earnings in a corporation and distributing taxable dividends after 2015 when the top marginal personal income tax rates on eligible and non-eligible dividends are much higher.

The increase in the top marginal personal tax rates on eligible and non-eligible dividends for 2016 and later years effectively results in a retroactive tax increase on the distribution of prior years’ retained earnings. It is therefore necessary for shareholders to consider whether it is better to distribute taxable dividends or retain funds within the corporation for a continued deferral of personal income tax. The required length of deferral and rate of return to recover the additional tax cost will depend on the individual’s income bracket and province of residence.

Global Tax Alert Americas Tax Center 3

To illustrate, assume an individual who is in the top income bracket and resident in Ontario has a CCPC that earns C$100,000 of interest income in 2015. The tax consequences of earning the interest income in 2015 and distributing it as a dividend in 2015 versus 2016 or 2019 are as follows:

Gross revenues 2015 2016 2019

Interest income $100,000 N/A N/A

Corporate tax (federal and Ontario combined) $46,170 N/A N/A

Net cash $53,830 $53,830 $53,830

RDTOH $26,670 $26,670 $26,670

Available for distribution to shareholder (assumes dividends can be paid to fully recover RDTOH)

$80,500 $80,500 $80,500

Personal tax (at non-eligible dividend rate) $32,305 $36,467 $37,634

Net after-tax cash $48,195 $44,033 $42,866

Effective combined tax rate 51.81% 55.97% 57.13%

Therefore, there is an additional tax cost of 4.16% if the 2015 earnings are distributed in 2016 instead of 2015, and 5.32% if the 2015 earnings are distributed in 2019 instead of 2015. It would require a very long deferral period and a significantly high rate of return to recover this additional tax cost if the earnings are left in the corporation.

It is also important to note that no adjustments are being made to existing RDTOH balances. As such, a CCPC will be required to pay a smaller dividend in 2016 and later years to recover existing RDTOH, since the RDTOH will be refunded at a rate of 38.33% (instead of 33.33%) of taxable dividends paid. However, this smaller dividend will still be subject to the higher personal tax rate if the individual is in the top tax bracket. As a practical matter, the smaller dividend would leave retained earnings in the company for which the future distribution of it would not result in the benefit of a dividend refund.

Future earnings (post-2015)In the context of future earnings, the changes ensure there is no incremental deferral advantage associated with earning investment income through a corporation as a result of the 4% increase in the top marginal personal income tax rate.

The changes do not significantly alter the federal integration of future investment income earned through a CCPC and taxed at the federal top marginal personal income tax rate. However, it is also necessary to consider the impact of these federal changes in the context of the related provincial income tax implications.

The integration analysis will vary by province and for individuals in lower income brackets. It is therefore essential for individuals earning investment income through a corporation to perform an integration analysis for their own particular situation. In addition, it is unclear at this time how the provinces will react to the federal changes and whether future changes to provincial personal or corporate income tax rates will be introduced.

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Immediate planning considerationsIndividuals earning investment income through a CCPC should consult with their tax advisor on what immediate actions, if any, should be taken to minimize the impact of the proposed changes. Each individual situation will vary depending on: • The individual’s financial needs

• The individual’s income bracket

• Availability of cash or liquidity of investments within the corporation

• The balances in the corporation’s general rate income pool (GRIP), capital dividend and RDTOH accounts

• The province (or provinces) in which the individual and corporation is liable for tax.

In some cases, it may be desirable to distribute income from the corporation before 2016 to avoid paying the higher rates of tax at the top federal income bracket on eligible and non-eligible dividends in 2016.

For additional information with respect to this alert, please contact your EY or Couzin Taylor advisor.

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