Tax II Chapter 4 Spring 2013
Notes
Chapter Four Lecture Notes
Special Refundable Tax System
For Investment Income of
Certain Private Corporations
David Christian Spring Term 2013
Thorsteinssons LLP UBC Faculty of Law
______
Notes
In my own case the words of such an act as the Income Tax, for example, merely dance before my eyes in meaningless procession – cross-reference to cross-reference, exception upon exception – couched in abstract terms that offer no handle to seize hold of – leave in my mind only a confused sense of some vitally important, but successfully concealed, purport, which it is my duty to extract, but which is within my power, if at all, only after the most inordinate expenditure of time.
Hand J.
1. The focus of this Chapter is on a special refundable tax system at the corporate level, which is fundamentally designed to:
· prevent deferral of tax by earning the investment income inside a corporation; and
· permit integration of tax when comparing the earning of investment income personally or inside a corporation.
The Chapter will look at two types of special taxes on “investment income” and will examine the “refundable nature” of these taxes. The investment income in this context consists of two broad categories: (i) all investment income except dividends received from other Canadian corporations, and (ii) dividends received from other Canadian corporations.
The refund of the tax imposed on these two categories of investment income is handled through a mechanism that is referred to as the “RDTOH account”. The name will become clear below. Dividends paid by a certain type of corporation that earns this investment income, and pays the special taxes on the investment income, will trigger a refund of tax to the corporation. The RDTOH account is a method of tracking the amount of tax the corporation can potentially get refunded to it upon payment of sufficient dividends by that corporation.
This Chapter will also look at how the corporate tax system deals with the one half tax-free portion of capital gains realized by a CCPC.
Investment Income Except Dividends from Other Canadian Corporations
2. This scheme imposes a special tax on the “aggregate investment income” of a Canadian-controlled private corporation (CCPC). We are familiar with the legal concept of a CCPC. What is captured by “aggregate investment income”? Read the definition of that term in subsection 129(4). This consists of the following net income amounts:
· The amount, if any, by which the “eligible portion” of the corporation's taxable capital gains for the year exceeds the total of (i) the eligible portion of its allowable capital losses for the year and (ii) net capital losses for other taxation years deducted in the year (paragraph (a)).
· The corporation's “income for the year from a source that is a property” other than the portion of any dividend from another Canadian corporation that was deductible under section 112 in computing the corporation's taxable income for the year (paragraph (b)). (Dividends from other corporations are subject to the other special refundable “Part IV” tax below.)
3. The “eligible portion” of a taxable capital gain is defined in subsection 129(4) as the portion of a taxable capital gain (or allowable capital loss, as the case may be) of the CCPC for the year from a disposition of a property that cannot reasonably be regarded as having accrued while the property was held by a non-CCPC. How could the latter arise?
4. What constitutes “income from a source that is a property”? Recall the concept of “income from property” in Tax I? Krishna describes it this way:
Generally, income from property is the investment yield on an asset. Rent, dividends, interest, and royalties are typical examples. We earn the yield on the investment by a relatively passive process. For example, where an individual invests in land, stocks, bonds, or intangible property, and collects investment income therefrom without doing much more than holding the property, the income is … income from property.
5. Remember Chapter 3 and the notion of a “specified investment business”? Income from that business did not qualify as an “active business” of a CCPC. Now read the definition of “income from a source that is a property” in subsection 129(4).
· You specifically include as this type of income the income from a specified investment business carried on by the CCPC in Canada (paragraph (a)). Consider some examples (rental apartment building, franchising business, investing in second tier mortgage financing, etc.).
· You specifically exclude from this type of income:
o the income from any property that is incident to or pertains to an active business carried on by the CCPC, and
o the income from any property that is used or held principally for the purpose of gaining or producing income from an active business carried on by it.
6. Read the decision in Shamita Inc. v. The Queen (copy enclosed with these materials).
7. What tax rate applies to a CCPC’s “aggregate investment income” and how does the refundable portion of that tax work? Remember Chapter 1, where we said the “base case” tax rate on a corporation’s income was as follows.
“Base case” tax rate to be applied to the corporation’s taxable income to arrive at the tax owing by the corporation / % / Section references and notesstart with (historical) federal tax rate / 38 / 123(1)(a) - most recent, but still historical, base federal rate
subtract the federal “general rate reduction” / 13 / 123.4(2) - this gives us the current base federal rate of 25% before making “room” for the provincial and territorial taxes - assume here the corporation’s income is basic “full rate taxable” income
subtract the “provincial abatement” / 10 / 124(1) – makes “room” for the provinces and territories to impose their own tax rate on the corporation’s “taxable income earned in a province” – this gives us the net current federal rate of 15% where the corporation’s income is subject to provincial or territorial tax
add the base case provincial tax rate on the corporation’s income earned in the province / 10 / the provincial rate here is the base rate of 10% in subsection 14(2) Income Tax Act (British Columbia)
thus, the total tax “base case” tax rate on the corporation’s taxable income in Canada is / 25 / the base corporate tax will vary across Canada as provinces and territories impose tax at rates different from British Columbia
8. Recall in Chapter 3 the “base case” is modified where the corporation is a CCPC and the income is “active business income” under $500,000. The “base case” is also modified where the corporation is a CCPC and the income is “aggregate investment income”. In this event, the corporate tax rate that applies to the aggregate investment income is built as follows.
start with initial base federal tax rate / 38 / 123(1)(a) - most recent, but still historical, base federal rate.general federal rate reduction / 0 / Read paragraph (b)(iii) of the definition of “full-rate taxable income” in 123.4(1), which backs-out of the income qualifying for the general rate reduction a CCPC’s “aggregate investment income”.
subtract the “provincial abatement” / (10) / 124(1) – recall this makes “room” for the provinces and territories to impose their own tax rate on the corporation’s “taxable income earned in a province” – this gives us the net current federal rate of 28% before the “special” additional tax on aggregate investment income.
add the special tax / 6.67 / 123.3 - this is the special additional tax applies to a CCPC’s aggregate investment income. This gives us the net federal rate of 34.67% -
provincial tax / 10 / the general corporate rate in British Columbia.
Total initial corporate tax on a CCPC’s aggregate investment income / 44.67 / Note: This is the tax rate before any refund out of the RDTOH account below.
The object of adding the refundable tax is that there be “no deferral of tax” on investment income earned by a corporation. Imagine an individual who would otherwise earn aggregate investment income personally. The personal tax rate (top rate) in British Columbia we saw from Chapter 1 is 43.7%. If that same income is earned inside a CCPC, the tax rate applicable to that income is 44.67%. There is certainly no deferral advantage gained by earning the aggregate investment income inside the CCPC. In fact, there is a 0.97% disadvantage to earning the income inside a CCPC.
9. This is not the end of the tax system for a CCPC’s aggregate investment income. Turn to the rules for a “refund” of some of the 44.67% tax paid by the CCPC as shown above. Read subparagraphs 129(1)(a)(i) and (ii). When a tax return is filed for a year, the Minister refunds to the CCPC (actually any private corporation – which will become relevant for Part IV tax below as well) an amount equal to the lower of two amounts:
· 1/3rd of all taxable dividends paid by the CCPC in the year; and
· the CCPC’s “refundable dividend tax on hand account” (RDTOH account for short) at the end of the year.
The amount refunded to the CCPC is called the “dividend refund” for the year.
10. The foregoing leads to the question: What amounts are in a CCPC’s RDTOH account at the end of a current year? Read subsection 129(3). The CCPC’s RDTOH account at the end of a current year means:
The amount by which the total of:
· 26 2/3% of the CCPC’s aggregate investment income for the current year (paragraph a), and
· the taxes payable under Part IV for the current year on dividends from other corporations (discussed below), and
· the CCPC’s RDTOH account at the end of the preceding year
exceeds:
· the CCPC’s dividend refund for its preceding year.
11. How does this look numerically? Walk through the following chart (slowly).
CCPC$ / Individual Shareholder Recipient of Dividend $ / Paid to and refunded by the Government
1. CCPC’s aggregate investment income in year one is / 100
2. CCPC’s tax paid on its aggregate investment income in year one as determined above is / 44.67 / 44.67
3. CCPC’s remainder, say, cash in the bank is / 55.33
4. CCPC’s RDTOH account at the end of year one – 26.67% of its aggregate investment income in year one (assume no Part IV tax or prior year RDTOH). Note, this is an asset of the CCPC because the government must refund it upon payment of sufficient dividends by the CCPC. / 26.67
5. Assume the CCPC pays a taxable dividend of $82.00 (sum of cash and RDTOH) in year two – which is included in the shareholder’s income in year two under 82(1)(a). / 82.00
6. The payment of the dividend in year two allows the CCPC to claim a refund under 129(1)(a) equal to the lower of (i) 1/3rd of the dividend and (ii) its RDTOH at the end of year two – assume the RDTOH has remained at 26.67 at the end of year two for simplicity. / 26.67
7. The CCPC’s net tax paid on the aggregate invesment income is thus the initial tax less the amount refunded to it (44.67 – 26.67 = 18.00). / 18.00 / 18.00
8. The individual shareholder must include the additional “gross-up” amount in income equal to ¼ of the dividend paid under 82(1)(b). / 20.50
9. The individual shareholder’s total income is / 102.50
10. The individual’s tax at the top rate of 43.7% (recall from Chapter 1) is / 44.79
11. The shareholder is entitled to the dividend tax credit, which from Chapter 1 was 83.67% of the gross-up amount. / 17.15
12. The individual shareholder’s net tax is / 27.64 / 27.64
13. Total net tax paid by CCPC and individual shareholder is / 45.64
In broad tax policy terms, the dual objective of this special system for taxing a CCPC’s “aggregate investment income” is (i) to prevent the deferral of taxation by earning the income inside a CCPC (which is accomplished by, effectively, requiring the prepayment of shareholder distribution tax), and (ii) to achieve a very rough integration of tax when dividends are paid out of the CCPC. Notice, the net tax rate inside the CCPC, after the refund of a portion of the tax initially paid on the aggregate investment income, is roughly the 20% corporate tax rate that, in policy terms, was the basis for the “gross-up and dividend tax credit” system seen in Chapter 1, which is designed in policy terms to avoid double taxation.
Of course, there are variations from year-to-year in the initial corporate tax rate and the total tax paid on the aggregate investment income. The variations arise as the corporate and personal tax rates are changed at both the federal and provincial levels. Compare the top personal rate on aggregate investment income in British Columbia (43.7%) with the initial tax rate inside the CCPC (44.67%) and the total tax paid by the CCPC and the individual shareholder (45.64%). As matters currently stand, there is no deferral advantage (in fact, in our example there is a slight initial cost of 0.97%) and perfect integration is not achieved (in fact, there is a slight absolute cost of 1.94%).
12. Recall one point from Chapter 3. Certain income that would otherwise qualify as a CCPC’s “income from a source that is property”, and would thus otherwise be subject to the refundable tax system above, is deemed instead to be the CCPC’s “active business income” in cases described in subsection 129(6). Read subsection 129(6), which is sometimes called the “source preservation rule” for associated CCPCs. Recall the examples: