In this issue, we cover:
Tax-efficient ways to withdraw money from your business
Income tax considerations for an international business expansion
Tax-efficient ways to withdraw money from your business
You’ve worked hard to build your business and create a profitable company. During the start-up years, you may have forgone paying yourself in favour of reinvesting in your business and growing your enterprise. Perhaps you are now at a point where your business has become more established and you are ready to start withdrawing some of the profits out of your corporation. Maybe you want to bolster your personal cash flow for lifestyle reasons or to fulfill your family’s financial obligations. Or instead, perhaps you are concerned about maintaining your corporation’s status as a small business corporation for the purposes of one day claiming the capital gains exemption. Whatever the reason, simply withdrawing cash from your business’ bank account will likely result in a significant tax bill. So the question then becomes: how do you take money out of your business in a tax efficient manner?
Unfortunately, the answer to this question isn’t as straightforward as you might think. The way in which it makes the most sense for you to take money out of your company may not be the same for another business owner. Consideration must be given to many factors, including the personal federal and provincial tax rates where you live, the corporate federal and provincial tax rates where your business is located, your cash requirements both in the short- and long-term, and whether your company possesses certain favourable income tax attributes that can be utilized to minimize tax.
This article discusses some of the more general approaches that business owners can take to withdraw money out of a business in a tax-efficient manner. Some of these strategies may even allow you to access corporate profits on a tax-free basis. However, to ensure that whatever money you do remove from your corporation does not create any negative tax consequences, it will be important for you to discuss your specific circumstances with your BDO advisor first, before withdrawing any cash.
Pay yourself and family members
Typically, business owners will pay themselves a salary from the business in a way that is similar to an employee being remunerated. If family members also work in the business, a reasonable salary can be paid to them as well. This is especially beneficial if family members have little or no other sources of income. Generally speaking, a “reasonable” salary in this instance would be one that approximates what would be paid to an unrelated third party for the same services.
Alternatively, dividends can be used to distribute money from the corporation to both you and your family members. This would require that you, your spouse, and your children hold shares of your corporation either directly or indirectly (i.e. through a trust or a holding company). Keep in mind that when planning to distribute dividends amongst family members, certain traps must be avoided to prevent running afoul of some fairly punitive tax rules, including the corporate attribution rules and the “kiddie tax” rules. For this reason, it will be important to consult with your BDO advisor before paying any dividends to your spouse or children. For more information about these rules, along with a more detailed discussion of the strategies that can be used to split income, see our Income Splitting Tax Bulletin.
Optimize your salary versus dividend mix
Remember, active business income of a Canadian-controlled private corporation (CCPC) is eligible for specially reduced rates of both federal and provincial corporate tax due to the small business deduction. In order to maximize the potential for this tax savings, it is common for owner-managers of CCPCs to pay themselves a combination of both salary and dividends. In the past, where the active business income of a company exceeded the federal small business limit, it was common practice for a corporation to automatically “bonus down” to that limit since the total corporate and personal tax associated with retaining the excess income and paying it out as a dividend often exceeded the personal tax cost of being paid a bonus. This concept is referred to as the “tax integration cost”.
However, with the changes to the rules governing the taxation of dividends in the past decade and the gradual reductions to the federal and (some) provincial general corporate tax rates, the cost of retaining income within a corporation has declined. As a result, paying a bonus may not always yield the most tax-efficient result. Furthermore, where profits are left in the business (to be distributed at a future date as a dividend), the additional personal tax on the dividend will be deferred. For more information, and a chart that illustrates the tax integration costs and potential amounts of deferrals for each province and territory in 2016, refer to our Incorporating Your Business Tax Bulletin.
Take note that there are other factors that can influence your decision to take a salary versus being paid dividends. Your cash flow needs must be taken into account, since retaining income in your business won’t work in cases where you need money for other purposes. Also, bear in mind that drawing dividends alone will not provide you with earned income for purposes of your RRSP contribution. Moreover, on the corporate side, you will want to consider the impact of any relevant payroll taxes, as well as any remittance requirements and filing obligations that may arise. In addition, you may wish to consider the potential impact that your remuneration decision could have on your corporation’s ability to claim scientific research and experimental development credits, where applicable.
As you can see, establishing the best possible remuneration strategy can be a complex undertaking. Your BDO advisor can help you determine your optimal mix of salary and dividends.
Convert “hard ACB” into cash
If you purchased your business from someone else, it is possible that the shares you acquired have “hard” adjusted cost base (ACB) which can become relevant when planning to withdraw cash from your business. Essentially, “hard ACB” is a tax term that represents the amount that you paid for the shares when you purchased them, and it can potentially be converted into cash (or debt that can be repaid later) using a holding company, thereby allowing you to access the capital you invested on a tax free basis.
In simple terms, a holding company would be set up for the purposes of acquiring the shares of your operating company in return for consideration equal to the ACB of your operating company’s shares. In this way, you could potentially receive proceeds, as cash or debt, in an amount up to the cost base of your shares without attracting any tax. You may even benefit from other additional advantages of incorporating a holding company, which are discussed in further detail below (see “Consider the use of a holding company”).
You should note that attention must be paid where you acquired the shares of your business from a non-arm’s length person, such as a relative, who would have either claimed V-day protection (for capital properties owned on December 31, 1971) or the capital gains exemption (CGE) on the disposition of those shares to you. This is because hard ACB on acquired shares does not include the amount of the gain realized by a non-arm’s length person that was reduced either by the application of the V-day rules or the CGE. If ACB related to a non-arm’s length person’s V-day protection or CGE is cashed in, then a deemed dividend could arise. Since these rules can be very complex, make sure that you involve your BDO advisor if you’re interested in converting the hard ACB of your shares into cash.
Repay outstanding shareholder’s loans
To help finance the start-up or growth of your business, you may have loaned funds to your company in the form of a shareholder’s loan. Now that your corporation is profitable, it may be a good time to consider having the company repay all or a portion of this loan. Any amount that you receive in settlement of your shareholder loan will be a tax-free distribution, similar to a return of capital.
Alternatively, you could also consider having your company start paying you interest on your shareholder loan. However, keep in mind that while any interest paid would be deductible to the corporation, it will be taxable to you as investment income.
Pay a capital dividend
Another potential tax-free distribution to consider is to pay yourself a dividend out of your corporation’s capital dividend account (CDA). In simple terms, the CDA is a notional balance that most commonly represents the non-taxable (currently 50%) portion of any capital gains (or similar receipts) that a private corporation has realized on the disposition of capital assets and of eligible capital property. A positive balance in a corporation’s CDA can be distributed to Canadian resident shareholders as a tax-free dividend, ensuring that the non taxable portion of the company’s capital gains (and similar receipts) do not subsequently become taxable in the hands of the shareholder.
You should note that CDA is calculated on a net cumulative basis, so the balance will be eroded by any capital losses realized by the corporation. However, capital losses realized subsequent to a distribution of the CDA will not have a retroactive effect on having previously received this distribution tax-free even if the loss is carried back. Accordingly, it is advisable to pay out the balance of the CDA as it becomes available.
That being said, calculating the CDA can be complex. There are rules which govern what can and cannot be included in the CDA, as well as timing considerations with respect to the recognition of additions (and depletions) to its balance. Unfortunately, there can be negative income tax consequences when a capital dividend is paid in excess of the corporation’s available CDA. Moreover, there are specific filing requirements that must be met when paying a capital dividend. For these reasons, it will be imperative that you speak to your BDO advisor in advance of paying a dividend from your corporation’s CDA.
As a planning note: if your corporation currently has no (or very little) CDA, consideration can be given to undertaking an internal sale of company assets that have unrealized capital gains. Triggering the realization of these available capital gains will create CDA that can then be distributed as a tax-free capital dividend. Although tax will be payable on the gain inside the corporation, distributing a combination of taxable and capital dividends may be beneficial when compared with just paying a taxable dividend. Once again, consult with your BDO advisor before effecting this type of strategy.
Consider the use of a holding company
While not a way to actually extract money from your business, the creation of a holding company could be a useful way to shift money out of your operating company and, in doing so, defer the realization of personal tax (payable on dividends subsequently paid to you) to a later time. A holding company can also be beneficial for the purposes of securitizing the corporation’s retained earnings, income splitting, and purifying your operating company to help ensure future access to the capital gains exemption by non-corporate shareholders.
With this type of corporate restructuring, shares of your operating company would be transferred to a new holding company on a tax-deferred basis. Then, cash can be shifted out of the operating company by paying dividends up to the holding company on a tax-free basis (although, it is important to be mindful of the anti-avoidance rule under section 55 when paying such intercorporate dividends). The money could then be used within the holding company for investment purposes, assuming that you won’t need access to the funds within the immediate future.
If you do require the cash, then this type of planning may not benefit you. Nevertheless, a potential deferral of personal income tax may be available if the money remains in the company (and is taxed there at corporate rates) until such time as your other sources of personal income decline and are consequently subject to a lower personal income tax rate.
A variation that has become more common is the use of a holding company as a beneficiary of a discretionary trust. This structure allows the benefits described above, plus the flexibility that a trust provides.
You should note, however, that the tax integration cost of earning investment income in a holding company and then paying it out as dividends may be an issue when compared to earning that same investment income personally. As a result, you should consult with your BDO advisor to determine whether setting up a holding company is right for you. For a further discussion of earning investment income in a holding company, read our article titled “Do investment holding companies still make sense?” in the 2016-02 issue of the Tax Factor.
Whether you find yourself in a situation where taking out some cash from your business is a question of necessity, or whether this is an issue that has arisen as a matter of course, taking the time to properly plan how you’re going to withdraw money from your business will ensure that you’ll pay the minimum amount of tax necessary. However, as we’ve seen, there is no cookie-cutter approach to taking money out of your company in a tax-efficient way. Instead, there are numerous potential avenues to explore, and many factors to consider, when selecting the most tax-beneficial plan for your unique situation. Your BDO advisor can help to create a strategy that works best for you.
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Income tax considerations for an international business expansion
Many successful businesses in Canada look beyond our borders for further growth. International expansion can take many forms, from online sales or acquiring a business with an international customer base to establishing a foreign subsidiary.
While there are costs and tax trade-offs to any method of expansion, Canadian owner-operators need to carefully weigh the options to understand which method is right for their business. While Canadian tax implications are a significant factor when planning for international growth, it is also important to consider foreign tax rules, many of which differ considerably from those here in Canada.
Structuring your expansion to optimize tax outcomes
The best business structure for your foreign operations is dependent on multiple factors, such as the size and nature of the Canadian business, the country or countries of foreign operation, and whether you will need to hire employees outside of Canada. Legal restrictions and efforts to minimize general liabilities, both at home and abroad, will also dictate appropriate structures.
At a high level, a few common business structures include:
- Foreign subsidiary: This is the creation of a legal entity in the foreign country to carry on business activities outside of Canada, which is the approach assumed by the Canadian tax system. Creating a foreign subsidiary offers several advantages, of which the most significant is that the foreign affiliate rules in Canadian tax law minimize double taxation. However, the actual application of the foreign affiliate rules can be complex. In general, active business income earned by a foreign subsidiary resident in a country with whom Canada has a tax treaty can be repatriated to the parent company in Canada free of Canadian tax.
- Foreign branch: In contrast to a foreign subsidiary, establishing a foreign branch allows you to do business in another country without establishing a new legal entity. However, while this is a simpler approach in some cases, there are also drawbacks—income is subject to immediate tax in Canada with no deferral of profits, and may be subject to withholding or branch taxes imposed by the foreign country. A foreign branch may also create increased liability and exposure for some businesses.
- Distributorship: This structure allows a Canadian business to sell merchandise to foreign customers by allowing a foreign entity to act as a distributor in the foreign country. This reduces exposure by keeping risk with the Canadian business and ensuring that most of the profits will be taxed in Canada.
While there can be advantages to operating a foreign branch, in many instances the optimal strategy is to establish a foreign corporation owned either by your Canadian corporation or by a Canadian holding company. Market and legal considerations may also shape your decision. For example, customers in a foreign country may prefer to have dealings with a “local” corporation rather than dealing directly with a Canadian firm.
Another area to consider is whether you will need to hire employees to work for your foreign business operations. Some businesses need a Canadian employee to travel abroad to set up the business or acquire new customers, while others require local employees or agents in the foreign country. Depending on your corporate structure and the number and type of individuals that will need to be employed, you may be required to withhold, report, and remit employer income tax on employee compensation in both Canada and the foreign jurisdiction.
Additional Canadian tax considerations
For Canadian-controlled private corporations (CCPCs), it is especially important to plan ahead as foreign operations can limit access to tax incentives provided to CCPCs and their shareholders. If foreign operations are carried out directly by the Canadian company, the company may lose access to lower tax rates provided by the small business deduction. Foreign operations may also restrict a shareholder’s ability to shelter a portion of a gain on the disposition of shares with the capital gains exemption. Creating another Canadian company to hold the operational assets or shares of the foreign business can help limit these risks.
In addition to affecting taxation and tax subsidies, the type and structure of foreign activities the business undertakes can result in additional tax reporting burdens. Activities, such as expanding operations beyond our borders, holding assets in a foreign country, or creating a foreign subsidiary, require additional reporting to the Canada Revenue Agency (CRA). The additional reporting is designed to ensure that Canadian businesses properly report income related to foreign assets and operations.
For reference, the reporting forms typically required in such situations may include:
The CRA takes this reporting very seriously, and can impose significant fines and penalties for non-compliance. In situations where these forms are required but not submitted on a timely basis, the fine can vary from $25 a day for up to 100 days (with a minimum fine of $100), to a penalty of $1,000 per month for up to 24 months. In some cases, non-compliance can also result in a penalty of 5% of the cost of the shares of the foreign affiliate or cost of the foreign property owned by the Canadian business. A full summary of potential penalties is available on the CRA website.
Canadian businesses are thus encouraged not only to carefully balance the best business structure for their foreign operations, but also understand the reporting requirements in advance so as to avoid unnecessary costs.
Foreign tax considerations
There are a myriad of foreign tax considerations when expanding to do business outside of Canada, many of which are dependent on the country or countries in which you intend to do business. Before making any specific plans for expansion, you should become familiar with the tax rules of your target country, especially any rules that apply only to businesses based outside of their jurisdiction.
If you are planning to do business in a foreign country for the first time as a branch operation, you should start by asking questions such as:
- Does the country have a tax treaty with Canada? Though Canada has a very wide income tax treaty network, it is best to check and confirm that your target country is covered. If a treaty exists, it is best to familiarize yourself with the relevant sections.
- What level of presence is required for the business to be subject to income tax rules or reporting? Many tax treaties use the concept of “permanent establishment” and the related rules to outline the minimum threshold of business activity required before a foreign business resident in another country (such as Canada) is subject to tax earned on its business profits in the local jurisdiction. In many countries, a sustained presence is required before a business is subject to taxes, but the threshold for reporting can be much lower.
- As a Canadian business, will it be subject to any special tax rules, additional taxes, or reporting within the foreign country? As with Canadian tax considerations, it is important to understand the full scope of your potential responsibilities before committing to a particular plan of expansion.
If instead you choose to create a separate corporation in a foreign jurisdiction, one area that will require careful consideration is transfer pricing. These rules establish the price for goods or services that are sold between related corporate entities in different countries, to ensure that such transactions occur at a fair price and that neither country is unfairly deprived of tax revenue. Transfer pricing rules in Canada, as well as in most of Canada’s trading partners, require substantial tax compliance to demonstrate how inter-company prices are established, especially if such prices are different from those charged to third parties. Failure to comply with these rules can result in substantial penalties, both in Canada and in the foreign jurisdiction.
Conclusion and additional materials
Decisions about where and what structure your business uses to undertake a foreign expansion are critical and can have significant long-term impacts on tax and business outcomes. Such decisions are best made in consultation with Canadian and foreign legal and tax advisors who can provide you with a detailed understanding of your potential tax and reporting obligations, as well as risk and exposure factors.
For those looking to expand business into the United States, BDO has a number of additional publications that can help assist in your planning. Our Tax Bulletin, Tax Consequences for Canadians Doing Business in the U.S., provides a general overview of what you need to know when considering expanding your sales or operations to our closest neighbour. More detailed information is also contained in a series of recent articles and webinars:
For advice and support on your business’ international expansion, please contact your BDO advisor.
The information in this publication is current as of December 1, 2016.
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.
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