In our previous the article, Income tax considerations for the owner-manager when planning for retirement, we looked at pension options for the owner-manager planning for retirement. However, some owner-managers may use their corporation as a savings vehicle as well as, or instead of, contributing to a pension. Below, we explore the income tax benefits and drawbacks of this option.
This article considers the income tax implications of retaining income in excess of business operations and the owner's personal spending needs in the corporation. We have assumed that the corporation is a Canadian-controlled private corporation (CCPC) where the owner is a Canadian resident owner-manager. Over the course of several years, a pool of investment assets will build up, and the owner-manager can withdraw these funds in retirement in the form of dividends.
How to use tax deferral to your benefit
When funds not needed for personal use are retained in the company, the first tax advantage achieved is the deferral of personal tax. This deferral advantage is illustrated in our article Tax strategies for owner-manager remuneration. Where the profits have been subject to the small business deduction, the combined deferral of federal and provincial tax ranges from 32.50% to 42.8%, depending on the province (2023 tax rates). The charts appended to the article referenced above show the deferral rates by province. Where the business income is taxed at the general business tax rate, the deferral of tax ranges from 17.5% to 27.03%. A larger deferral is achieved by retaining income taxed at the small business rate in the company, but there is still a substantial deferral achieved by retaining general rate business profits in the corporation.
Additionally, as mentioned in the Tax strategies for owner-manager remuneration article, when funds are eventually flowed out to the owner-manager in the form of dividends, there is generally a small integration cost for income taxed at small business tax rates (up to 1.65%), and a larger integration cost (up to 7.54%) where the income is taxed at general business tax rates. However, investment returns in the company can be sufficient to offset these integration costs, depending on the length of time of investment and the rate of return on such investments.
How investment income is taxed in a CCPC
Investment income earned on funds in excess of those needed for business operations are taxed differently than business profits in a CCPC. Investment income is subject to the regular corporate tax rate and an additional 10.67% refundable tax. The refundable tax is refunded to the corporation when taxable dividends are paid out of the corporation and the corporate tax return is filed on a timely basis. This refundable tax is designed to make the combined corporate and personal tax on investment income earned in a company approximately the same personal tax rate on investment income if it had been earned directly, therefore eliminating any deferral advantage. See below Chart 1 of the Appendix, Column D, there is only a small deferral in some provinces when earning investment income in a corporation, and a small over-payment of tax in other provinces and territories (2023 tax rates).
Investment income generally takes the form of interest, dividends, capital gains, and net rent. However, for purposes of taxes on investment income in a CCPC, most Canadian source dividends are not included in investment income. Chart 1 in the Appendix shows the integration rates that would apply to interest income, net rents, and foreign source dividends on marketable securities that are not subject to a foreign tax credit. The same general rates apply to taxable capital gains, which are one-half of capital gains realized.
Canadian source dividends from marketable securities (i.e., publicly traded shares) are subject to a special 38.33% corporate tax that is refunded when dividends are paid from the company and the corporate tax return is timely filed. These dividends are subject to tax when received into the corporation, but there is no net corporate tax cost once such dividend income is paid out to the individual shareholder and the dividend refund received. Regular corporate tax does not apply to these dividends.
Canadian source dividends from closely held private companies are generally not subject to any tax when paid between Canadian corporations.
If there is a strategy to retain excess funds in the corporation, it is often prudent to separate these funds from the risks inherent in the operations in the company. A common strategy is to put a holding company in place that is owned by the owner-manager, and which holds the shares of the operating company. This type of structure does not affect how the excess funds are taxed. The process for setting up such a structure is beyond the scope of this article. However, please contact your BDO advisor for further details and to determine if setting up a holding company structure makes sense in your situation.
How accumulating funds impacts small business deductions
In addition to the increased income tax rate paid on investment income in the corporation, where the investment income exceeds $50,000 in a given taxation year, the small business limit decreases in the next taxation year at the rate of $5 for each $1 of investment income earned over the $50,000 in the current taxation year. Meaning, where investment income in the corporation reaches $150,000 in the previous year, the corporation will no longer be able to access the small business deduction in the current year (($150,000 - $50,000) x 5 = $500,000). For this purpose, investment income of associated corporations is aggregated, so having active business income in one corporation and investment income in a separate corporation under common ownership will not avoid this reduction in the small business limit. Note that most provinces follow the federal government in this reduction to the small business limit, but Ontario and New Brunswick do not.
Deductions from investment income
The types of expenses that can be deducted from investment income are expenses directly related to earning that income, such as investment counsel fees. While the payment of a large salary to a Canadian resident owner-manager in respect of their efforts to earn active business income is generally allowed as a deduction for Canadian income tax purposes, the same is not often the case when the corporation is only generating investment income. According to the Canada Revenue Agency (CRA), a deduction of salary to the owner-manager would be allowed when the owner-manager actively manages the investments on a day-to-day basis. The amount of activity required for an owner-manager to be considered active in the day-to-day operations will be a question of fact. However, the CRA has stated that where a corporation's only activity is investments which are managed through a third party, such as an investment manager, the owner-manager would not be considered active in the day-to-day operations of the business.
Also, salaries and bonuses are not deductible in computing a capital gain, nor can proceeds from the sale of a business be paid out by salary or a bonus.
When the owner-manager is not considered active in the day-to-day operations, it would therefore not be reasonable to pay them a salary. It would also not be reasonable for the corporation to deduct employee expenses such as reimbursing the owner-manger for vehicle or cell phone expenses.
Tax saving strategies for retiring owner-managers
When it comes time to retire, and there is a pool of investments in the company, funds for the retired owner-manager can be paid by dividend as a source of retirement income. While funds are accumulating, the additional tax cost of keeping investments in the corporation is acceptable to many owner-managers because of the personal tax cost of paying dividends to reduce the investment capital in the corporation. However, with little or no deferral of tax on investment income earned in the corporation, it usually makes sense to at least pay dividends to recover the refundable tax paid in the corporation.
In addition, withdrawing smaller amounts in the form of dividends will reduce the overall tax cost of receiving the dividends where such dividends are not taxed at the top personal tax rate. The top personal tax rate for federal tax purposes is reached at taxable income of $235,675 in 2023. The top personal tax rate for provincial tax purposes varies by province – the top provincial 2023 personal tax bracket is taxable income over $1,059,000 taxed in Newfoundland and Labrador. Your mix of income in retirement will determine the actual tax rate on the dividends.
Another factor in retirement is managing net income after age 65 when all Canadian taxpayers can receive old age security (OAS). To receive maximum OAS, you must have lived in Canada for at least 40 years after age 18. As an owner of a corporation, you can manage net income through payment of dividends to reduce the claw-back of OAS benefits. The claw-back starts as 15% of net income over $86,912 and OAS is fully clawed back at an estimated net income of $142,428 (2023 income amounts that will affect the claw-back on your 2023 tax return). It is the taxable amount of dividends that affects the OAS claw-back. Actual dividends are increased by a factor of 15% for ineligible dividends or 38% for eligible dividends and the grossed-up amount is the taxable amount. Dividends paid from a CCPC out of investment income or income subject to the small business deduction are generally taxed as ineligible dividends.