Buyer beware: foreign income in a corporation

Many business owners are focused on growing their business operations and may not be taking advantage of the opportunity that corporate investing presents. Quite often, a corporation’s—specifically a Canadian-controlled private corporation(CCPC)—balance sheet has cash sitting idle in a low-interest-earning bank account. Typically, this is down to the owner of the corporation not having been  made aware of the fact that corporate funds can be invested in the same way as their personal holdings; or, if they were aware, were more reluctant to do so because they didn’t want their corporate holdings to take on any additional risk on top of ongoing business risk. Nonetheless, properly invested retained earnings can go a long way to supplement a business owner’s retirement plan with some planning and smart investment choices.

With that in mind, business owners may turn their attention to investing in foreign dividend-paying stocks directly. Investing in foreign dividend stocks with high-dividend yields may, on the surface, appear to be attractive investments for a Canadian corporation. However, what many business owners aren’t aware of is that there’s a punitive tax effect on earning foreign dividend income inside a corporation.

So, what’s the issue?

Taxation of interest and foreign dividends

Corporate investment income is taxed as passive income at flat rates that vary by province and territory. There are no graduated tax rates for corporate investment income. The corporate tax rate on investment income is typically similar to the highest personal marginal tax rate and exceeds 50% in many provinces.

Interest income and foreign dividends are taxed as regular income. A portion of the corporate tax is refundable and is added to the non-eligible refundable dividend tax on hand account (NERDTOH).  Both income sources are less tax efficient than capital gains or Canadian dividends.

The NERDTOH account is a notional account. It includes the refundable corporate tax on passive income earned in the corporation (i.e., interest, foreign income, and taxable capital gains). When the corporation pays a taxable dividend to shareholders, it’ll receive a proportional tax refund on dividends paid, up to the balance of the NERDTOH account. For more information on how investment income is taxed in a corporation, see “Taxation of investment income within a corporation.”

In a corporate setting, the taxation of foreign dividend income is even more punitive than interest income. In this situation, the amount that would be added to the corporation’s NERDTOH is less than what it would be if for interest income due to the foreign tax withholding mechanism when the dividend is paid in Canada. On U.S. dividends, for example, the withholding tax requirement under the Canada-U.S. tax treaty is 15%. Keep in mind, the withholding tax requirement can differ depending on the source country and whether or not a tax treaty is in place.

To see this in action, let’s compare the combined corporate and shareholder integrated tax rates between earning $10,000 of interest income with foreign dividend income in a corporation once the monies are eventually flowed out to the shareholder by way of an ineligible dividend.

If a corporation were to earn $10,000 of foreign dividend income and its shareholder was in the highest marginal tax bracket personally, after taxes were paid at both the corporate and personal level, the shareholder would be left with only $3,585 in their hands. Even interest income, which is traditionally known as tax unfriendly, comes out further ahead―earning $10,000 of interest income in a corporation translates into $4,207 personally after taxes. So, as illustrated, earning foreign dividend income in a corporation can be extremely punitive from a tax perspective and should likely be avoided if that was the sole intention of the investment.

Foreign exposure without the tax issues

What’s an alternative for those who like foreign exposure when investing inside their corporation, but don’t want the tax consequences of foreign dividends? An investment in a corporate class mutual fund.

A corporate class structure is a single, taxable entity consisting of several classes of shares, with each class representing a different mutual fund. Investors buy into the overall corporate structure by purchasing shares of one or more classes (funds). Since a corporation computes its net income and net capital gains as a single entity, it can offset the income and capital gains of one fund with the expenses and capital losses of another, providing more flexibility in reducing potential taxable distributions.

For investors looking for foreign exposure in their portfolios, this is an attractive option since corporate class mutual funds never distribute interest or foreign income. Only Canadian dividends, capital gains dividends, or return of capital are paid out.  In this way, a corporate client could get exposure to international equities but doesn’t have to worry about receiving punitive foreign income distributions or dividends. To learn more about the benefits of corporate class mutual funds in a corporation, see “Corporate Class Mutual Funds in a Corporation.”

Taxation of Canadian dividends and capital gains in a corporation

The corporate taxation of both Canadian eligible dividends and capital gains is more attractive than foreign dividends and interest income. Eligible dividends received from taxable Canadian corporations are also subject to a refundable tax, which is added to the eligible dividend tax on hand (ERDTOH) account. However, when such dividends are paid to the shareholder, they’re only taxed in the shareholder’s hands since the corporate tax is fully refundable.

Capital gains are a more tax-efficient form of income as only half are taxable (taxable capital gain, which is taxed at the same tax rate as interest income). A portion of the tax is also refundable and added to the RDTOH account.

The non-taxable half of the capital gain is added to the capital dividend account (CDA). No money is actually paid into the CDA. Like NERDTOH and ERDTOH, it’s also a notional account. Corporations can elect to pay a capital dividend, up to the balance in the CDA, and the shareholder receives the dividend tax free.

Let’s continue with our previous example and use it to compare the corporate taxation of interest and foreign dividend income with Canadian eligible dividends and capital gains.

As you can see, after taxes, the shareholder stands to receive more money if he or she had received of eligible Canadian dividends ($6,066) and or realized capital gains ($7,103) than if he or she had received interest or foreign dividend income. As a result, corporate class mutual funds can provide investors with foreign equity exposure while receiving only the most tax-efficient income sources.

Be tax efficient with corporate class mutual funds

With investment income in a corporation being taxed at high, flat tax rates, tax efficiency is critical. Thanks to the non-resident withholding tax, foreign dividends are subject to the highest tax rates―even higher than interest income. However, that doesn’t mean foreign investments should be avoided. Corporate investors seeking globally diversified portfolios that are tax efficient can consider investing in corporate class mutual funds. Since they can only distribute Canadian eligible dividends and capital gains, the most tax-efficient sources of income, corporate investors can have the asset allocation they want with the tax benefits they like.

1 The Ontario corporate tax rate on the taxable amount of interest, foreign income, and capital gains is 50.17%. The corporate tax rate on eligible Canadian dividends is 38.33%. 2 The refundable tax rate on interest and capital gains is 30.67% (Part I tax). The refundable tax rate on foreign income is 18.77%. The refundable tax rate on eligible Canadian dividends is 38.33% (Part IV tax). 3 The shareholder’s personal tax rate on actual ineligible dividends received is 47.74%. The shareholder’s personal tax rate on actual eligible dividends received is 39.34%. These are the top tax rates for an Ontario resident receiving such dividends.