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4562 Lecture 4 - Corporate Tax for Private Corporations- Investment
Income and Integration
- Inadequate Consideration
- Introduction to Transfer Pricing
Last updated on January 7, 2015
Midterm information
The midterm is on Sunday, February 8, from 7 to 9 pm and will cover Lectures 1 to
4. The midterm location is: ACW (Accolade West) 206
Students who have a conflict should contact your course director at least 2 weeks
prior to the midterm to be put on the list to write an alternate ADMS 4562 midterm.
Past midterms are/will be posted under Exam Information.
The midterm information sheet (which will be given to you at the midterm) is posted
with this week’s lecture notes.
The format of the midterm is described on the course outline. Note: you cannot
bring your Act to the exams.
Readings
FIT Ch. 12, 12300
Sections 82, 83, 89, 112, 123.3, 129, 186
Recommend
Ch. 12, Review Questions 11 to 17, Multiple Choice 4, Exercises 7 to 10
For Exercise 10, please use the federal and provincial personal income tax rate
tables on pages 412 and 415 of FIT. The federal rates are the correct rates for 2014.
The provincial rates are hypothetical because rates vary by province. If you need
personal (i.e., non-corporate) tax rates on an exam, they will be given to you
In this course, the foreign tax credits will always equal the foreign taxes paid
Lecture 4 Problem Set: See the separate document in lecture 4 file. Also review the
comprehensive summary problem in Chapter 12 (12500). The recommended exercises
are also very good, especially exercise 10 (which shows how integration works). You can
ignore the algebraic calculations found in footnote 2 of the solution to exercise 10.
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Specified Investment Business (SIB) income
Last week we learned that SIB income
= investment income which is not active
= Canadian and foreign rents, royalties, interest, dividends and taxable capital gains
SIB income is not active business income: this prevents taxpayers from incorporating
investment income and using the SBD to pay a low rate of corporate tax
There are two types of SIB income: Canadian dividend income and everything else
(which is called Aggregate Investment Income)
2.1
Canadian dividend income
- not taxable under Part I (because of the s. 112 deduction)
- subject to Part IV tax which is potentially refundable as a dividend refund
2.2
Aggregate Investment Income (AII), CCPCs only
= all investment income included in taxable income
= SIB income minus Canadian dividends (s. 112) minus Net Capital loss deduction (s.
111(1)(b))
In other words Aggregate Investment Income
= Canadian investment income (Interest, Rents, Royalties, TCG but not Dividends)
plus: Foreign investment income (Interest, Rents, Royalties, TCG and Dividends)
minus: Net capital loss deduction
AII is subject to an extra 6 and 2/3% additional refundable tax (ART). This brings the
initial tax rate to approximately 47.67% in 2013 in theory; i.e., 38% - 10% + 6.67% =
34.67% plus 13% theoretical provincial tax rate = approx. 47.67%)
26 and 2/3% of AII earned by CCPCs is potentially refundable as a dividend refund
With non-eligible dividends (i.e., with dividends subject to an 18% gross-up) a combined
federal and provincial 15.3% corporate income tax rate prevents double taxation of
investment income earned corporately and paid out as dividends. The actual combined
federal and provincial corporate income tax rate, assuming a hypothetical 13% provincial
corporate tax rate, is 21% (i.e., 47.67% – 26.67%)
6 and 2/3% Additional Refundable Tax (ART) on aggregate investment income was
added effective July 1, 1995 to bring the initial rate closer to the top personal rate to
eliminate any deferral of tax on investment income through the incorporation of
investments
Common mistakes made by students include
1. forget rental income and royalties and net capital loss deduction
2. deduct all net capital loss carryforward not amount deducted
3. include investment income deemed to be active
4. forget to do all calculations
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How the Dividend Refund works to Refund the Tax s. 129(1)
1. Some of the Part I tax paid on AII by CCPCs and all of the Part IV tax paid on
Canadian dividends by private corporations goes into an account called the RDTOH
account (Refundable Dividend Tax on Hand account)
2. When taxable dividends are paid, this tax is refunded. The tax refund is called a
dividend refund and is equal to the lesser of: (a) RDTOH closing balance; and (b) 1/3 of
taxable dividends paid
3. After the dividend refund, the net corporate tax paid is low enough (theoretically) so
there is no double taxation. With active business income, the SBD reduces the initial tax
rate to about 15.3% to help small business owners finance operations. With investment
income, there is no initial rate reduction because this would encourage wealthy investors
to incorporate their investments to defer tax - therefore the reduction (the dividend
refund) comes at the end when the income is distributed to shareholders). And, the
investors then pay personal income tax on the dividend distributions that they receive.
The net Part I tax rate (i.e., net of the refundable portion) on investment income other
than Canadian dividends is 21% (47 and 2/3% - 26 and 2/3%) in theory. (It actually is
slightly lower since many provincial corporate tax rates are less than 13%; for example
Ontario’s general corporate tax rate is 11.5%.)
The net tax rate (i.e., net of the refundable portion) on Canadian dividends is zero: there
is no Part I tax and all the Part IV tax is refundable.
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RDTOH s. 129(3)
= Opening Balance
minus prior year’s Dividend Refund
plus Refundable Part I tax
plus Part IV tax
Purpose of RDTOH = to keep track of refundable taxes on investment income. Initial
tax rates on investment income are > top personal rate but taxes are refunded if income is
flowed through to shareholders as dividends
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Dividend Refund [129(1)]
= lesser of: (a) RDTOH closing balance; and (b) 1/3 of taxable dividends paid*
*note that the dividends must be taxable (not capital dividends) and that the dividends
must be paid (not just declared)
Purpose = to refund the RDTOH (i.e., the refundable taxes paid by the corporation)
when dividends are paid to shareholders
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Aggregate investment income (AII), CCPCs only, S. 129(4)
= investment income subject to refundable Part I tax
= Specified investment business (SIB) Income (interest, dividends, net TCG, rents,
royalties minus losses) other than Canadian Dividends minus Net capital losses claimed
How to remember
AII = all interest, net TCG minus Net CL claimed, all rents and royalties, only Foreign
dividends
Purpose = AII is used to compute ART and Refundable Part I tax
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Additional Refundable Tax (ART), CCPCs only s. 123.3
= 6 and 2/3% of the least of
1. Aggregate investment income (AII)
2. Taxable Income (TI) minus amount eligible for the Small Business Deduction (SBD)
Purpose of ART = to make the initial tax rate on investment income > top personal tax
rate
In theory, ART increases the initial combined corporate tax rate on investment income
to 47.67% (with an assumed 13% provincial corporate tax rate)
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Refundable Part I tax, CCPCs only s. 129(3) = least of 3 amounts
1. 26 and 2/3% of AII - [NBFTC - 9 and 1/3 % Foreign Inv Income] *
2. 26 and 2/3% of [TI – SBD amount -100/35 NBFTC – 4 BFTC]
3. Part I tax
* Amount computed in square brackets cannot be negative; if negative then equals
nil
(this is the most complicated calculation)
NBFTC (non-business foreign tax credit) and BFTC (business foreign tax credit)
Purpose of Refundable Part I tax =
To put 26 and 2/3% of the AII in the RDTOH to be refunded if income is flowed through
to shareholders as dividends. The RDTOH dividend refund mechanism reduces the net
rate of tax on AII to 21% (47.67% minus 26.67%) in theory.
Item 1 is essentially 26 and 2/3% of AII that is not eligible for foreign tax credits
Item 2 is essentially 26 and 2/3% of TI not eligible for the SBD or foreign tax credits
Item 3 is essentially tax paid
Refundable Part I tax is the least of the three.
When there is no foreign income, Refundable Part I tax simplifies to
1 26 and 2/3% x Aggregate Investment Income
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2. 26 and 2/3% [Taxable Income - amount eligible for the SBD]
3. Part I tax
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Part IV Tax (Canadian Dividends Received), S. 186
= 1/3 x taxable dividends received from non-connected corporations
= for dividends received from connected corporations, the recipient’s % of the payers’
dividend refund
Purpose of Part IV tax =
1. to make the initial rate on portfolio (non-connected) Canadian dividend income = 33
and 1/3% which is > top personal tax rate (on dividend income).
2. to make the initial tax rate on dividends from connected corporations = the dividend
refund received by the connected payer corporation
Note that all private corporations (not just CCPCs) pay a refundable Part IV tax on
taxable dividends received. If the dividend is received from a connected corporation, the
Part IV tax is limited to the recipient's share of the payer's dividend refund. (If the
connected corporation did not earn any AII and did not pay any Part IV tax, there will be
no dividend refund.)
8.1
Connected (Part IV tax)
Corporations are connected if one company owns >10% of the votes and fair market
value of the company or controls* the other company (s. 186)
* When determining if one company controls another (for purposes of this definition
only) you include any shares owned by the shareholder and non-arm’s length persons
This means that if a connected company pays dividends, the recipient will only pay Part
IV tax if the dividend causes the payer to get a dividend refund
The 1/3 Part IV rate = (approximately) the top personal tax rate on dividends and
therefore eliminates the potential for a tax deferral (earning dividend income in a
corporation)
Part IV tax is totally refundable when dividends are paid out by the corporation
Example:
X Ltd. owns 40% of S Ltd. S Ltd. got a $100 dividend refund when it paid a $2,000
taxable dividend. X Ltd. received 40%, i.e., $800, of the $2,000 dividend paid. Note: the
% represents both voting rights and fair market value.
Question: Calculate X Ltd’s Part IV tax payable.
Answer:
X Ltd.'s Part IV tax = 40% x $100 = $40 [note: it’s not 1/3 x $800 = $267] because X
Ltd. and S Ltd. are connected
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X Ltd. and S Ltd. are connected because one company (X Ltd.) owns greater than 10% of
the votes and value of the other company (S Ltd.); X Ltd. owns 40%.
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Capital Dividend Account (S. 89) = the cumulative total (i.e., starting
from day 1 of the company, or Jan. 1, 1972 if this is later, until today)
of the excess, if any, of:
Non-taxable portion of capital gains minus non-allowable portion of capital losses*;
Tax-free portion of eligible capital property (ECP) gains**;
Capital dividends received; and
Life insurance proceeds received minus ACB*** of policy
minus
Capital dividends paid
* Recall: that with charitable donations of marketable securities to a registered charity (or
other qualifying institution) the taxable portion of the capital gain is now 0%, and in these
cases 100% of the capital gain is added to the capital dividend account.
Also note that “the excess, if any” means that if there are more allowable capital losses
than taxable capital gains there is no “excess” and a zero results for this line of the
formula. (You then look at the remaining lines of the formula to see if there is a positive
balance in the capital dividend account)
** The tax-free portion of ECP gains only adds to the capital dividend account at yearend. Hence, capital dividends based on such ECP gains should only be paid after yearend
*** The ACB is typically nil (i.e., $0) for (simple) term life insurance
Purpose = To keep track of tax-free amounts that can be distributed to shareholders as a
tax-free capital dividend (if appropriate election filed). Only private corporations have a
capital dividend account.
Example:
ABC Inc. is a CCPC with a June 30th year-end. ABC Inc. is considering paying a capital
dividend on January 2, 2015. How much of a capital dividend can it pay on this date?
ABC Inc. was incorporated in 1999 and it earned/realized the following gains/losses:
 Capital gain of $50,000 in 2003 and a capital gain of $40,000 in 2007;
 Capital loss of $30,000 in 2004; and
 A gain on the disposition of goodwill of $100,000 in 2009. The sale
proceeds of the goodwill was $100,000 and the CEC account balance was
nil (i.e., $0).
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ABC Inc. had taxable income of $300,000 in its 2013 year-end and taxable income of
$600,000 in its 2014 year-end. All of this 2013 and 2014 income is active business
income.
ABC Inc. had a term life insurance policy on its senior executives and in 2013 it received
$250,000 as a payout on the death of its president.
ABC Inc. received a capital dividend of $25,000 in 2005 and paid the following capital
dividends:
 $100,000 in 2011; and
 $75,000 in 2013.
Answer:
ABC Inc.’s CDA balance and the maximum capital dividend that it can pay as of January 2,
2015 is:
Non-taxable portion of capital gains $25k (i.e., $50k x ½) plus $20k (i.e., $40k x ½) minus nonallowable portion of capital losses $15k (i.e., $30k x ½) =
$30,000
Plus: Tax-free portion of eligible capital property (ECP) gains ($100k - $0) x ½ =
$50,000
Plus: Capital dividends received
$25,000
Plus: Life insurance proceeds received
$250,000
Minus: Capital dividends paid ($100k + $75k)
($175,000)
CDA balance
$180,000
Additional details about the capital dividend account will be discussed in lecture 6.
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Eligible Dividends [s. 82] and General Rate Income Pool (GRIP)
The May 2006 federal budget lowered the personal tax on dividends subject to tax at the
higher general corporate rate for dividends paid after 2005. This has been done by
increasing the gross-up and dividend tax credit on “eligible dividends” starting in 2006. A
dividend is eligible if the payer corporation designates it as such when it is paid.
Dividends paid out of active business income eligible for the small business deduction or
investment income eligible for refundable tax treatment will (generally speaking) not be
eligible for designation.
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Eligible dividends, received by an individual, are grossed-up by 38% (as opposed to
18%). Individuals will then be eligible for a dividend tax credit (DTC) equal to 6/11 of
the gross-up federally. In theory, the provincial DTC will equal 5/11 of the gross-up. The
actual provincial DTC varies by province.
The General Rate Income Pool (GRIP) Account [s. 89(1),(4),(7)]
Each CCPC will have a general-rate income pool (GRIP) and can designate and pay
eligible dividends during the year to the extent that its GRIP has a positive balance at
year end. Each CCPC’s GRIP will include:
- eligible dividends received: plus
- 72% of taxable income earned in 2012 and thereafter (excluding active business income
eligible for the small business deduction and investment income eligible for refundable
tax treatment); plus
- 70% of taxable income earned in 2011 (excluding active business income eligible for
the small business deduction and investment income eligible for refundable tax
treatment); plus
- 69% of taxable income earned in 2010 (excluding active business income eligible for
the small business deduction and investment income eligible for refundable tax
treatment); plus
- 68%1 of taxable income earned from 2006 to 2009 (excluding active business income
eligible for the small business deduction and investment income eligible for refundable
tax treatment); plus
- 63%2 of taxable income earned in 2001 to 2005
(excluding active business income eligible for the small business deduction and
investment income eligible for refundable tax treatment); plus
- Dividends received from connected taxable Canadian corporations in taxation years
ending after 2000 and before 2006 that were paid out of the payer’s GRIP account
Less: taxable dividends paid in taxation years ending after 2000 and before 2006;
Less: eligible dividends paid (in 2006 and thereafter)
Example:
ABC Inc. is a CCPC with a December 31st year-end. ABC Inc. was incorporated in 2011 and had
the following taxable income:
2011
$600,000
2012
nil
2013
nil
2014
$700,000
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2
Note the assumed 32% combined federal-provincial rate (from 2006 to 2009).
Note that the assumed rate is 37%, because federal-provincial rates have been that high in the past.
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ABC Inc. operates an active business in Canada and is not associated with any other companies.
ABC Inc.’s taxable capital at all times is less than $10M. ABC Inc. did not earn any investment
income other than the eligible dividend received in 2012 (described below).
ABC Inc. received an eligible dividend in 2012 of $50,000. ABC Inc. paid an eligible dividend
in 2013 of $30,000.
Required: compute ABC Inc.’s GRIP account balance as of December 31, 2014.
Answer:
ABC Inc.’s December 31, 2014 GRIP account balance is:
Eligible dividends received (in 2012)
$50,000
72% of taxable income earned in 2014 (excluding active business income eligible
for the small business deduction): $700k - $500k = $200k x 72% =
$144,000
70% of taxable income earned in 2011 (excluding active business income eligible
for the small business deduction): $600k - $500k = $100k x 70% =
$70,000
Less: eligible dividends paid (in 2013)
($30,000)
$234,000
Part III.1 Tax (excess eligible dividends)[s. 185.1 and 185.2]
Corporations making excess designations (of eligible dividends) will pay Part III.1 tax equal to
20% of the excess designation. A corporation that makes an excess designation in error can avoid
Part III.1 tax by electing to treat all or part of the excess designation as a separate non-eligible
dividend. The election must be filed within 90 days after the mailing of the notice of Part III.1
assessment.
A Part III.1 return must also be filed by a corporation resident in Canada paying taxable
dividends (eligible or non-eligible).
Election not to be a CCPC [s. 89(11)]
The rules permit a CCPC to elect to be treated as a non-CCPC and be subject to the regime that
applies to public companies and other non-CCPCs (no small business deduction, etc.). NonCCPCs each have a LRIP (low-rate income pool) and a non-CCPC’s LRIP includes the noneligible dividends it receives among other amounts. A non-CCPC must pay non-eligible
dividends before eligible dividends to the extent that it has an LRIP at the end of its taxation
year.
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When a corporation ceases to be a CCPC it will have a deemed year-end (immediately before
ceasing to be a CCPC). S. 89(8) uses various balance sheet accounts to compute an opening
LRIP balance when a corporation ceases to be a CCPC. [Similar rules apply, i.e., a deemed yearend and an opening GRIP balance computation, when a non-CCPC becomes a CCPC, s. 89(4)].
Will Integration Exist for Business Income Taxed at the General Rate?
The 38% gross-up on eligible dividends will compensate for a 27.5% general corporate rate
(15% of which is the federal tax rate and 12.5% is the theoretical provincial tax rate). Note: if the
gross up and DTC compensates (i.e., reduces personal tax by an amount equal to the corporate
tax paid) then integration will exist (and the total tax paid on business income will be the same
regardless of whether the income was earned by an individual or a corporation).
1. the federal corporate rate is 15%; however,
2. the provincial rates are not all 12.5%.
The Ontario general corporate rate is 11.5%. The Ontario corporate tax rate on M&P
income is 10%; and the Ontario corporate tax rate on the first $500,000 of qualifying
active business income earned by a CCPC is 4.5%.
The 2009 Ontario budget also proposed to lower the general corporate tax rate further (i.e. to
11% in 2012 and then to 10% in 2013); however, the March 27, 2012 Ontario budget cancelled
these proposed reductions. Hence, Ontario’s general corporate tax rate will remain at 11.5%.
Will Small Business Owners Still Bonus Down?
The answer is yes. CCPCs earning active business income in Ontario will generally still prefer to
bonus down to $500,000 even though eligible dividends can be paid out of a CCPC’s GRIP
account. Recall that, generally speaking, business income over $500,000 will generally add to a
CCPC’s GRIP account.
Information on Ontario’s corporate tax rates can be found at:
http://www.cra-arc.gc.ca/tx/bsnss/tpcs/crprtns/prv/on/menu-eng.html
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Inadequate Consideration [s. 69]
Additional tax rules can apply in non-arm’s length (i.e., related party) transactions.
If a taxpayer has acquired property from a non-arm’s length person for an amount in
excess of FMV then the taxpayer will be deemed to acquire the property at FMV
[s.69(1)(a)].
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Example 1:
If Mr. Robin sells shares (that are capital property) worth $45,000 to his daughter and his
daughter pays Mr. Robin $50,000, then Mr. Robin will compute his capital gain/capital
loss on sale using his actual proceeds of disposition of $50,000. However, Mr. Robin’s
daughter will acquire the shares at an ACB of $45,000 (i.e., their FMV) due to s.
69(1)(a). Mr. Robin and his daughter are related by blood.
If a taxpayer has disposed of property to a non-arm’s length person for no proceeds (i.e.,
a gift), or for proceeds that are less than FMV, then the taxpayer will be deemed to have
sold the property for FMV [s.69(1)(b)].
Example 2:
If Mr. Pod sells land (that is capital property) worth $500,000 to his sister and his sister
pays Mr. Pod $300,000, then Mr. Pod will compute his capital gain/capital loss on sale
using proceeds of disposition of $500,000 (i.e., their FMV) due to s. 69(1)(b). Mr. Pod’s
sister will acquire the land at a cost of $300,000 (i.e., what she paid). Mr. Pod and his
sister are related by blood.
If a taxpayer acquires property by way of gift or inheritance then the taxpayer is deemed
to acquire the property at FMV due to s. 69(1)(c).
Notice how in example 2 (above) it would have been better for Mr. Pod to have gifted the
land to his sister, since he would still have a disposition at FMV but his sister would have
an ACB of $500,000 (i.e., FMV) instead of an ACB of $300,000.
If Mr. Pod wanted to give his sister a gift of $200,000 then he could have sold her the
land for FMV and then given his sister a gift of $200,000. This way the ACB of her land
should be $500,000, i.e., the amount she paid for the land.
Note: s. 69 does not apply to services.
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Transfer Pricing [s. 247]
The transfer pricing rules found in s. 247 of the Act are very complicated and will only be
introduced here. Also see paragraph 19,410 of FIT for a nice summary of these rules.
When a Canadian taxpayer buys or sells a product or service from a related non-resident
then the transfer pricing rules must be considered.
If transfer pricing rules did not exist a Canadian taxpayer may attempt to move income to
a low-tax foreign country by either:
(1) paying more than FMV for a good or service purchased from a related non-resident
(to increase Canadian expenses); and/or
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(2) selling a good or service for less than FMV to a related non-resident (to lower
Canadian revenues).
Transfer pricing rules require Canadian taxpayers to document how they determine the
transfer price for goods and services (including intangible assets) purchased or sold to a
related non-resident.
If the transactions are not at FMV then the CRA will: (1) adjust the transfer price to
FMV; and (2) charge a penalty equal to 10% of the transfer price adjustment*.
However, if: (1) appropriate documentation exists, as of the due date for the taxpayer’s
tax return; and (2) a reasonable attempt was made to transact at FMV
then there will not be a penalty. (There will still be an adjustment to the transfer price to
FMV.)
* “Small” transfer price adjustments, equal to the lesser of: (a) 10% of gross revenue for
the year; and (b) $5M are not subject to a penalty [s. 247(3)].
Example
Save Inc. is a Canadian company that is related to Offshore Inc. a company resident in a
foreign country with no income tax. In an attempt to reduce its Canadian tax, in 2014
Save Inc. paid $1M to Offshore Inc. in return for management services provided by
Offshore Inc. The FMV of the management services provided was minimal, estimated to
be $10,000.
Question:
What are the potential s. 247 tax consequences? Assume Save Inc.’s gross revenue in
2014 is $4M. How would your answer change if Save Inc.’s gross revenue in 2014 was
$40M?
Answer:
Save Inc. is not paying FMV for the management services and hence s. 247 will apply
and reduce Save Inc.’s deduction to $10,000 (i.e., FMV). The extra $990,000 (i.e., $1M $10,000) will not be deductible.
Save Inc. will also be liable for a 10% penalty of $99,000 (i.e., 10% x $990,000).
If Save Inc.’s gross revenue was $40M then there would be no penalty since the
adjustment is “small”; i.e., the adjustment of $990,000 is less than $4M; i.e., the lesser of:
(a) 10% x gross revenue ($40M) = $4M; and
(b) $5M.
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