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CHAPTER 9 TOBIAS INTEGRATION OF CORPORATION AND SHAREHOLDER TAXES

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Title: CHAPTER 9 TOBIAS INTEGRATION OF CORPORATION AND SHAREHOLDER TAXES


1
CHAPTER 9 TOBIAS INTEGRATION OF
CORPORATION AND SHAREHOLDER TAXES
  • FRANK LAVITT
  • Section 9.4 of Tobias (Pages 286 to 292 is not
    part of the examinable materials)

2
  • The Canadian Income Tax System is one of the few
    in the world which attempts to successfully
    achieve integration.
  • Integration refers to ensuring that the combined
    corporate and personal tax on income earned
    through and distributed by a corporation, is
    equal to the tax that would have been paid if
    income had been earned directly by the individual
    (living person) taxpayer.

3
  • Many students and practitioners, have a difficult
    time with the taxation of the investment income
    of a CCPC particularly with the mechanics of the
    various tax calculations involved and how they
    inter-relate.
  • Unique terminology and special tax accounts such
    as refundable dividend tax on hand, dividend
    refunds, Part IV tax, refundable tax levies and
    refundable Part I taxes confuse rather than aid
    in understanding.

4
  • It is not nearly as difficult as it first
    appears.
  • If you grasp the fundamental concept of
    integration and focus on that, the materials that
    we will be discussing today will be less
    challenging.

5
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6
  • Elements of Integration System
  • The integration framework is composed of
    different elements, which we call "integration
    tools".
  • The following is an introductory summary.
  • (1) The first element is the refundable portion
    of Part I tax. The refundable tax is 20 of
    Canadian investment income.

7
  • Why levy a tax if it is only going to be
    refunded?
  • The refund is only available when the corporation
    pays a taxable dividend to the shareholders.
  • As long as the money is retained in the
    corporation, tax must be levied to prevent
    inappropriate tax deferral.

8
  • (2) The second element is a separate refundable
    tax on the investment income of a CCPC.
  • The tax is levied at 6 2/3. This is the
    Additional Refundable Tax.
  • Without this Additional Refundable Tax, the
    combined federal and provincial corporate tax
    rate is less than the highest marginal personal
    tax rate.

9
  • This tax is levied to prevent any opportunity for
    tax deferral by receiving investment income
    through a corporation rather than personally.
  • This tax is refunded when the corporation pays a
    taxable dividend.

10
  • (3) The third element is Part IV tax on dividend
    income.
  • Recall that dividends are deductible in
    determining a corporation's taxable income.
  • Were it not for Part IV tax, dividends would be
    completely tax free to the corporation.
  • Individual investors would pay personal tax on
    dividends received.
  • Part IV tax is levied at 33 1/3, which is
    approximately the rate individuals pay on taxable
    dividends.

11
  • In Manitoba, the combined top marginal tax rates
    on dividends is
  • Eligible - 23.83
  • Non-Eligible - 37.40
  • The Part IV tax then prevents any opportunity for
    tax deferral by receiving dividends through a
    corporation rather than personally.
  • To prevent double taxation, Part IV tax is
    completely refundable (at a rate of 1 for every
    3 of dividends paid) when the corporation pays
    taxable dividends to the shareholders.

12
  • (4) While the foregoing three taxes are
    refundable, the refund only occurs when the
    corporation pays a taxable dividend out to its
    shareholders.
  • A tax account - the Refundable Dividend Tax On
    Hand Account ("RDTOH") - is used to "inventory"
    these refundable taxes.
  • The RDTOH account is a running accumulation, net
    of any refunds paid, of refundable taxes paid -
    or, "on hand", as the name implies.

13
  • Do not be confused by the name "refundable
    dividend tax on hand".
  • This account houses all three types of refundable
    taxes, not just those (i.e. Part IV) levied on
    dividend income.
  • The word "dividend" in the account name refers to
    the fact that these taxes are refundable on
    paying a dividend.

14
  • (5) The next-to-last element is the dividend
    refund.
  • This is the amount of refundable taxes,
    accumulated in the RDTOH account, which are
    actually refunded when a taxable dividend is
    paid.
  • The rate at which the taxes are refunded is 1
    for every 3 in taxable dividends paid.
  • The refundable taxes refund is called a "dividend
    refund".
  • The logic of the 13 ratio will be covered later.

15
  • (6) The last integration element is the dividend
    tax credit. The dividend tax credit prevents
    double taxation as any taxable dividend is a
    distribution of after-tax corporate income.

16
  • AGGREGATE INVESTMENT INCOME
  • One of the items involved in the RDTOH account is
    aggregate investment income.
  • There is no small business deduction on
    investment income, nor does it qualify for the
    general rate reduction.
  • Under Part I, investment income is effectively
    taxed at a high rate.

17
  • By paying a taxable dividend, a private
    corporation may get a significant portion of this
    tax back through a dividend refund.
  • By paying a dividend, the investment income flows
    through the corporation.
  • The resulting dividend refund may result in a
    relatively low effective tax rate on the
    investment income.

18
  • The dividend received is then included in income
    by the corporate recipient but then deducted in
    arriving at taxable income, hence there is no
    Part I tax paid by the corporate recipient on the
    dividend.
  • This would create the possibility of a long-term
    deferral of tax when the income is not
    distributed to shareholders.
  • This is known as "dividend parking".

19
  • If the recipient of the dividend was an
    individual (i.e. a living person) instead of a
    corporation, the individual would have to pay tax
    on the amount of investment income as it was
    received or accrued.
  • The tax system offsets this form of bias by
    ensuring the investment income is continuously
    taxed at a high rate within the corporate
    structures until it is eventually distributed to
    the individual shareholders.

20
  • This is part of the integration system.
  • It acts as a disincentive to accumulate passive
    income in a private corporation.
  • Where the recipient corporation is connected to
    the payer corporation, the recipient corporation
    had either influence or control over the payment
    of the dividend.
  • Therefore, the companies may wait until there is
    a balance in the RDTOH account and then elect to
    pay a dividend in order to trigger a dividend
    refund.

21
  • Once the dividend refund is triggered, the
    federal government refunds part of the previous
    taxes paid under either Part I or Part IV or
    both.
  • For corporations not connected, the assumption in
    the integration system is the payer received 1
    as a dividend refund for every 3 in taxable
    dividends paid.

22
  • REFUNDABLE PORTION OF PART I TAX
  • The refundable portion of Part I tax is 20 of
    CCPC's investment income.
  • Investment income is all income from property,
    both Canadian and foreign.
  • Income from property includes rents, taxable
    capital gains (net of losses), and interest.

23
  • Taxable dividends from Canadian and foreign
    affiliate corporations are excluded, where these
    were deductible in determining taxable income and
    a separate tax is levied, as applicable, under
    Part IV.
  • Only a corporation that was a CCPC throughout the
    year qualifies for the Part I refundable tax.
  • Investment income also includes any income from a
    specified investment business carried on in
    Canada.

24
  • Any refundable portion of Part I tax is
    accumulated in (added to) the RDTOH account.
  • The 7 general rate reduction for taxation years
    after 2003 (and other planned rate reductions in
    the future) do not apply to a CCPC's investment
    income.
  • This is because the tax/income already benefits
    from the refundable tax provision.

25
  • AGGREGATE INVESTMENT INCOME
  • Aggregate investment income is broadly defined to
    include income from property, plus net taxable
    capital gains, less certain adjustments.
  • Property income, for the purposes of this
    definition, includes net income from all
    property, other than
  • (a) exempt income and
  • (b) dividends which are deductible in computing
    taxable income.

26
  • The meaning of the term "income from property" is
    amplified by the definition "income" or "loss"
    which includes income from a specified investment
    business carried on in Canada, but excludes
    income from the following sources
  • (a) from any property that is incident to or
    pertains to an active business carried on by a
    corporation, or
  • (b) from any property used or held primarily for
    the purpose of earning income from an active
    business carried on by the corporation.

27
  • Net losses from property are deducted from the
    foregoing amounts of property income.
  • Foreign investment income is calculated as
    aggregate investment income from foreign sources.
  • Hence, aggregate investment income includes that
    income from both Canadian and foreign sources.

28
  • As part of the system of integration, one-half of
    the capital gains and capital losses that is not
    included in income, is included in the
    corporation's capital dividend account.
  • As mentioned last week, the Act permits the
    corporation to pay a tax free dividend out of the
    capital dividend account.
  • The capital dividend is received free of tax by
    the Canadian Resident shareholder.

29
  • This completes the full integration of capital
    gains through a private corporation or
    Canadian-controlled private corporation and, with
    respect to the tax-free portion of the capital
    gains, places the shareholder in the same
    position as if he or she received the gain
    directly.

30
  • ADDITIONAL REFUNDABLE TAX
  • Basic Rules
  • For Canadian-controlled private corporations, a
    refundable tax is imposed on "aggregate
    investment income".
  • This tax can be summarized as follows
  • 6 2/3 X the lesser of

31
  • (a) aggregate investment income, and
  • (b) taxable income minus the amount on which the
    small business deduction is based.

32
  • Aggregate investment income (AII) can be
    summarized as follows
  • Net taxable capital gains for the year,
  • Less net capital losses deducted under Division
    C,
  • Plus income from property (Canadian and
    foreign),
  • Includes interest, royalties, rents and
    dividends.
  • Less dividends deducted under Division C,
  • Less losses from property (Canadian and foreign).

33
  • REFUNDABLE DIVIDEND TAX ON HAND (RDTOH)
  • The Concept
  • "Refundable dividend tax on hand" (RDTOH) may be
    viewed as an account which accumulates all of the
    tax paid by a private company on its portfolio
    dividend income (i.e., Part IV tax at 33 1/3)
    and a portion of the Part I tax paid by a
    Canadian-controlled private corporation on other
    investment income.

34
  • The principal components of the account are as
    follows
  • the refundable portion of Part I tax (including
    the ART) that is paid on investment income
  • the amount of Part IV tax that is paid on taxable
    dividends and
  • the RDTOH balance at the end of the previous
    year, less "dividend refunds" of the previous
    year that arise when the corporation pays taxable
    dividends.

35
  • The taxes that are accumulated in the RDTOH
    account are refundable to the company at the rate
    of 1 of refund for every 3 of taxable dividends
    paid.
  • These refunds are commonly referred to as
    "dividend refunds", which reduce the balance in
    the refundable dividend tax on hand account.

36
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37
  • RDTOH Continued
  • The basic purpose of the RDTOH calculation is to
    aggregate the two types of refundable taxes
    (i.e., refundable portion of Part I tax for
    investment income and Part IV tax for portfolio
    dividends), net of the amount of refundable taxes
    actually received.
  • The refundable portion of the Part I tax is
    designed to produce a refundable tax equal to 26
    2/3 of investment income (excluding most
    dividends).

38
  • The refundable portion of Part I tax is limited
    by the amount of tax payable under Part 1,
    because there should not be a potential refund of
    a portion of Part I tax that has not been paid.

39
  • Such non-payment of Part I tax may be due to the
    carryover of losses, deductions such as the small
    business deduction and the MP profit deduction,
    or credits such as foreign tax credits and
    investment tax credits.

40
  • DEEMING RULES OR ANTI AVOIDANCE RULES
  • What are known in practice as "deeming rules" are
    provided as an anti-avoidance provision that
    converts what would be property income (e.g.,
    rent and interest) into active business income.
  • However, this deeming provision only applies in
    situations where the income was derived from an
    associated corporation that had deducted the same
    amount in determining its active business income.

41
  • Were it not for these deeming rules, it would be
    possible for a corporation that was approaching
    the 400,000 business limit for its small
    business deduction to transfer certain of its
    assets to a new associated corporation which
    would rent the assets back to the original
    corporation.
  • The rental expense incurred by the original
    corporation would be deductible, thereby reducing
    its active business income and preventing income
    in excess of 400,000 from being taxed at full
    corporate rates.

42
  • The rental income to the new corporation would be
    considered income from property or income from a
    specified investment business and would,
    therefore, be eligible for refundable treatment.
  • However, as a result of the deeming rules, the
    amounts received are deemed to be active business
    income of the recipient.

43
  • As a result, the combined active business income
    of the original corporation and of the new
    corporation, which receives rent deemed to be
    active business income is the same as it would
    have been if the new corporation had not been set
    up.

44
  • The fact that the two corporations must share the
    400,000 business limit has no effect on the
    total active business income of the group.
  • Thus, any active business income in excess of
    400,000 within the associated group will be
    taxed at full corporate rates as it would have
    been without the new corporation.

45
  • These deeming rules are summarized in the chart
    below

46
  • As indicated previously, the incentive to
    re-characterize business income, that would be
    taxed at the high corporate rate, as investment
    income is greatly reduced with the higher 45
    gross-up and tax credit on eligible dividends.

47
  • PART IV TAX
  • Part IV tax is levied on taxable dividends that
    have been excluded from taxable income under
    sections 112 and 113.
  • Without this Part IV tax, there would be
    inequality in the tax system, as individuals
    could incorporate a company to receive dividends
    they would otherwise receive personally, and
    avoid paying taxes (at least on a current basis).
  • Part IV tax is levied at the rate of 1/3,
    applies to all private corporations, not just
    CCPCs.

48
  • Any Part IV tax paid is also added to the RDTOH
    account and is refundable on paying a taxable
    dividend to shareholders.
  • The 1/3 rate is used, because it is approximately
    the tax rate that applies to taxable dividends
    received by individuals.
  • (Remember that Manitoba has a higher top dividend
    tax rate - 37.40).
  • Subsection 186(1) uses the term "assessable
    dividends" to describe the dividends subject to
    Part IV tax.

49
  • These are defined at subsection 186(3) as
    dividends that have been deducted in determining
    taxable income.
  • An assessable dividend, as defined under
    subsection 186(3), is an amount received by a
    private corporation on account of a taxable
    dividend, which is deductible under section 112
    and 113 in computing the recipient's taxable
    income.

50
  • There are two types of assessable dividends
  • (1) those received from non-connected
    corporations (generally these are from corporate
    shares held as part of an investment portfolio,
    and are generally referred to as portfolio
    dividends) and
  • (2) those received from connected corporations.
  • The first type are always subject to the 1/3 Part
    IV tax.
  • The second type are only subject to the Part IV
    tax in limited circumstances, and in a different
    manner.

51
  • First, we'll define a connected corporation.
  • Corporations are connected if
  • the dividend-paying corporation is controlled by
    the dividend-receiving corporation or
  • the dividend-receiving corporation owns more than
    10 of the voting shares of the dividend-paying
    corporation and
  • those shares represent more than 10 of the fair
    market value of all the issued share capital.

52
  • For the purposes of Part IV tax, subsection
    186(2) contains a definition of controlled
    corporation.
  • A corporation is controlled by another
    corporation if more than 50 of its voting shares
    belongs to
  • the other corporation
  • persons related to the other corporation
  • or
  • the other corporation and persons related to it.

53
  • Consider the following situation.
  • Is Benson Ltd. connected with Indy Ltd.?

54
  • Solution
  • Benson Ltd. is connected with Indy Ltd. because
    Benson Ltd. is controlled by Indy Ltd. under
    paragraph 186(4)(a).

55
  • Consider the following situation.
  • Is Xavier Ltd. connected with Callus Ltd.?

56
  • Solution
  • Under paragraph 186(4)(b), Xavier Ltd. is
    connected with Callus Ltd. because Callus Ltd.
    holds more than 10 of the voting shares and more
    than 10 of the FMV of all the outstanding shares.

57
  • Dividends are allowed to pass freely (i.e.,
    without Part IV tax) between connected
    corporations because the money is not really
    leaving the "economic entity".
  • The only time there is Part IV tax on dividends
    between connected corporations is when the payer
    receives a dividend refund from its RDTOH.
  • The Part IV tax payable by the recipient
    corporation should be viewed as simply a
    replacement of that refundable tax.

58
  • Connected Corporations Dividend
  • ABC Inc. owns 100 of the shares of XYZ Inc.
  • XYZ Inc. paid a dividend of 40,000 up to its
    parent company (ABC Inc.).
  • XYZ Inc had 10,000 of refundable Part I taxes in
    its RDTOH account.
  • On paying the taxable dividend, these taxes were
    refunded to XYZ.
  • What is ABC Inc.'s position vis-à-vis Part IV
    taxes and RDTOH?

59
  • Solution
  • Dividend refund to XYZ from its RDTOH 10,000
  • ABC Inc.
  • Part IV tax payable on 40,000 dividend 10,000
  • Addition to RDTOH 10,000
  • Change in the economic position
  • of both companies
  • considered together NIL

60
  • In the preceding example, the Part IV tax
    liability of ABC Inc. was equal to the dividend
    refund realized by its subsidiary, and not 1/3 of
    the dividend received.
  • This is because ABC is only required to replace
    the dividend refund paid to XYZ.
  • This "matching" is accomplished by the formula
    given at paragraph 186(1)(b).

61
  • Payer's dividend refund X Dividend received
    from a connected company
  • Total dividend paid by the payer
  • As you can see from the formula, the recipient's
    Part IV tax on dividends from a connected
    corporation is related to the dividend refund
    realized by the dividend-paying corporation and
    not 1/3 of the dividends.
  • If the payer corporation does not receive a
    dividend refund, then no Part IV tax is payable
    by the connected recipient corporation.

62
  • APPLICATION OF NON-CAPITAL LOSSES TO PART IV
    TAXES
  • It is possible for a private corporation to
    reduce dividend income subject to Part IV tax by
    applying otherwise available non-capital losses.
  • The corporation may either apply the non-capital
    losses to reduce taxable income or apply the
    non-capital losses against dividend income
    subject to Part IV tax.

63
  • From a tax-planning perspective, it is generally
    unwise to utilize losses to reduce Part IV, since
    Part IV tax is a refundable tax.
  • The only time losses should be used to reduce
    Part IV tax is where those losses are expiring
    due to the seven- or ten- or twenty-year carry
    forward limitation.

64
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