As part of its 2018 budget, the federal government announced two proposed measures to restrict the tax advantages of earning passive investment income in a private corporation:
- Limiting access to the small business tax rate
- Limiting access to refundable taxes
This article focuses on the second measure by explaining changes to the rules for obtaining a refund from the refundable dividend tax on hand (RDTOH) account that were proposed in the budget.
Refundable dividend tax on hand (RDTOH)
Canada has a tax system for Canadian private corporations and their shareholders that is built on the concept of “integration.” Briefly, this means an owner earning investment income in a corporation should pay the same amount of tax on that investment income as they would pay if such income was earned personally. Part of integration is a refundable tax mechanism, refundable dividend tax on hand (RDTOH), that applies on income earned from passive investments held in a private corporation. Generally, under this mechanism, passive investment income earned by a Canadian controlled private corporation (CCPC), such as interest, rents, royalties, taxable capital gains and portfolio dividends from foreign corporations, is subject to a higher tax rate than active business income, and a portion of that higher tax is refunded to the corporation when it distributes taxable dividends to its shareholders. Subjecting such investment income to a higher tax rate up front can reduce the incentive of retaining this income in a private corporation.
There are generally two components to the RDTOH account in a corporation. The first arises from “Part 1 refundable tax,” and the second from dividends received from other corporations. These two components are discussed in further detail below.
Part I refundable tax
Let's consider how the refundable tax mechanism works in more detail. Passive income earned by a CCPC is taxed at a high combined corporate tax rate, ranging from 50.17 percent to 54.67 percent in 2018 (depending on the province or territory). This includes a federal refundable tax of 10.67 percent.
The combined rate is much higher than the combined general tax rate that applies to active business income (which ranges from 26.5 percent to 31 percent depending on the province or territory). The refundable portion of the taxes (i.e., 30.67% of investment income) is added to the corporation's RDTOH) Note that foreign investment income on which a foreign tax credit is claimed results in an adjustment that reduces the RDTOH account. A tax refund is allowed to the corporation upon payment of a taxable dividend. The refund is determined at a rate of 38.33 cents for every $1 of taxable dividends paid, limited to the balance in the RDTOH account.
Taxable dividends are classified as either eligible or non-eligible, and this determines the rate of tax applicable to the receiving individual shareholder. Eligible dividends are paid from the active business income taxed at the general corporate rate. Non-eligible dividends are generally paid from active business income taxed at the small business rate or from passive investment income. It is important to note that eligible dividends are taxed in the hands of the individual shareholder at a lower rate than non-eligible dividends. For example, in British Columbia, the current 2018 tax rate on eligible dividends to an individual taxable at the top rate is 34.19 percent, while the equivalent rate on non-eligible dividends is 43.73 percent. The rates on both types of dividends vary by province or territory.
Currently, the payment of either an eligible or non-eligible dividend will generate a dividend refund where the corporation has an RDTOH account balance. This means that a corporation can receive an RDTOH refund upon the payment of a lower-taxed eligible dividend sourced out of business income taxed at the general corporate rate in situations where the RDTOH was generated from investment income that would need to be paid out as a higher-taxed non-eligible dividend.
This can result in a tax deferral advantage — the corporation gets tax refunded, plus the individual pays lower tax on the eligible dividend. The higher-rate personal tax on the non-eligible dividend is effectively deferred until a non-eligible dividend sourced from investment income is paid. Assuming the top personal tax rates for 2018, deferral of personal tax when an eligible dividend is paid to generate a dividend refund for the corporation ranges from 1.2 percent to 13.37 percent depending on the province or territory. This is the tax rate differential between eligible dividends and non-eligible dividends.
Dividends received from other corporations
The explanation above deals with the RDTOH account that arises from tax on investment income earned in the corporation, also known as Part I refundable tax. However, there is a second component of the RDTOH account, and that comes from dividends received from other corporations. When a corporation holds portfolio investments in other Canadian corporations, dividends from these corporations are not subject to regular corporate tax, but are subject to a fully refundable tax of 38.33 percent, known as Part IV tax. For dividends from non-portfolio, or “connected” corporations (where there is at least 10 percent ownership), these dividends can be received tax-free, except where the recipient corporation must pay tax equal to the amount of tax refunded to the payor upon payment of a dividend. In that case, the tax is added to the recipient's RDTOH account.
The budget's new rules
To eliminate the tax deferral advantage, the budget proposes that a refund of RDTOH will only be available where a private corporation pays non-eligible dividends, with one exception for RDTOH that arises from eligible portfolio dividends received by a corporation. This new measure will apply to taxation years that begin after 2018.
To implement the change, there will be two separate RDTOH accounts. The current RDTOH account will be known as “non-eligible RDTOH” and will track refundable taxes paid under Part I on investment income, as well as under Part IV on non-eligible inter-corporate dividends. Refunds from this account will be obtained only when non-eligible dividends are paid.
A new RDTOH account, known as “eligible RDTOH,” will track refundable taxes paid under Part IV on eligible portfolio dividends. Under the proposed changes, the payment of a non-eligible dividend can result in a refund from the eligible RDTOH account only when there is no balance left in the non-eligible RDTOH account. Otherwise, only the payment of an eligible dividend will result in a dividend refund from the eligible RDTOH account.
As noted above, where a corporation pays a dividend to a connected corporation, the recipient pays refundable tax equal to the amount of tax refunded to the payor and the tax is added to the recipient's RDTOH account. Under the proposals, this rule will continue and the account for the RDTOH addition for the recipient corporation will be matched to the RDTOH account from which the payor corporation obtained its refund.
RDTOH transition rule
There is a special transition rule that will apply to allocate the existing RDTOH balance of a CCPC between the two separate RDTOH accounts. Specifically, the amount allocated to the CCPC's eligible RDTOH account will be equal to the lesser of the CCPC's existing RDTOH balance and an amount equal to 38.33 percent of the balance of its general rate income pool (GRIP). Any remaining balance will be allocated to its non-eligible RDTOH account. For any other corporation, such as private corporations that are not CCPCs, the existing RDTOH balance will be allocated to the corporation's eligible RDTOH account.
This transition rule applies to a corporation's first taxation year in which the new eligible RDTOH account becomes applicable. Note that an anti-avoidance rule will apply to prevent the deferral of the application of this measure through the creation of a short taxation year, such that the measure could apply to a taxation year that straddles December 31, 2018.
Planning for the RDTOH change
As these new rules generally come into effect in 2019, you can still obtain a deferral in 2018 if your corporation has both a GRIP account and a balance in its RDTOH account.
Contact your BDO tax advisor to find out whether your company should pay out eligible dividends to recover the RDTOH balance before the new rules take effect.
The information in this publication is current as of March 19, 2018.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.