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If you haven’t reviewed your remuneration plan recently, some changes may produce significant savings |
At one time, when planning tax-effective owner-manager remuneration strategies, there was an almost universally accepted belief that paying out bonuses to owner-managers to reduce corporate income to be at or just below the small business limit was the way to go (the small business limit is currently $500,000 federally and in all provinces except Manitoba and Nova Scotia). This was because income in the company taxed at the small business rate, and then paid out as dividends to an individual, would cost the owner-manager approximately the same amount of tax as if that income were paid as remuneration. But, income taxed at the general business rate would be subject to a higher overall amount of tax once the net income was paid out as a dividend to the individual owner-managers. That is, “integration” would be achieved at the lower small business corporate tax rate, but would not be achieved at the higher general corporate tax rate. This was because the federal government and most provinces placed a priority on ensuring small business income was integrated.
However, the corporate tax system was substantially changed in 2006 with the introduction of the eligible dividend rules as an initial step to counter the stampede of corporate conversions to income trusts. At the same time, the federal government and some provincial governments started a gradual process of lowering general corporate tax rates. Soon it became clear that as the general tax rate changes were phased in, the tax cost of keeping “high-taxed” general corporate income in Canadian-controlled private corporations was going to decline dramatically, particularly in those provinces which also undertook to reduce provincial corporate tax rates.
The tax rate comparison chart on page 3 shows where we stand in 2011, assuming that the federal corporate tax reductions proceed as announced to April 30, 2011, and that dividends are paid out in the year earned. We have used Ontario rates below to demonstrate how the numbers work in the chart on page 3. However, especially for provinces west of Ontario, most of the conclusions will be equally applicable in other provinces.
In evaluating the tax costs of keeping business income over the small business limit in a corporation compared to paying such funds to the owner-manager as remuneration, there are two components to consider. The first is that if corporate tax rates are 28% and personal tax rates are 46.41%, there is a deferral advantage if income is initially taxed in the corporation, and retained there for some period of time. The second consideration is the overall tax cost of retaining funds and eventually paying an eligible dividend to owner-managers compared to the overall tax cost of paying remuneration in the year the funds are earned. Where the tax deferral is long enough, the deferral benefit can more than offset the higher integrated tax cost which results if the income is initially retained in the business. The break-even point will be dependent on your company’s cost of capital. Of course, any such calculation is just an estimate, but it is important to understand the two parts to the analysis.
In 2011, the deferral factor in Ontario will be 18.41% on funds subject to the general rate of income tax, meaning that there will be an initial benefit (of 18.41%) of retaining income. However, the integration factor is 1.88%, meaning that the total integration cost after the flow through of the dividends is 1.88%. At this low cost, the deferral benefit will generally offset this integration cost, unless the income will be paid to the shareholder in the very near future. To illustrate how substantially things have changed, the deferral factor in 2005 was at best 10.3% while the integration cost (without the Ontario clawback) was 9.7%. There have been similar and major shifts in most other provinces.
A complicating factor to this analysis is the fact that the personal tax rate on dividends will increase between 2011 and 2012, and then is projected to remain at the 2012 rate. This means that income earned in 2011, and paid out as a dividend in 2012 or future years, will have a higher integration cost than if it is paid out as a dividend in 2011. The integration factor in Ontario for 2011 income paid out in 2012, for income earned after July 1, 2011, is 2.86%. Because the personal tax rates on dividends are not scheduled to change after 2012, this is an issue for 2011 only.
As the Ontario corporate general tax rate will continue to decline, to a combined federal and provincial tax rate of 25% by July 1, 2013, the integration cost will be reduced to less than 1% by 2014. At current and announced tax rates, similar results are expected (or are already available) in British Columbia, Alberta, Saskatchewan, Manitoba, New Brunswick, the Yukon and the Northwest Territories.
Of course, a decision to bonus or pay dividends is based on several factors other than the immediate income tax cost. These other considerations often include determining whether a salary should be paid to the owner-manager to allow maximum Registered Retirement Savings Plan (RRSP) contributions and to allow Canada Pension Plan contributions to be made. Depending on the size of the company payroll and the province(s) of operation, there may be payroll taxes to pay on remuneration, which can increase the cost of this option. Another consideration is that paying a salary sets up the ability to create an Individual Pension Plan, but these plans will become much less popular due to the 2011 budget proposal that will eliminate or greatly reduce deductible past service contributions by employers (see “Individual Pension Plans — Do They Still Make Sense?” in this edition of the Tax Factor).
We believe that these tax changes will create a significant increase in the use of investment holding companies as a primary retirement savings vehicle and in the use of corporations that carry on a personal services business.
Holding company for your retirement portfolio
If a decision has been made that it is better to retain earnings in your corporation, rather than to bonus out the funds, a decision needs to be made of how to invest such funds if they are surplus to the current needs of the business. If the funds are surplus to the needs of the business, often a holding company will be set up and the excess funds can be distributed to the holding company via a tax-free inter-corporate dividend. The holding company can be used to separate investment funds from the risks of the operating business, and can also be used as an incorporated investment portfolio. Also, where there are multiple shareholders, each shareholder can set up their own holding company to allow for maximum flexibility.
Mixing investment earnings in a holding company with eligible dividends received from the operating company can also enhance the deferral benefit. This is because the investment income is subject to a refundable tax, which is refunded on the payment of a dividend. If the dividend refund can be triggered by flowing an eligible dividend from the operating company through the holding company to shareholders, this could result in a significant tax deferral on the investment income earned by the holding company. In an ideal situation, the cash paid out as an eligible dividend will be just large enough to cover personal costs and to trigger a full refund of the refundable tax.
The significant deferral on general rate income that is now available may make maintaining investments in a corporation a more tax efficient solution to retirement savings than paying salary or bonuses to make the maximum annual RRSP contribution. Again, such an analysis must be made based on individual circumstances. However, factors favouring using an incorporated investment portfolio include:
- The timing of dividends paid from the corporation is entirely discretionary, unlike a Registered Retirement Income Fund which has mandatory minimum payments. This means that dividend payments can be controlled to ensure that Old Age Security and certain income based credits are not clawed back, especially if immediate cash is not needed,
- It may be possible to split income with adult children and a spouse (subject to specific conditions),
- The amount of dividends that can be received tax-free each year is much higher in many provinces than the amount of RRSP income, due to the dividend tax credit and due to the fact that investment income in an RRSP is taxed as ordinary income when paid out, and
- If there is value remaining in the holding company at death, that value will be subject to tax as a capital gain (subject to post-mortem planning).
Personal Services Businesses
Another idea that needs to be looked at differently with the reduction in general tax rates is the idea that retaining income in a corporation operating a personal services business is detrimental. A personal services business means a business of providing services where an individual who performs services on behalf of the corporation (or a related person) owns at least 10% of the corporation and the individual would reasonably be regarded as an officer or employee of the business to whom the services were provided if it were not for the existence of the corporation. There are exceptions if the corporation employs more than five full-time employees in the business throughout the year or the services were rendered to an associated corporation. We discussed these rules in more detail in the 2007-03 issue of the Tax Factor, “Independent Contractors and Personal Services Businesses”.
With the new tax rate environment, an employee may wish to incorporate their services, such that their service company provides their services to their former employer, and they now provide the same services that they used to provide directly, but through their service company. For example, say that John is the president of A Co and a resident of British Columbia. As an officer of the company, he is an employee. John sets up a British Columbia service company, owned by him, called John’s Services Ltd. (JSL). JSL then bills A Co. for “executive services”. The executive services income is taxed in JSL, or it can be paid to John as an employee of JSL. Because JSL only has one employee, John, and because of the nature of the services provided to A Co, JSL will be a corporation operating a personal services business. Any income of JSL not paid as employment income to John or as certain employment related expenses, will be taxed in JSL at the general corporate rate, or 26.5% in 2011. To the extent that this income is surplus to John’s current year needs, it can be kept in the company and a deferral of 17.2% has been achieved. In order for this tax deferral planning to be most effective, any employment or personal expenses not allowed to be deducted in JSL, such as office in the home expenses or child care expenses should be incurred by John personally, and a salary large enough to deduct these expenses on John’s personal tax return should be paid. As John will need at least some money to live on, he’ll need to decide on whether he should receive these additional funds as a salary or as dividends. In addition to tax rate considerations and creating a dividend refund if a dividend is paid, he’ll need to consider other issues, such as whether he wants to make CPP contributions and whether salary should be used to create earned income to allow for RRSP contributions.
If you haven’t reviewed your remuneration plan recently, some changes may produce significant savings. Given the complexity of implementing this planning, consult your BDO advisor to ensure that your remuneration strategy is the best for your current and future interests.
Next section: Individual Pension Plans - Do They Still Make Sense?
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