Chapter 15 Notes:Examples

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Humber College *

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Management

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Apr 3, 2024

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Chapter 15: Corporate Taxation and Management Decisions The Decision to Incorporate: - Deciding whether or not the business should be incorporated - The decision to incorporate has the immediate effect of separating the business from its owner - The system of integration means that, in order for incorporated business income to be made available to the owner, it must go through two levels of income tax. First, the corporation is subject to income tax on its business profits. Then, when any after-tax profits are distributed by way of taxable dividends to individual shareholders, the second level of income tax will be payable by those individuals on the amounts received - In terms of income tax advantages that can result from incorporating a business, there are two important benchmarks: o Tax reduction o Tax deferral  Combined federal tax can be as low as 9% and no higher than 13% - Perfect integration means that there is no income tax savings or income tax cost from incorporating income since the combined corporate and personal income tax payable would equal the personal income tax on the income if it were not from an incorporated business. There may be some tax deferral in this situation Tax Reduction and Deferral: - Whether the use of a corporation will result in a reduction or deferral of income tax will depend on the type of income being earned as well as the income tax classification of the corporation o A public corporation o A CCPC earning active business income that is eligible for the SBD, and business and property income that is not eligible for the SBD o A CCPC earning investment income (net taxable capital gains and other property income, excluding taxable dividends) o A CCPC in receipt of taxable dividends that are both eligible and non-eligible Taxable Dividends Paid to Shareholders: - Income earned by a corporation: corporation must pay income tax on the income first, leaving the after-tax part of the additional income available for distribution as a taxable dividend . When received, the taxable dividend would be grossed up, increasing the individuals net income and taxable income. In addition, the individual would be entitled to a dividend tax credit to apply against income tax payable. o The taxability will depend on the type of dividend (eligible, non-eligible) o Non-eligible dividends are grossed up by 15% and benefit from a federal dividend tax credit of 9/13 of the gross up o Eligible dividends are grossed up by 38% and benefit from a federal dividend tax credit of 6/11 of the gross up

Personal Income Tax on Dividends Non-Eligible Dividends Eligible Dividends Federal Dividend Tax Credit 9/13 6/11 Provincial Dividend Tax Credit Ex. 20% Ex. 36% Dividends Received 100% 100% Gross Up 15% 38% Taxable Dividends 115% 138% Times the Comb Fed/Prov Income Tax Rate Ex. 51% (33% Fed +18% Prov) Ex. 51% = Comb Fed/Prov Tax Rate on Dividends Received 58.7% 70.4% Less: Dividend Tax Credit [(9/13+20%)(15%)] (13.4%) Less: Dividend Tax Credit [(6/11+36%)(38%) (34.4%) Effective Personal Income Tax Rate on Dividends Received 45.3% rounded to 45% in the textbook 36.0% CCPC – Active Business Income (ABI) - A CCPC can be subject to two different income tax rates on its ABI. o A low tax rate is available on up to $500,000 of income that is eligible for the SBD o A higher income tax rate on income that is not eligible for the SBD - Corporate income eligible for the SBD o Taxable dividends received will be non-eligible - Corporate income not eligible for the SBD o Taxable dividends received are designated as eligible

- Way less tax will be payable by incorporating the business vs. $100,000 of income subject to 51% tax (33% fed +18% prov) = $51,000 tax payable compared to $11,500 or $28,5000, leaving $49,000 in income post-tax. $325 is the cost to incorporate “Bonusing Down” Active Business Income (ABI) - A traditional income tax planning technique for CCPC’s that have ABI in excess of their business limit is to “bonus down.” Bonusing down means that an extra expense is used to reduce taxable income to an amount that is fully eligible for the SBD. - If, for example, a CCPC with no associated corporations were to have business profits from an active business of $600,000, only $500,000 would qualify for the SBD. The $100,000 excess amount would be subject to high corporate income tax rates. - However, the business can declare a bonus to the principal shareholder of $100,000, the business profits and net income would be reduced to $500,000, eligible for SBD - Bonusing down strategy involves minimizing corporate income tax while deferring individual income tax to the extent possible. The individual would only be required to include the bonus as employment income when received. - Bonus must be paid within 180 days of the taxation year Shareholder Benefits - If the decision is incorporate a business that was previously carried on by an individual as a sole proprietor, it is important for the individual to realize that the business no longer belongs to them but instead belongs to the corporation - It is essential for the individual to separate their personal affairs from the business affairs of the corporation to avoid adverse income tax implications to both the individual shareholder and the corporation - The income tax provision of concern is ITA 15(1), this applies where “a benefit is conferred (grant or bestow rather than receive or enjoy” by a corporation on a shareholder of the corporation.” The value of the benefit is then included in the income of the shareholder as income from property for the calendar year in which the benefit is conferred unless there is a specific exclusion provided. - The value of the benefit is defined as the difference between the FMW of the economic advantage obtained or received minus the FMW of any consideration given up in exchange Shareholder Benefit Taxation – 4 Step Process 1) Is there a benefit? (an economic advantage) 2) Has the benefit been conferred because of the individuals shareholding? 3) What is the value of the benefit 4) Is the benefit excluded? - Shareholders are often employees. To determine whether they are receiving the benefit because they are a shareholder, you must ask if other employees/non-shareholders are receiving the same benefit

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- Most common shareholder benefits: o Personal expenses (paying for hobby interests, legal expenses, alimony, child support, divorce settlements, travel expenses, costs of education) o A shareholder selling personal property at amounts in excess of FMV o A shareholder purchasing corporate property for less than its FMV o A corporation making improvements to shareholder property o Other important benefits (automobile, loan, benefits to family members, use of corporate property) Shareholder Loans and Indebtedness – ITA 15(2) - The purpose of this provision is to prevent dividends from being paid out in the impression of loans or other indebtedness where shareholders would simply borrow the after-tax income from their own corporations for an indefinite period of time without paying any income tax - ITA 15(2) does not apply to resident corporations - ITA 15(2) applies when an individual shareholder or an individual related to an individual shareholder either (1) receives a loan from the corporation for (2) becomes indebted to the corporation. - ITA 15(2) requires that the receipt of a loan or the amount owing is to be included in the income of the individual shareholder or an individual related to the shareholder who owes The Mechanics of Shareholder Loans and Indebtedness 1. Determine whether an individual has received a loan or become indebted to a corporation in which the individual is a shareholder 2. Determine whether the specific loan exceptions of ITA 15(2.4) apply (if they do apply then there is no ITA 15(2) income) 3. Determine whether the loan has been repaid within one year of the taxation year of the corporate lender. If the loan has been fully repaid within one year, ITA 15(2) will not apply. If part of that loan is repaid within the timeframe, then that part of the loan is not subject to ITA 15(2) a. Any part of the loan not repaid is subject to ITA 80.4, which requires any interest benefit to be included in income to the extent that interest at a prescribed rate exceeds the actual interest charged on the loan or indebtedness. b. The two sets of rules are not allowed to overlap. ITA 80.4(3) prevents any interest benefit from being determined on any part of a loan or indebtedness that was required to be included in income under ITA 15(2) c. If the interest benefit was received under shareholder capacity = income from property, under employment capacity = employment income 4. Any repayments that relate to amounts included in income under ITA 15(2) will be entitled to a deduction under ITA (2)(j) in the year of repayment

The Main Exceptions: must meet the two criteria - The loan must be made to the individual as a result of an employment capacity and not a shareholder capacity - Bona fide arrangements must be made to repay the loan within a reasonable period of time 1. Loans in the ordinary course of business and money lenders 2. The two year exception 3. The minority shareholder exception: a. The exception requires that an individual is an employee of the lender, is not related to the corporation, nor owns 10% or more of the issues shares of any class of the corporation b. For the 10% share ownership test, any shares owned by related persons are considered to be owned by the employee. An employee would be related to the corporation if persons related to that individual legally control the corporation 4. Specific Loan Exception a. To purchase a home: the housing loan exception only applies to loans made or debts arising in respect of an individual who is an employee or who is the spouse or common-law partner of an employee of the lender. The exception further requires that the employee or spouse/common-law partner must be use the proceeds to acquire a dwelling for the employee or their partners habitation. Cannot be used to purchase a rental property b. The share loan exception requires that the borrower be an employee of the lender. The borrower must use the loan to acquire previously unissued fully paid shares of the corporate employer directly from the employer. In addition, the shares must be held for the employee’s benefit. Selling the shares immediately after acquiring them would disqualify the loan for the exception. c. The car loan exception applies to loans made in respect of an employee of the lender where the loan proceeds are used to enable or assist the employee to acquire a motor vehicle to be used in the performance of the employee’s employment duties.

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