Tax-efficient ways to withdraw money from your business

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).

To ensure this is a tax-efficient method of withdrawing money from the corporation, it will be critical to consider both the tax on split income (TOSI) rules and the corporate attribution rules before any distribution is made.

TOSI rules - Taxable dividends from a private corporation will be subject to the highest rate of personal tax, with restrictions on personal tax credits that offset this tax, unless an exclusion from the TOSI rules is available.

Corporate attribution rules - Transfers or loans to a corporation in order to effectively shift income to another family member may result in additional tax for the individual making the transfer or loan, unless certain conditions are met. Planning will help to avoid any punitive tax result under the corporate attribution rules.

With complex rules in place to restrict income splitting, consult with your BDO advisor before paying any dividends to adult family members (including spouses), as well as minor children.

Remember, active business income of a CCPC is eligible for specially reduced rates of both federal and provincial/territorial 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.

Some time ago, in situations 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. The reason was that 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 when paying the excess income as a bonus. This concept is referred to as the tax integration cost.

However, with changes to the rules governing the taxation of dividends in 2006 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.

As a cautionary note, if you decide to retain income in your corporation to take advantage of the tax deferral, and invest in passive assets, this may increase the passive investment income earned by the corporation. If that is the case, it will be necessary to consider the impact of the new passive investment income rules. These rules generally apply to taxation years that begin after 2018, and will restrict the small business deduction that can be claimed by a CCPC where passive investment income of an associated group exceeds $50,000 in the previous year.

Our Incorporating Your Business Tax Bulletin provides further discussion on retaining income within a corporation, along with a chart that illustrates the tax integration costs and potential amounts of deferrals for each province and territory. This Tax Bulletin also provides a more detailed explanation of the passive investment income rules.

Take note that other factors 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.

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.

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. There are additional advantages of incorporating a holding company, as well as a number of issues to consider. Your BDO advisor can help determine if setting up a holding company makes sense for your business situation.

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. Note that recent changes to the tax rules may allow a non-arm’s length person to transfer their shares of a small business, family farm or fishing corporation to an adult child or grandchild without negative tax consequences. Since these rules can be very complex, make sure you involve your BDO advisor if you're interested in converting the hard ACB of your shares into cash.

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 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 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. It is also important to note that in certain circumstances the TOSI rules will apply to tax interest income earned by individuals from private corporations at the highest tax rate. Therefore, before any interest is paid, consideration should be given to whether the TOSI rules are a concern in order to avoid any negative tax consequences.

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 (tangible and intangible). 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 said, calculating the CDA can be complex. There are rules that 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, specific filing requirements 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. An additional complication has been introduced with the new passive investment income rules discussed earlier. If the capital gains are realized by the corporation on the internal sale of passive assets, these capital gains may impact the corporation's ability to claim the small business deduction. Once again, consult with your BDO advisor before effecting this type of strategy.