Tax Planning and the Salary Dividend Mix - Part III
Our series on eligible dividends wraps up.
By Ed Kroft, LLB, LLM, CGA (Hon.)
In the last issue, I discussed the October 16, 2006, proposed legislation and how the new “eligible dividend” proposals were intended to work. Since that time the legislation for eligible dividends has been tabled and received Royal Assent on February 21, 2007.
The legislation has both immediate and future ramifications for taxpayers.
This article will deal with some of the planning implications flowing from the implementation of the legislation, as well as some of the administrative and compliance issues.
Communication of Eligible Dividend Status
In the last issue I mentioned that subsection 89 (14) of the Income Tax Act (“the Act”) states that the “eligible dividend” must be designated as such by the payor. The payor must notify the recipient in writing at the time of the payment of the “eligible dividend.” In response to many questions from taxpayers and their representatives regarding the designation of eligible dividends, the Canada Revenue Agency (CRA) issued a press release in late December which is found on its Website under the heading “Designation of Eligible Dividends.”
This document outlines what the appropriate notification will be for the 2006 and 2007 taxation years, both for public corporations and all other corporations. For 2006, the CRA indicated it would accept designations based on the identification of eligible dividends on the T3 and T5 slips. Other acceptable methods are posting a notice on the corporation’s Website and in corporate reports or shareholder publications.
Nevertheless, for 2007 and subsequent taxation years, for all corporations, other public corporations, the notification requirements of subsection 89 (14) of the Act must be met each time a dividend is paid. Examples of notification could include identifying eligible dividends through letters to shareholders and dividend cheque stubs, or, where all shareholders are directors of a corporation, a notation in the minutes of a corporation.
As a result of the passage of the legislation, dividends paid on or after February 21, 2007, must be designated as such at the time of payment. However dividends paid before February 21, 2007 can be designated as such up to May 22, 2007, (90 days after Royal Assent). There will not be any “fairness relief,” if taxpayers do not make the appropriate designation of eligible dividends.
If a corporation makes an excessive designation it will face a penalty tax under Part III.1 (section 185.1) of the Act. The corporation will be permitted to eliminate the Part III.1 tax liability if each shareholder of the corporation joins with the corporation in an election to convert otherwise “eligible dividends” into taxable dividends. These taxable dividends would be eligible for the ordinary gross up and dividend tax credit rather than the enhanced gross up and dividend tax credit associated with the payment of eligible dividends.
Ed Kroft, LLB, LLM, CGA (Hon.), is a partner in the Vancouver offices of McCarthy Tetrault, Barristers and Solicitors, which has more than 40 tax lawyers across Canada. His practice is limited to taxation.
Some Tax Planning Issues
Preferences for Individual Shareholders?
Eligible dividends will attract a lower tax liability because of the associated enhanced dividend tax credit. Therefore, it will be preferable for individual taxpayers resident in Canada to receive eligible dividends as distinct from ordinary taxable dividends, which are subject to the normal dividend tax credit. The pool from which eligible dividends can be appropriately paid is the "general rate income pool" (GRIP), which, generally speaking, contains after tax high rate active business earnings of the corporation and other corporations which have paid a dividend to the corporation.
It has been customary for taxpayers to bonus down the earnings of the corporation to a taxable income number which does not exceed the threshold at which the small business deduction can be accessed by the corporation.
However, will corporations continue to bonus down to the “small business” threshold of $400,000 in 2007 if shareholders can only access eligible dividends from GRIP? Bonusing to $400,000 might otherwise eliminate the GRIP.
It is suggested that corporations must carefully review whether to continue to bonus down to the small business threshold or leave taxable income inside the corporation to be taxed at higher corporate tax rateswith the prospect of more favourable tax efficient distributions to shareholders in subsequent years. Although the corporation may be subject to higher corporate rates of tax in the near term, the prospect of the tax deferral available to individual shareholders who would receive the payment of eligible dividends in a subsequent year at a lower tax rate will, after the lapse of a number of years, offset the immediate cost of the corporation paying the higher corporate taxes.
In 2006, there is also the added issue in British Columbia of whether to bonus down to $300,000 or $400,000. It would appear that in 2006 it may have been more advantageous to bonus down to $400,000 rather than $300,000.
This may have resulted from the applicabilityof the B.C. dividend tax credit of 12 per cent to eligible dividends which represent after tax income which was taxed inside the corporation at the 4.5 per cent (rather than the 12 per cent) B.C. corporate tax rate.
In all circumstances it will be necessary fora corporation to “run the numbers” to determine whether to bonus down and whether the immediate tax cost of paying the higher rate of corporate tax is offset by the benefits of tax deferral.
One may also wish to bonus down so as to maximize the “earned income” and the RRSP contribution limits of any bonus recipient in any of these circumstances. The need to bonus down may prove important for other reasons such as the preservation of the corporation’s entitlement to tax preferences such as refundable investment tax credits flowing from scientific research and experimental development expenditures. In addition, the status of the corporation’s shares as “qualified small business shares” could depend on the continued qualification of the corporation as a “small business corporation,” which in turn could be affected by the failure or need to bonus down income that was not active business income.
Payment of Eligible Dividends to Different Persons
Different shareholders may benefit from the classification of dividends as “eligible dividends”. For example, individuals resident in Canada can claim the dividend tax credit whereas non-residents of Canada may not. Therefore corporations may choose to establish multiple classes of shares upon which to pay different types of dividends. This practice of paying different amounts or types of dividends on different classes is now employed to split taxable dividends or to shift capital dividends from the capital dividend account. Income splitting will continue with the payment of eligible dividends as a valuable tool. Shareholders who receive eligible dividends will be able to receive a much higher amount of eligible dividends tax free as distinct from those who receive taxable dividends subject to the normal dividend tax credit.
Deemed dividends will also be eligible for treatment as eligible dividends. Consequently, it will be necessary to consider the impact of these new rules in circumstances where shares are redeemed or repurchased, whether pursuant to a negotiated sale or the terms of a shareholder’s agreement. Repurchases of shares following the death of a shareholder may trigger eligible dividends.
“Dividend Refunds” under section 129 of the Act of $1 of corporate tax from the RDTOH account arise once $3 of taxable dividends are paid. The RDTOH account usually contains a refundable portion of Part I tax on investment income and Part IV tax on dividends. Taxpayers may discover, when calculations are done, that it may be possible for the corporation to obtain a dividend refund of corporate taxes paid on investment income when it pays “eligible dividends” out to the shareholders. This may occur where a corporation has a mix of investment income and active business income subject to the high rate of tax which falls into the GRIP.
When assets are sold in the course of a sale of a business, the allocation of the sales price to various assets may in turn be affected by the desire of the corporation selling the assets to subsequently pay eligible dividends to shareholders. To the extent that the corporation generates active business income from the sale of items such as inventory and goodwill, then the amount in the GRIP will increase. This is distinct from allocations of the sales price to assets which give rise to capital gains. GRIP, however, can increase from the recapture of CCA previously claimed against active business income.
Get a GRIP Before Year End?
A GRIP calculation must be done at the end of the taxation year. If eligible dividends will be paid during a taxation year when insufficient GRIP exists, the corporation must “locate” GRIP before year end to avoid the penalty tax. This could occur from receipt of “eligible dividends” from other corporations, dividends from foreign affiliates or earnings of taxable high rate active business income. Don’t forget the transitional rule for the calculation of GRIP for the 2001 – 2005 taxation years in subsection 89(7) of the Act. In addition, GRIP might arise in a taxation year if a corporation is reassessed for additional active business income, though generally I cannot conceive of someone calling CRA to audit the corporation to consciously generate GRIP in this way.
Loosen Your GRIP
As GRIP may be a positive or negative number, a corporation might consider paying “eligible dividends” while GRIP still exists. This is no different than practices now adopted by practitioners to clear the “capital dividend account” before it goes negative.
Is There Any Way Out of These New Rules?
A Canadian-controlled private corporation may elect not to be “CCPC” for purposes of these new rules. However, short of dealing with these new rules contained in section 249 of the Act (which results in a year-end status change), a CCPC will have to learn the impact of these new rules. As time goes on and advisors become familiar with the new rules and the nuances that flow from the calculations and implementation of the rules, further planning opportunities and pitfalls will surely arise.