Tax Aspects of Dividends Paid by Corporations

Private corporations pay dividends of various kinds, often in order to achieve a particular result for the purposes of the Income Tax Act (Canada).  

The Business Corporations Act (Saskatchewan) distinguishes between a dividend (which, under corporate law, means the distribution of an equal amount, per share, of money or other property to the holders of all shares of a particular class of shares) and the payment of the value of a particular share by the corporation to the holder of that share upon the redemption or purchase for cancellation of the share. Nevertheless, the Income Tax Act (Canada) deems that, generally, the excess of the amount paid to the shareholder (upon redemption or purchase of a share for cancellation) over the paid-up capital of that share is also a dividend for income tax purposes. Any of the following references in this memo to a dividend includes a deemed dividend. Dividends and deemed dividends must be authorized by a resolution adopted by the directors of a corporation.

Canadian-controlled private corporations are generally eligible for a low rate of corporate income tax on active business income. In Saskatchewan, the combined rate of such federal and provincial tax is 11%. If all of the taxable income reported by a corporation was subject to that low rate of tax, the only kind of dividend that the corporation can pay is a taxable “non-eligible” dividend. Such dividends do not require any form of designation or election by the corporation.  In the hands of a recipient that is a Canadian resident individual, such dividends qualify for a dividend tax credit that reduces the combined federal and Saskatchewan marginal rate of income tax on the dividend to as little as 6.87% and to no more than 40.37% (depending on the amount of other income reported by the recipient).

If a Canadian-controlled private corporation earns active business income that is in excess of the amount that is eligible for the low rate of corporate income tax, it must pay tax at a higher rate. In Saskatchewan, the combined rate of such federal and provincial tax is 27%. Having paid that higher rate of tax, however, the corporation can add 72% of such active business income to its general rate income pool (“GRIP”). If the corporation makes a designation (which it does by informing the recipients of a dividend in writing), it can pay an eligible dividend to a maximum of the balance in its GRIP as of the end of the current taxation year. (Eligible dividends paid by such a corporation are deducted from its GRIP and any eligible dividends received by such a corporation are also added to its GRIP.)  Since a public corporation must pay income tax at the combined rate of 27% on all of its business income, a public corporation can designate any amount of dividends as eligible dividends.

In the hands of a recipient that is a Canadian resident individual, eligible dividends qualify for an enhanced dividend tax credit that reduces the combined federal and Saskatchewan marginal rate of income tax on the dividend to as little as 0% and to no more than 29.64% (depending on the amount of other income reported by the recipient).

Some of the federal income tax paid by a Canadian-controlled private corporation on investment income (which includes taxable capital gains), to the extent of 30 2/3% of that income, is refundable if the corporation pays dividends. A private corporation resident in Canada (regardless of whether it is Canadian-controlled) also pays refundable Part IV tax at the rate of 38 1/3% on all dividends that it receives (other than on dividends received from a connected corporation on which no tax refund was received by the payer thereof). Part IV tax paid on eligible dividends received is tracked by way of the eligible refundable dividend tax on hand (“ERDTOH”) account, and is refundable (at the rate $0.38333 per $1.00 of dividends paid) upon the payment of either an eligible or non-eligible dividend. All other refundable tax paid is tracked by way of the non-eligible refundable dividend tax on hand (“NERDTOH”) account, and is only refundable (at the same rate as above) upon the payment of a non-eligible dividend.

Certain sources of income are tax-free. Common examples are one-half of a capital gain and a death benefit received by the beneficiary of a life insurance policy. A private corporation resident in Canada (regardless of whether it is Canadian-controlled) tracks in its capital dividend account (“CDA”) the tax-free half of capital gains that it realizes plus the excess of any death benefits that it receives from a life insurance policy over the adjusted cost basis of the policy, minus one-half of any capital losses that it realizes. The corporation may elect (by filing form T2054 with the Canada Revenue Agency) to pay a capital dividend to a maximum of the corporation’s current balance in its CDA. A capital dividend is tax-free to a Canadian resident recipient. A private corporation decreases its CDA in respect of any capital dividends that it pays and increases its CDA in respect of any capital dividends that it receives.

The provisions of the Income Tax Act (Canada) related to dividends are more complicated than the simplified description set out in this memo. You should only pay eligible dividends or capital dividends after obtaining advice from a tax accountant or a tax lawyer. Melvin Gerspacher is a tax lawyer. You can contact him at m.gerspacher@rslaw.com or at 306-380-5753.

Income Splitting With a One Percent Prescribed Rate

For every calendar quarter, the Canada Revenue Agency (the CRA) announces prescribed interest rates for different purposes under the Income Tax Act (Canada). The Income Tax Regulations state that the basic prescribed interest rate is calculated as the average of the yields on 90 day Government of Canada Treasury Bills auctioned in the first month of the preceding calendar quarter, rounded up to the nearest whole percentage. April was the first month of the second calendar quarter of 2020.  Not surprisingly (given the COVID-19 pandemic), the average yield in April on such treasury bills declined greatly, by more than one-half, so that it went down to 0.27 percent. By virtue of rounding upward, the basic prescribed interest rate for the third calendar quarter of 2020 (July 1, 2020 to September 30, 2020) is set at 1 percent. The basic prescribed interest rate plus 2 percent (for a total of 3 percent during the third calendar quarter of 2020) is the rate of interest paid by the CRA on tax refunds owed to individuals. The basic prescribed interest rate plus 4 percent (for a total of 5 percent during the third calendar quarter of 2020) is the rate of interest that accrues on income tax arears.

The basic prescribed interest rate is relevant to the concept of income splitting under the Income Tax Act. Each individual resident in Canada files a separate income tax return and is subject to tax on his or her income at increasing marginal federal and provincial tax rates as the individual’s income increases. An individual resident in Saskatchewan earning more than $214,368 must pay a combined tax rate of 47.50% on each dollar of additional interest, business or salary income. If that individual has a spouse or other family member with much lower income, that family member would pay a much lower combined tax rate (or even no tax) if he or she reported the same additional income. The most obvious way in which the lower income family member could earn additional investment income in place of the higher income family member would be for the higher income family member to make a gift or interest-free loan of the capital (that he or she would otherwise invest) to the lower income family member. However, the Income Tax Act has “attribution rules” which generally deem the investment income which the lower income family member earns from the capital that he or she received or borrowed from the higher income family member to be income of that higher income family member. There are a few exceptions to the attribution rules.  The most helpful exception to the attribution rules applies if the lower income family member borrows the capital pursuant to a loan agreement under which the borrower is required to pay interest on the borrowed capital at a rate not less than the basic prescribed rate in effect at the time that the capital is borrowed and the borrower pays such interest that accrues during each calendar not later than January 30th following each calendar year.

If a loan agreement is entered into specifying an interest rate of 1 percent, the loan is advanced during the third calendar quarter of 2020 and the borrower pays the resulting interest that accrues during 2020 not later than January 30, 2021, the borrower would report any income that he or she earned during 2020 from the investment of the borrowed funds. The lender would report the interest that he or she received from the borrower in January, 2021 on his or her 2021 income tax return (assuming that the lender follows the cash basis). The borrower is entitled to deduct the interest that he or she pays to the lender in the year in which the interest is paid (assuming that the borrower also follows the cash basis). The above income tax reporting can go on indefinitely, from year to year, even if the basic prescribed interest rate in effect in future calendar quarters increases from 1 percent.

A trust of which lower income family members are beneficiaries could be the borrower from the higher income family member.

There are subtle aspects of the Income Tax Act, the interpretation of which requires expert knowledge. Therefore, anyone that is considering implementing an income splitting strategy should seek advice from a tax accountant or a tax lawyer. Melvin Gerspacher is a tax lawyer.  You can contact him at m.gerspacher@rslaw or at 306-380-5753.

Area of Expertise Tax Law