To Have and to Hold Part 2: Incorporation of Investment Income

September 2024

Stephanie Pantaleo, CPA, MTax, CIM^®
Vice President, Family Office Services

 

Our June publication covered the tax considerations of incorporating business income in Canada. To summarize, business income is subject to a lower corporate tax rate compared to the tax rate imposed on an individual who earns business income directly. The result is that there are more after-tax dollars in the corporation versus if the income was earned personally. The longer the after-tax funds are held by the corporation before being distributed to individual shareholders as a taxable dividend, the greater the tax benefit resulting from the deferral of personal tax.

Now, if the after-tax dollars are held by the corporation, it is likely that these dollars will be put to work – either reinvested back into the business (to purchase new equipment or fund a new marketing effort, for example) or used to earn investment income. Earning investment income introduces an entirely new tax regime separate from that of taxes levied on business income.

Incorporation of Investment Income

To begin, investment income includes dividends [1], rents, interest, foreign non-business income, royalties and capital gains, and is often referred to as passive income.

The taxation of investment income earned by Canadian corporations resident in Canada [2] is very complex, and the legislation in this area continues to evolve.

So how is investment income earned in a corporation taxed?

Recall the principle of integration. The underlying concept of integration is that income earned by a Canadian corporation and then paid to an individual as a taxable dividend, should equate to the same amount of tax if the income had been earned directly by the individual. Our June publication illustrated how the initial corporate tax bill on $100 of business income, plus the personal taxes levied on the distribution of the after-tax corporate profits, approximately equates to the amount of personal taxes that would have been incurred if the individual earned the $100 of business income directly.

While this principle holds true to business income, integration does not apply to investment income. The total corporate tax plus personal tax on the after-tax corporate profits will not equate to the personal tax bill if the investment income had been earned directly by the individual. Further, the corporate tax rate levied on investment income is much higher than corporate business income rates – effectively minimizing the potential opportunity for personal tax deferral that we observed with business income earned by a corporation.

To illustrate, a corporation resident in Ontario that earns $100 of interest income is subject to a tax rate of 50.2% [3], generating taxes of approximately $50 and after-tax corporate profits equal to approximately the same amount. A portion of the $50 of corporate taxes is refundable to the corporation – more on this in a moment. If the individual (top income earner, residing in Ontario) earned the $100 of interest income personally, they would be subject to a 53.5% tax rate, leaving them with approximately $46 in after-tax funds.

On the surface, it appears that the individual is better off earning the $100 of interest income in the corporation versus earning it personally, as there are more after-tax profits ($50 versus $46) available in the corporation. The difference of $4 highlights that there is still some personal tax deferral available by earning investment income in a corporation, but not nearly as much of a deferral as we observed with business income [4]. However, it would be incorrect to stop the analysis here because the principle of integration requires us to look to the total corporate and personal tax levied on this $100 of income once the corporate profits are distributed to shareholders.

Of the initial corporate taxes paid of $50, $31 is refundable to the corporation when the corporation makes a taxable distribution to its shareholder reducing the total corporate tax bill from $50 to $19 (being the original tax of $50 less the tax refund of $31). When the corporation distributes the $50 in after-tax corporate proceeds plus the $31 it receives as a refund, so $81 in total, the individual will pay approximately $39 of personal tax leaving them with $42 of after-tax proceeds. Recall from above, if the individual earned the $100 of interest income personally they would have approximately $46 in after-tax personal funds compared to $42 if the interest income originated in the corporation. Earning the interest income in the corporation is costlier by $4.

To summarize:

1. There is a tax cost of incorporating investment income once the after-tax corporate profits are distributed to shareholders – a purposeful flaw to the principle of integration.
   
2. Although the tax rate imposed on investment income earned by a corporation is higher than the tax rate charged on business income, there may still be some personal tax deferral. This depends on the individual’s personal tax rate. The example above quantifies the deferral presented for an individual subject to the top marginal personal rate in Ontario, but if an individual’s personal tax rate is less than the corporate tax rate imposed on investment income, then no personal tax deferral is available.

 With all this being said, if the use of a corporation provides a personal tax deferral opportunity, the longer the corporation holds the after-tax funds within the corporation, the more the individual benefits from the personal tax deferral.

Additional Considerations for Incorporation

 While not an exhaustive list, below are a few additional points to consider when earning income in a corporation. 

• There are annual costs (legal, accounting and tax) that should be considered with incorporation.
• A corporation that earns investment income does not preclude the corporation from earning business income as well – the different corporate tax regimes of business and investment income will be applicable. However, if a corporation/corporate group earns “too much” investment income, business income earned by that corporation/corporate group may not be subject to the lower corporate business tax rate, but rather the general business tax rate instead [5].
• The use of a corporation may permit some income splitting opportunities between adult shareholders which could result in an overall tax savings. However, income splitting may be limited due to tax law changes effective 2018 referred to as the tax on split income rules, or “TOSI.”
• The use of a Canadian corporation may limit a Canadian resident’s potential US estate tax exposure by holding US situs assets.
• In general, the existence of a corporation may permit shareholders to participate in an estate freeze. However, the use of a corporation will require a good estate plan to avoid the double taxation that may arise on death.
• A corporate structure will not act as a shield from future tax law changes. While there may be a perceived benefit for incorporating today, the benefit may not be available (or such benefit may change) in the future if there are any changes in the tax law.

Parting Words

It is evident that the use of a corporation creates an additional level of complexity to your affairs, and the tax system itself is far from simple.

While it may be helpful to quantify whether there is an opportunity to personally defer and save on the taxes in the short-term, before committing to a corporate structure, one must also weigh the tax and non-tax considerations as they specifically relate to the structure of your business, your investment holdings as well as your required personal cash flow. It will take a good plan (with a good advisor) to determine whether or not such a structure makes sense for you today and in the future.

Remember, it is not a question of whether taxes will be paid, it’s a matter of when.

 

 

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