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4562 Lecture 4 - Corporate Tax for Closely Connected CorporationsInvestment Income
Last updated on January 17, 2012
Midterm 1 information
The midterm is on Sunday, February 5, from 7 to 9 pm and will cover Lectures 1 to
4. The midterm location is ACW 206
Students who have a conflict should contact Cynthia Shea (and c.c. your course
director) at cshea@yorku.ca 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.
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, 12
For Exercise 12, please use the federal/provincial rate tables on page 792 of FIT.
The federal rates are the correct rates for 2011. The provincial rates are
hypothetical because rates vary by province. If you need personal (i.e., noncorporate) 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 12 (which shows how integration works;
integration will be discussed in lecture 11). You can ignore the algebraic calculations
found in footnote 2 of the solution to exercise 12.
Remember to print the lecture notes, read the lecture notes and do the Problem Set and
Exercises. You should also review the recommended Review Questions and Multiple
Choice Questions and bring your textbook and the Act to class.
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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)
= 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 44.67% in 2011 in theory; i.e., 38% - 10% + 6.67% =
34.67% plus 10% theoretical provincial tax rate = approx. 44.67%)
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 a 25% gross-up) a net 20%
corporate rate prevents double taxation of investment income earned corporately and paid
out as dividends. Eligible and non-eligible dividends will be discussed in lecture 11. The
actual net corporate tax rate, assuming a hypothetical 10% provincial corporate tax rate,
is 18% (i.e., 44.67% – 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
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4. forget to do all calculations
2.3
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 RDTOH and 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 20% 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 about 18% (44 and 2/3% - 26 and 2/3%) in theory. (It
actually is slightly higher since many provincial corporate tax rates exceed 10%.)
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 RDTOH closing balance and 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 44.67%
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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 -25/9 NBFTC – 3.77 BFTC]**
3. Part I tax
* Cannot be negative, if negative then equals nil.
** In 2012 and thereafter this will increase to “4 x BFTC”
(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 18% (44.67% 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.
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When there is no foreign income, Refundable Part I tax simplifies to
1 26 and 2/3% x Aggregate Investment Income
2. 26 and 2/3% [Taxable Income - amount eligible for the SBD]
3. Part I tax
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Part IV Tax (Dividends), 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 from non-connected corporations. 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.
Example:
X Ltd. owns 40% of S Ltd. and S Ltd. got a $100 dividend refund when it paid a $2,000
taxable dividend. 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 $2,000 x 40% = $267]
because X Ltd. and S Ltd. are connected
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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This means that if a connected payer pays dividends, the recipient will only pay Part IV
tax if the dividend causes the payer to get a dividend refund (i.e., the dividends are paid
out of investment income which created RDTOH for the payer)
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
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Capital Dividend Account (S. 89) = cumulative total 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
** 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)
You will learn more about the capital dividend account after the midterm.
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