The Impact of Integration on Owner-Manager Remuneration Strategies
Over the next several years, significant federal corporate tax rate reductions are scheduled to be phased-in. At the same time, the effective tax rate on eligible dividends is scheduled to increase. If you carry on business using a corporation and have income subject to the top corporate tax rate, these rate reductions will have a considerable impact on your owner-manager remuneration strategy. In this article, we will review the concept of “integration”, the upcoming tax rate changes and address the impact of these changes on your remuneration strategy.
Integration Basics
As an owner-manager, there are two main methods by which you can receive remuneration from your corporation. You could pay yourself a salary, which is generally a deductible expense for your corporation and is fully taxable to you. Or you could have the income taxed in your corporation, and then pay the after-tax income out to you as a shareholder as a taxable dividend. You could also pay yourself a mix of salaries and dividends. Since dividends and salaries are subject to different tax consequences, there can be differences in the tax cost under each alternative. Any dividends received from your corporation are taxed at reduced personal tax rates, which take into account the fact that the income has already been taxed in your company. When you report dividends on your personal tax return, you first “gross-up” the dividend (to approximate the pre-tax corporate income out of which the dividend was paid) and you can claim a dividend tax credit to reduce your personal tax (which is intended to approximate the corporate tax that was paid by your company).
The Canadian tax rules are based on the concept of integration. A tax system is said to be integrated if the same amount of overall tax is paid when the income is earned indirectly through a corporation or directly by an individual. Integration, however, only works when corporate and personal tax rates are set at appropriate levels.
In the past, the concept of integration only worked for business income earned in a Canadian-controlled private corporation (CCPC) that was eligible for the small business deduction (allowed on the first $500,000 of active business income earned by a CCPC). Income earned by CCPCs that was over the small business limit, or business income earned by another type of corporation (such as a public company), were subject to higher corporate tax rates. All dividends, however, were subject to the same personal tax rates and these personal rates were set at a level to ensure that integration worked for CCPCs. Therefore, dividends paid out of business income subject to the top corporate tax rates were under-integrated, resulting in some double taxation when these dividends were paid out.
This all changed in 2006 when the concept of “eligible dividends” was introduced. In very basic terms, an eligible dividend is a dividend paid after 2005 by a corporation from business income that was taxed at the top corporate rate. These dividends are subject to a different gross-up and tax credit that reduces the effective personal rate of tax on the dividend and addresses the under-integration problem associated with business income subject to top corporate tax rates. The result is that there are now two distinct integration systems — one for “eligible” dividends paid out of business income subject to the top corporate tax rates and one for “ineligible” dividends paid out of corporate income taxed at small business rates. That said, our integration systems do not work perfectly — there can be a savings or a cost of having business income taxed in your corporation and then paid out as a dividend under both systems. And while the majority of the provinces and territories have made changes to how they tax both eligible and ineligible dividends, there are some jurisdictions where integration costs remain and must be taken into account in coming up with an appropriate owner-manager remuneration strategy. As an appendix to this publication, we have reproduced a chart from our Incorporating Your Business bulletin which shows the relative costs of distributing corporate income in 2009 as a dividend.
Note, however, that if income is taxed at the corporate level and the payment of dividends is deferred into subsequent taxation years, a deferral of the personal tax on the dividends will be achieved. The advantage of this tax deferral is often more than enough to compensate for any integration cost that exists by having the business income taxed at the corporate level and must also be taken into account in coming up with an appropriate remuneration strategy.
Eligible Dividend Rate Changes and the Impact on Remuneration Planning
We are currently in a period of changing tax rates that is complicating owner-manager remuneration strategies. There will be significant reductions in the federal corporate tax rate on general business income over the next few years that will reduce the rate from 19% this year to 15% by 2012 (note that many provinces are reducing their general corporate tax rate as well). At the same time, the personal tax rate on eligible dividends is being increased, to take into account the corporate tax rate reductions and to ensure that integration will still work on business income that is taxed at the top corporate tax rates. The top federal marginal tax rate on eligible dividends will increase from 14.55% this year to 19.29% by 2012. Details of these rate changes are provided in the table below.
As a result of the changes in the federal personal tax rate on eligible dividends and the reductions in the top federal corporate tax rate, over the next 4 years integration will generally work for business income taxed at the top corporate tax rate and paid out as an eligible dividend, but only if the dividend is paid in the same year. When the payment of an eligible dividend is being deferred to a subsequent year, integration will not work and there will be an integration cost, as the tax rate on eligible dividends is increasing.
As a result, it is very important over the next few years to take into account when eligible dividends are expected to be paid. In the next few years, if you are planning to pay an eligible dividend from your corporation, it may make sense to accelerate payment of that dividend a year or two in order to pay tax on the dividend at a lower tax rate. Note that there are other considerations that need to be taken into account as well before making this decision — for example, you will need to assess the impact that accelerating the payment of a dividend will have on your personal tax instalments. If you have no plans to pay a dividend in the near future and you retain the income in the corporation for an adequate period of time, the deferral of personal tax on the dividend will more than likely outweigh the integration cost that may be caused by the increasing tax rate on eligible dividends.
With the scheduled changes to corporate tax rates and the taxation of eligible dividends, it is important to understand the impact these changes will have on your remuneration strategies. Consult your BDO advisor to ensure that your remuneration planning makes sense for your situation.
Next section:
The Tax Advantages of Incorporating for Professionals
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