Chapter 1 Lecture Notes
Basic Legal Principles and Base Tax Rates
David Christian
Spring Term 2013
Thorsteinssons LLP
UBC Faculty of Law
______________________________________________________________________________
Notes
Income tax law is not a matter of pure reason. It is … interpretation of changing
statutory provisions.
Frank J. (1942)
Basic Corporate Law Principles
1.
As you will recall from corporate law, the “corporation” is an artificial
legal person, possessing the legal capacity of a natural person. It follows
that:
(a)
(b)
a shareholder can lend money to the corporation, and thus be a
creditor of the corporation as well as its shareholder; and
a shareholder can be an employee of the corporation, and thus be
both a shareholder and an employee of the corporation.
2.
A corporation must have a directing mind, and this must by definition be a
natural person or persons – being the directors, officers and other
employees. The corporation in effect acts through the agency of these
persons when they are acting in their capacity as directors, officers and
other employees.
3.
The following symbols and acronyms are sometimes used in this course:
SH
shareholder(s)
shares
Ltd
corporation
The
A
corporation’s asset(s)
The
4.
In corporate tax law, the corporation’s separate legal existence is usually
respected – even if a shareholder wants to ignore it for tax purposes. A
corporation is treated as a separate “taxpayer” (see subsection 248(1) and
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the definitions of “taxpayer” and “person”). As a legal person the
corporation owns assets, earns income, has expenses, and pays an income
tax on its “taxable income” just as any other taxpayer. Recall Tax I –
“taxable income from a source”. The shareholder of a corporation is also
a separate legal person and is thus a “taxpayer”. The rate of tax that
applies to the corporation’s taxable income, and to amounts paid out to the
shareholder, is the subject matter of Part A of this Course.
5.
As you know from constitutional law, Canada is a federation. The federal,
each provincial, and each territorial government imposes an income tax.
In British Columbia’s case (as with all of the other provinces and
territories except Alberta and Quebec), the provincial income tax is
administered and collected by the federal government, and thereafter
remitted to the provincial or territorial government.
“Base Case” Corporate Tax Rate
6.
Consider, for now, a public corporation (definitions will be examined in
Chapter 2) earning income from carrying on a business in British
Columbia. I use this example because such a corporation is subject to the
“base case” tax rate applicable to corporations in Canada. In Chapters 3
and 4 important special cases are examined that deviate from this base
case. The base case is the starting point, because each special case in the
later chapters can only be understood with reference to the “base case”.
“Base case” tax rate to be
applied to the corporation’s
taxable income to arrive at the
tax owing by the corporation
%
Section references and notes
start with (historical) federal tax
rate
38
123(1)(a) - most recent, but still historical,
base federal rate
subtract the federal “general rate
reduction percentage”
13
123.4(2) - this gives us the current base
federal rate of 25% before making “room”
for the provincial and territorial taxes assume here the corporation’s income is
basic “full rate taxable” income
subtract the “provincial
abatement”
10
124(1) – makes “room” for the provinces
and territories to impose their own tax rate
on the corporation’s “taxable income earned
in a province” – this gives us the net current
federal rate of 15% where the corporation’s
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Notes
income is subject to provincial or territorial
tax
add the base case provincial tax
rate on the corporation’s income
earned in the province
thus, the total tax “base case” tax
rate on the corporation’s taxable
income in Canada is
10
25
the provincial rate here is the base rate of
10% in subsection 14(2) Income Tax Act
(British Columbia) or the “BC Act” for
short1
the base corporate tax will vary across
Canada as provinces and territories impose
tax a rates different from British Columbia
Notice, the base case corporate tax rate is a combined “federal-provincial
rate”, and it is “built” by applying the various sections. This is the result
of many years of preferences and amendments by both levels of
government, and is a fact of life in determining corporate tax in Canada
(i.e., arriving at net results by applying, in some cases, many sections at
one time).
“Base Case” Individual Tax Rate
7.
An individual who resides in British Columbia on the last day of a
taxation year is taxed at the top tax bracket (which is often used as the
reference point for policy and planning) at the following combined
federal-provincial tax rate on the individual’s taxable income from a
source:
1
The determination of the corporation’s taxable income earned in a province is set out in
Regulations 402(1) and (3). The allocation of the corporation’s taxable income to a province turns
first on whether the corporation has “permanent establishment” in a province. The taxable income
is then allocated to those provinces based on an average of the corporation’s gross revenues and
salaries attributable to a permanent establishment in a province. The provinces and territories adopt
the same allocation rules when imposing their provincial and territorial income tax on corporations.
Our example here assumes only one permanent establishment which is located in British Columbia.
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Notes
29
the top rate in 117(2)(d) – the low rate is
15% (up to $44,561)
add the provincial rate
14.7
the top rate in 4.1(1)(e) of the BC Act again, top individual tax rates vary from
province to province – the low rate is 5.06%
(up to $37,568)
combined federal-provincial rate
43.7
start with the federal rate
The “Gross-up & Dividend Tax Credit” System for Individual Shareholders
8.
What do you see thus far about the “corporate tax system”? Assume a
corporation carries on a profitable business and earns in a year business
income of say $100. This is its “taxable income” from a business for the
year. Also assume the corporation pays income tax on the $100 of this
taxable income, and declares and pays a dividend to its individual
shareholder(s) who is at the top individual tax bracket.
9.
The dividend received by the individual shareholder(s) must be included in
the shareholder’s income by reason of paragraph 12(1)(j) and paragraphs
82(1)(a) and (a.i). It has long ago been held that a dividend declared and
paid by a corporation is not a deductible expense to the corporation in
earning income from its business. The dividend is not incurred for the
purpose of earning profits (and thus, no section 9 deduction is available),
but rather the dividend is simply a non-deductible application of the
corporation’s profits once earned.
10.
What is the total tax on the $100?
the corporation’s tax, at the “base case” federal-provincial
corporate tax rate of 25%, on the $100 of business income is
$25.00
the individual shareholder’s tax on the available $75.00 dividend
received, at the top individual federal-provincial tax rate of
43.7%, is
$32.76
thus the total tax paid is $57.76
$57.76
the total effective tax rate on the $100 of business income is
computed as the total $57.76 of tax paid by the corporation and
the shareholder as a percentage of the $100 of business income
earned, or approximately …
58%
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Notes
11.
Why would shareholders, who have the choice, carry on business through
a corporation? Incorporating a business can make commercial sense –
i.e., limited liability. What about the total taxes paid?
If the $100 of
taxable income could be earned directly by the individual as a sole
proprietorship, and taxed at only the top individual rate of 43.7%, why
incorporate the business and pay a total tax of approximately 58% - some
15% more?
12.
This question was addressed in part during the 1972 tax reform process in
Canada. The (i) “gross-up” and (ii) “dividend tax credit” system was
invented for all dividends received by individual shareholders from
corporations resident in Canada. This is largely the system we have today.
In short, the individual shareholder is “given some credit” for corporate
tax that is assumed to have been paid. When the system was invented the
assumed corporate tax rate was approximately 20%.
13.
It is important to understand the original tax policy behind the gross-up
and the dividend tax credit:
assume the corporation’s income is
Shareholder
$100
assume the corporation’s tax at 20% is
$20
Ltd
$100 of Taxable
Income Earned
assume the actual dividend paid to the
shareholder is
$80
the “gross-up” (or add-back) to the actual $80
dividend paid was fixed at an amount equal to
“¼ of the dividend paid” - i.e., $20 here …
$20
… both the actual dividend and this “gross-up”
go into the shareholder’s taxable income
$100
now compute the shareholder’s tax on this
“gross-up dividend amount” at the top tax rate
of say 43.7%
$43.7
deduct from this tax a “dividend tax credit”,
which is equal in theory to the to the gross-up
amount (i.e., the tax paid at the corporate level
$20
the shareholder’s net tax is
$23.7
the total tax is ($20 plus $23.7)
$43.7
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Notes
the total “effective tax rate” is the $43.7 as a
percentage of the $100
43.7%
The theory of the “gross-up” and “dividend tax credit” is to the effect that
if the actual corporate tax rate was 20%, there would be no advantage or
disadvantage to “incorporating” the source of income - from the tax
perspective. The same tax is paid if the $100 of taxable income is earned
“through a corporation” (i.e., 43.7% in the above example) or directly by
the individual (43.7%). This concept is sometimes described as
“integration” if you are focusing on the net all-in tax rate; and “neutrality”
if you are focusing on the incentive or disincentive to incorporate.
14.
Before 2006 the integration system had one glaring hole: corporate income
taxed at the general corporate rate did not integrate with shareholder
income (because the dividend tax credit did not compensate the
shareholder for the full amount of corporate tax paid). This was fixed for
2006 and subsequent years. The “fix” was the creation of different grossup and dividend tax credit rates for corporate income taxed at the general
“base case” rate. Taxable dividends paid from corporate income taxed at
the “base case” rate are called “eligible dividends” (because they are
eligible for the higher dividend tax credit).2 Taxable dividends that are not
eligible dividends are called “ordinary dividends”.
15.
Now move from policy to law. The “gross-up” for “ordinary” dividends is
1/4 (or 25%) of the actual dividend received (by reason of paragraph
82(1)(b)) (eligible dividends are discussed in more detail in paragraphs 21
– 25). This grossed-up income applies for federal and provincial income
tax purposes because individual provincial income is largely the same as
federal income. The gross-up is fixed, and is based on the theoretical 20%
corporate tax rate in the chart above. Moreover, the gross-up applies
regardless of the actual corporate tax rate or amount of corporate tax paid
by the corporation.
16.
The “dividend tax credit”, in policy terms, should equal the gross-up. The
idea is that the shareholder is given a credit (federally and provincially)
against the shareholder tax for the assumed corporate tax already paid.
Under the existing law, the dividend tax credit is indeed granted in part by
2
Discussed further in Chapter 5.
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Notes
the federal government and in part by the provincial government. Twothirds (2/3rds) of the dividend tax credit is granted by the federal
government as credit against the individual’s federal income tax (see
section 121). Historically, one-third (1/3rd) has been granted by
provincial governments as a credit against provincial individual income
tax. This split has reflected the historical fact that provincial individual
tax has been roughly half of the federal tax (or 1/3rd of the total individual
tax).
17.
In British Columbia the matter is further refined (or complicated,
depending on your perspective). The current provincial portion of the
dividend tax credit for ordinary dividends is only 17% of the gross-up, not
1/3rd (see section 4.69 of the BC Act).3 The reason for the reduction was
a policy choice made by the government of the day; it reduced the
dividend tax credit to ensure that the top provincial tax rate was equal to
the top provincial tax rate, plus surtaxes, under the prior system.4
18.
In any event, it is clear the total dividend tax credit available to an
individual resident in British Columbia on an ordinary taxable dividend is
not equal to the full amount of the gross-up, but rather equals the federal
portion under section 121 (2/3rds or 66.67% of the gross-up) plus the
British Columbia portion under the BC Act (17% of the gross-up). Thus,
rather than the individual shareholder being entitled to a dividend tax
credit equal to 100% of the gross-up amount, the individual is entitled to
83.67% of the gross-up amount as a tax credit.
19.
We now know, of course, that the “base case” corporate tax rate is not 20%
but rather 25%. (We will see different rates in Chapters 3 and 4). And we
now know that there is less than 100% tax credit for the gross-up through
the dividend tax credit mechanism. Using the 25% base case rate, and the
dividend tax credit at 83.67% rather than 100% of the gross-up, a distinct
lack of integration arises:
3
4
The provincial dividend tax credit on ordinary dividends was reduced from 25.5% to 21% in 2009 and further reduced to
17% in 2010. These reductions were made to take account of falling corporate tax rates. However, the initial reduction in
the historical dividend tax credit rate (from 33% to 25.5%) has never been rectified.
Until 2000, provincial individual tax was computed as a percentage of federal tax, rather than on net income. This system
was advantageous for provincial governments in an era of rising tax rates – the provincial government received increasing
revenue without political cost whenever the federal government increased the personal income tax rate. When federal
personal income tax rates began to decline in the late 1990s, this advantage disappeared. At that time provincial
governments across Canada moved away from the “tax on tax” system to tax net income – so that federal tax cuts would not
reduce provincial revenue, and so that provincial governments could take credit for provincial income tax reductions.
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Notes
Shareholder
Ltd
$100 of Taxable
Income Earned
the corporation’s tax on the $100 at the
base rate of 25% is
$25.00
the actual dividend paid to the shareholder,
being the $100 less the $25.00 is
$75.00
“gross-up” the dividend by ¼ of the actual
dividend, or $18.75,5 for a total amount
included in the shareholder’s income of
$93.756
shareholder tax at the top
provincial tax rate of 43.7%
$40.97
federal-
deduct the “dividend tax credit”, being the
83.67% of the $18.75 gross-up, or
$15.69
net shareholder tax
$25.28
the total $50.28 of tax on $100 of income
translates to an effective tax rate of 50.2%,
or rounded to
50%
20.
Thus, where the “base rate” of corporate tax applies to the corporation’s
income (i.e., 25%), the individual shareholder pays an additional tax of
approximately 6.3% by earning the $100 of taxable income “through the
corporation” as opposed to earning the $100 directly and being subject
only to the personal tax rate at 43.7%. However, there is, while the profits
are retained by the corporation and not paid out as a dividend, a “deferral”
of tax of 18.7% - being the difference between the 43.7% personal tax that
would be paid if the source of income was held personally and the base
case corporate tax rate of 25%.
21.
The “disintegration” or “non-neutrality” of earning income taxed at the
full corporate rate caused, in part, the trend towards the conversion of
public corporations to income trusts. By establishing the business in a
trust format, corporate tax was, until the announcement of proposed
changes on October 31, 2006, eliminated entirely. Income earned by an
income trust is passed through the trust to its unitholders, who pay tax on
5
Conceptually, this represents assumed corporate tax paid at 20%. This is why the actual dividend
(assumed to be 80% of the corporate profit, after deduction of 20% tax) is multiplied by 25%: 25%
of 80% is 20%, the amount of the corporate profit available for distribution by dividend that is
assumed to have been consumed by corporate tax. Thus, the assumed corporate income is $90.00,
on which the assumed 20% tax ($18.00) has been paid, leaving a dividend of $72.00.
As noted, this is the assumed corporate income that is, in theory, the amount on which the
corporation is assumed to have paid 20% tax. This amount is in tax policy supposed to be fully
“creditable” in the form of the “dividend tax credit”.
6
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Notes
the income at their tax rates. If the unitholder is tax-exempt – such as a
pension fund or RRSP – no tax is paid. If the unitholder is not resident in
Canada, only withholding tax of 15 – 25% is paid. In order to counter the
trend of corporations converting to trusts – ostensibly, to preserve the
corporate tax base – the federal government announced in November 2005
that it would provide an enhanced dividend tax credit to offset corporate
income taxed at the base rate. The enhanced dividend tax credit for
eligible dividends became law starting with the 2006 taxation year. Most
provinces – including British Columbia, Alberta and Ontario – have
matched the enhanced federal dividend tax credit.
22.
The enhanced dividend tax credit relies on a 38% gross up.7 The dividend
tax credit is a percentage of the gross up. For 2013 (and thereafter, until it
is changed if the corporate tax rate changes) the federal percentage is
54.55 (6/11). The provincial rate is 354/9, resulting in an aggregate
dividend tax credit for eligible dividends that is 89.99% of the gross up.
23.
The enhanced dividend tax credit applies only to “eligible dividends” paid
by corporations from their “general rate income pool” or “GRIP”. The
computation of the GRIP is complicated, but it essentially describes
corporate income that is taxed at the base case corporate rate.
24.
So, does the enhanced dividend tax credit work? Apply the same analysis
as in paragraph 19 but with the increased dividend tax credit.
7
The initial rate of the gross-up for eligible dividends was 45%, which represented an assumed corporate tax rate of 32%. As
corporate tax rates have fallen, the gross-up for eligible dividends fell with them.
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Notes
Shareholder
Ltd
the corporation’s tax on the $100 at the
base rate of 25% is
$25.00
the actual dividend paid to the shareholder,
being the $100 less the $25.00 is
$75.00
“gross-up” the dividend by 38% of the
actual dividend, or $28.50,8 for a total
amount included in the shareholder’s
income of
shareholder tax at the top
provincial tax rate of 43.7%
$100 of Taxable
Income Earned
$103.50
9
federal$45.23
deduct the “enhanced dividend tax credit”,
which is equal to 89.99% of the gross-up,
or
$25.65
net shareholder tax
$19.58
the total $44.58 of tax on $100 of income
translates to an effective tax rate of
44.58%, or rounded to
45%
25.
Therefore, in 2013, where the “base rate” of corporate tax applies to the
corporation’s income (25%), the individual shareholder pays slightly more
tax (0.88%) by earning the $100 of taxable income “through the
corporation”, rather than directly.
Contrast this with the 6.3%
disadvantage that would have applied absent the enhanced dividend tax
credit, and you can see how the creation of the enhanced dividend tax
credit has increased integration, and the neutrality of the corporate tax
system.
26.
The foregoing assumes the shareholder receiving the dividend is an
individual at the top rate. What is the “base case” where the shareholder
is another corporation? The “base case” rule is that dividends can be paid
tax-free between corporations. A corporation that is a shareholder must
include the dividend into income (subsection 82(1)(a)) but is entitled to a
deduction equal to that amount (subsection 112(1)). The gross-up and
8
Conceptually, this represents assumed corporate tax paid at 28%. When the actual dividend
(assumed to be 71% of the corporate profit, after deduction of 29% tax) is multiplied by 38% and
the product added to the dividend, the result is approximately $100, on which the assumed 28% tax
has been paid. Of course, the corporate tax is actually 25%, so the dividend tax credit “over
integrates” the personal and corporate tax. This effect is countered by reducing the dividend tax
credit on eligible dividends.
As noted, this is the assumed corporate income that is, in theory, the amount on which the
corporation is assumed to have paid 28% tax.
9
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dividend tax credit rules do not apply to a corporate shareholder. Why
should the dividends be tax free? The theory is the taxable income has
already been taxed once, or is assumed to have been taxed once, at the
first-tier corporate level. To tax the income again, at the second-tier
corporate shareholder level, would be corporate “double taxation”.
However, as we will see in later chapters, there are many important
exceptions to this base case inter-corporate dividend rule.
Individual
gross-up & dividend tax credit system
Holdings Ltd.
dividend is tax-free
Ltd.
corporate tax on the income
taxable income
27.
Also, what if the individual shareholder has no other source of income –
i.e., is otherwise at the low rate of income tax. Who might this be?
Family members. Such an individual can receive up to approximately
$30,000 of dividends and pay almost no tax. Why?
Tax credits.
An individual with no other source of income benefits fully from the basic
personal tax credit available to all individuals (Tax I) and the federal and
provincial dividend tax credit. Approximately:
Dividends
Gross-up (¼)
Taxable Income
Federal Tax (15%)
Personal credit
DTC (2/3 gross-up)
Federal Tax
Provincial Tax (5.06%)
Personal Credit
30,000
7,500
37,500
5,625
1,623
5,003
0
1,898
561
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Notes
DTC (17% gross-up)
Provincial Tax
1,275
62.00
The foregoing concept has for years been a staple of tax planning. In 2000
the federal government introduced an “income splitting tax” (commonly
known as the “kiddie tax”), in section 120.4 of the Act. The kiddie tax is
beyond the scope of this course. I note, however, that other family
members may still benefit from this low rate on dividend income. Of
course, the corporate tax remains the same.
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