Corporate market and its taxation

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Corporate market and its taxation

• Presented by
• Diane Hamel, CGA
• Director, Tax Estate Planning

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Business Vehicles

• Sole Proprietor

• Trust

• Partnership

• Corporation

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Benefits of Incorporation (Legal)

• The decision to incorporate
• separation of business and personal activities
• separation of several business interests
  (separate real estate from operating business)
• degree of permanence
• limited liability

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Benefits of Incorporation (Tax)

• The decision to incorporate
• Tax deferral
• Income splitting, estate freezes
• Tax rates
• 50 solution
• US Estate Tax Planning

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Disadvantages of incorporation

• Administrative costs
• Potential of double taxation
• Tax on capital

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TAX ON CAPITAL

• Applied by provinces
• Taxable Capital is based on year end Balance
  Sheet
• Quebec rate 0,64
• Tax deductible

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Taxable capital

• INCLUDE (generally)
• Share capital
• Retained earnings
• Loans and advances guaranteed by a corporate
  asset
• Loans and advances from shareholders and
  corporations
• All other debt outstanding for more than 6 months
• DEDUCT (generally)
• Deficit
• Investment allowance

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Investment allowance

• Eligible investments X Total assets

• Taxable capital
• otherwise
  
  determined

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Eligible investments

• Shares and bonds of other corporations
• Loans and advances to other corporations

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Example

• ASSETS
• Shares 100
• GIC 400
• 500

• LIABILITIES
• Payables 25
• Bank loan 225
• SHAREHOLDERS
• EQUITY
• Share capital 50
• Retained earnings 200
• 500
  

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Example (contd)
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Tax on capital and life insurance

• Cash value of a life insurance policy is not an
  eligible investment
• Cumulative life insurance premiums in excess of
  cash values reduce retained earnings

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TAX ON INCOME

• Public corporations
• Private corporations
• Canadian-controlled private corporations

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CCPCs2 Types of Income

• Canadian Controlled Private Corporation (CCPC)
• Active Business Income
• business vs. mere investment
• Passive (Non-business) Income
• Interest
• Dividends
• Rents, Royalties
• Capital Gains

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Two layers of tax

• In the hands of the Corporation when earned

• In the hands of the shareholder when received
  from the Corporation

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How is this Income Taxed?

• Corporate Tax
• on net income (after deductions)
• salary and bonus deducted from corporate income
• contributions to RCA deducted from corporate
  income
• dividends paid not deductible
• Personal Tax
• on distributions from the corporation
• salary/bonus
• dividend

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Personal tax rates - 2001
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Corporate tax rates - 2001
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Now listen carefully...

• Different types of corporate income are taxed at
  different rates

• more taxes are paid when income is distributed
  to shareholders

• need to ensure that method of distributing
  minimizes aggregate tax

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Frequent tax strategy

• Declaring a bonus to reduce the taxable income of
  the corporation to 200,000
• Why ???

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Integration on passive income
Theory combined personal and corporate tax
paid on income earned through a corporation and
paid to a shareholder
should be equal to tax paid on the same
income, if earned directly in the hands
of an individual shareholder
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Taxation of passive income

• Interest
• 52.30 of which 26.67 is refundable
• Dividends
• 0 if from connected corporation (10 votes
  value)
• 33.33 otherwise (portfolio dividends
• Capital gains
• 25.15 of which 13.34 is refundable
• Non-taxable portion credited to CDA

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Integration on passive income

• REFUNDABLE DIVIDEND TAX ON HAND (RDTOH)
• 26,67 of the passive income is refundable when
  the corporation pays out a dividend.
• Dividend refund ("DR") Lesser of
• 1/3 of taxable dividend paid
• RDTOH balance

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Integration on passive income

• CAPITAL DIVIDEND ACCOUNT (CDA)
• Mechanism that allows income that is not taxable
  to the corporation to be distributed to the
  shareholder tax free
• Non-taxable portion of the capital gains
• Proceeds from a life insurance policy (the
  portion that exceeds the ACB of the policy)

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Integration - Interest
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Integration - Dividends
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Integration - Capital gains
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To summarize...

• Dont just look at the corporations tax rate
• Shareholder might be biased toward receiving
  capital gains over dividends
• Key to owner/manager planning is
• structuring tax-efficient succession of
  businesses
• minimizing tax on corporate distributions

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2000 Mini-Budget (Oct.18, 2000)

• Reduction of capital gains inclusion rate to 50
• Significant
• 1/3 reduction - from 75 to 50 in one year
• Effective rate on capital gains 24.6 (effective
  rate on dividends 34.1)

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Change ...

• Before
• CAPITAL GAINS/DIVIDENDS...WHO CARES
• October 18, 2000
• DIVIDEND BAD
• CAPITAL GAIN GOOD

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So ...

• Why talk about insurance ?

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Question

• If taxes are going down, why would I want to
  invest in a tax shelter?

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Answer

• Because zero tax is better than low tax ...

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The Old hide-the-insurance-in-the-corporation
Trick

• Corporate - owned life insurance strategies still
  make sense
• creates CDA
• allows for tax-sheltered growth
• of corporate income
• allows tax-free extraction of corporate-assets
• may allow to reduce taxes
• payable on death

Reduce taxes payable on death ?
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CASE STUDY

• Now lets look at a case where life insurance was
  used to not only fund, but also reduce taxes
  payable on death

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Reducing taxes payable on death

• Freds age 50, Wilma 49
• Fred has done an estate freeze
• Freds shares
• FMV 3.0 M ACB nil
• Corporation has 2.5 M stock portfolio
• Corporation has 500,000 in Bonds

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Reducing taxes payable on death

• FREDS OBJECTIVES
• Wants to minimize taxes (now and at death)
• Wants to pass as much cash as possible on to
  Pebbles and Bam-Bam

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What if Fred Did No Planning?

• LETS TALK ABOUT FRED
• Fred dies first
• Freds shares pass to Wilma
• Spousal rollover - no taxes
• Wilma and kids are shareholders of Flintstone
  Holdings

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What if Fred Did No Planning?

• NOW LETS TALK ABOUT WILMA
• Wilma has shares
• Wilma has no income
• Wilma eventually dies
• Wilma is deemed to dispose of her shares
• Wilmas estate has tax liability
• 24.1 x 3.0 M 723,000
• Does Wilmas estate have cash?

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What if Fred Did No Planning?

• LETS TALK ABOUT THE KIDS
• Moms estate was reduced because of tax problem
• Kids are left with shares of
• Flintstones Holdings

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Questions

• How can we increase value of childrens
  inheritance?
• How can we reduce overall taxes payable (today
  and at death)?
• Answer Life Insurance

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Lets Talk Opportunity..

• Life insurance can help reduce taxes by using the
  50 solution
• Flintstone Holdings purchases a life insurance on
  Fred and Wilma for 1,500,000 on a joint
  second-to-die basis (50 of the value of the
  shares)

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Lets Talk Opportunity..

• Upon Freds death, the shares are transferred to
  Wilma
• Upon Wilmas death, Flintstone Holdings receives
  tax-free life insurance proceeds of 1,500,000
• Flintstone Holdings redeems shares from Wilmas
  Estate with 1,500,000 cash and a promissory note
  of 1,500,000

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Oups... more theory

• Share redemption taxed as a dividend
• Share redemption results in a disposition of the
  shares held by the Estate
• The disposition may result in a loss to the
  Estate
• The loss can be carried back to the deceased
  final tax return to eliminate the capital gain
  otherwise realized

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In short ...

• The redemption price is taxed as a dividend
• The capital gain on the final tax return is
  eliminated

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50 Solution - Estates Liability

• Redemption of Wilmas shares
• (i) Proceeds of Redemption 3,000,000
• PUC 0
• Deemed Dividend 3,000,000
• Tax-free capital dividend 1,500,000
• Taxable dividend 1,500,000
• Income tax _at_ 34.1 511,000

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50 Solution

• Estate tax liability reduced from 723,000 to
  511,000 (reduction of 29)

• Results

• Insurance funds the tax liability

• Estate has promissory note from Flintstone
  Holdings (1.5 M) and extra cash of 989,000

• Pebbles and Bamm-Bamm left with growth of
  Flintstones Holdings with an additional value of
  1.5 M

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But is is worth it ?

• Financially, does it make sense to increase the
  coverage from 723,000 to 1,500,000

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Of course ....

• Assuming the policy is funded over a 10 year
  period, a discount rate of 5, and that the taxes
  are deferred over a 33 year period,

NPV NPV DB - prem.
Taxes pay 723,000
47,940 97,809 1,500,000
102,086
74,861 Difference
54,146 22,948
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In conclusion

• Even in a dropping tax environment, insurance is
  still a viable vehicule to
• SHELTER investment income,
• FUND and
• REDUCE taxes payable

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Thank you !