Impact of the Taxation of Dividend Proposals on Owner-Manager Remuneration Planning in Québec
Issued October 20, 2006
Status of Taxation of Dividend Rules
Income earned at the corporate level is subject to both corporate income tax and, on distribution as dividends to individuals, personal income tax. The personal income tax system provides partial relief from corporate income taxes to individuals on dividends paid by Canadian corporations through the gross-up and the dividend tax credit system. This system generally works well when corporate income tax is paid at the small business rate. When income is taxed at a higher rate, the system does not provide sufficient relief for taxes paid at the corporate level. Previously, the taxation of business income in a corporation that was not eligible for the small business deduction was not “integrated”. What this meant is that earning business income in a corporation and then paying out a dividend out of the after-tax income to the shareholders resulted in more tax than if the income was earned by an individual directly.
Federal Response
The former Liberal government announced changes to the rules for the taxation of dividends, intended to level the playing field between corporations carrying on business and the use of income trusts. Under the new rules, “eligible dividends” are to be grossed-up by 45% (rather than 25%) and a new dividend tax credit is allowed (equal to 18.966% of a taxable dividend or 27.5% of the actual dividend). In general terms, eligible dividends are designated dividends paid by public corporations and other corporations that are resident in Canada from income that is not small business income or investment income. The new dividend rules apply federally for dividends paid after 2005.
Québec Response
In the 2006 Québec budget, a new dividend tax credit was proposed for eligible dividends that are paid or are deemed to have been paid after March 23, 2006. The 45% gross-up will apply for Québec purposes and the Québec dividend tax credit will be 11.9% of the taxable dividend or 17.255% of the actual dividend. The government of Quebec has also announced that the dividend tax credit on ineligible dividends, which are basically dividends paid out of small business income or investment income, will be reduced from 10.83% to 8.0% of taxable dividends or from 13.5375% to 10% of actual dividends.
Combined top marginal tax rate – With the changes, the top marginal Federal and Québec tax rates will be 29.69% on eligible dividends and 36.35% on ineligible dividends after the changes vs. 32.81% before these changes were announced.
The Integration Issue and Owner-Manager Remuneration
As just discussed, the taxation of business income in a corporation that was not eligible for the small business deduction was not integrated, as more combined tax would be payable if the corporation was taxed on this income and it was then paid to top-rate individuals as a dividend. The solution to this problem was generally to bonus down to the small business limit (generally the greater of the Federal or provincial small business limit).
For Québec in 2006, with the introduction of a corporate small business rate and a $400,000 limit for that rate, the bonus decision actually became a two-step process – deciding on whether bonusing down to the Québec small business limit of $400,000 makes sense, and if a bonus did make sense, then deciding on whether a further bonus should be declared to reduce income to the Federal small business deduction limit. This would be a two step process in Québec as unlike the other provinces, there is not a significant difference between the general rate on business income and the small business rate.
The bonus decision, however, was more complicated than that, as even though there could be an overall integration cost associated with not bonusing out income, there is also an initial tax deferral provided by not bonusing, as the general corporate tax rate is lower than the top personal tax rate. In other words, the integration cost was not realized until a dividend is paid, and if that dividend payment could be delayed long enough, the eventual integration cost can be mitigated if the tax deferred is reinvested long enough.
Under the new rules proposed, a corporation’s “general rate income pool” (in very basic terms, after-tax income that is not small business income or investment income) can be paid to shareholders as an eligible dividend, which is taxed at a lower personal tax rate.
The general rule in Québec before the introduction of the taxation of dividend rules was to retain high-rate corporate income, and that rule has not changed with the taxation of dividend changes.
Other Factors to Consider
The following is a brief description of some items that may be worth considering, when a corporation is considering either bonusing down or paying a dividend.
Québec Payroll Tax - When a bonus is paid to an owner-manager, the bonus will be subject to the payroll tax to the extent that total remuneration paid with the bonus exceeds $1 million. The tax rate for the payroll tax varies depending on the amount of the payroll. Remunerating an owner-manager by way of a dividend will not be subject to payroll tax.
RRSP earned income – Where cash is available in the corporation and the shareholders will require cash as well, consideration should be given to paying at least enough salary ($105,556 in 2006) to allow for a maximum RRSP deduction of $19,000 in 2007.
Impact of eligible dividends on tax credits and OAS – With a 45% gross-up, eligible dividends will result in higher net income, which could have a negative impact on credits and benefits, such as Old Age Security (due to the clawback), the age credit, the GST credit, child tax benefits and provincial tax credits.
Alternative Minimum Tax – Although eligible dividends will attract less regular income tax, eligible dividends and ineligible dividends are subject to AMT based on the actual amount of the dividend paid.
Preferential R&D rules – Special rules are available for CCPCs and these incentives can be lost if a corporation’s taxable income for the prior year is greater than $300,000 (where the previous year ends in 2006).
There are many issues to consider when remunerating an owner-manager – for more information on your specific situation, contact your BDO Advisor.
