Taxation of investment income within a corporation
Investment Insight
For people with cash or investments in their corporations, the tax cost of withdrawing these funds or winding up their corporations can be quite high. To defer these taxes, individuals often choose to keep a corporation going and concentrate on maximizing its investment returns. Having the corporation invest in a tax-efficient manner can make a big difference to its net after-tax return; unfortunately, the taxation of investment income within a corporation isn’t always well understood.
Let’s review the taxation of corporate investment income.1
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 usually higher than the highest personal marginal tax rate and exceeds 50% in many provinces.
Interest income and foreign income, including foreign dividends, are taxed as regular income at the passive income tax rate. A portion of the tax is refundable and added to the non-eligible refundable dividend tax on hand (NERDTOH) account.
Capital gains are a more tax-efficient form of income, as only half are taxable (taxable capital gain), and they’re taxed at the passive income tax rate. A portion of the tax is also refundable and added to the NERDTOH account. The non-taxable half of the capital gain is added to the capital dividend account (CDA).
Dividends received from taxable Canadian corporations are subject to a 38.33% refundable tax, which is all added to the eligible RDTOH account (ERDTOH).
Capital dividend account
No money is actually paid into the CDA. It’s a notional account that includes the non-taxable portion of all capital gains. Corporations can elect to pay a capital dividend, up to the balance in the CDA, and the shareholder receives the dividend tax free. This is very attractive to shareholders.
Refundable dividend tax on hand account
Both the NERDTOH and ERDTOH accounts are notional accounts. The NERDTOH account tracks refundable tax on investment income (i.e., interest, foreign income, and taxable capital gains). The portion that’s added to the NERDTOH account is 30.67% of that income. The ERDTOH account includes the 38.33% tax on eligible dividends received from a taxable Canadian corporation. When the corporation pays a taxable dividend to shareholders, it’ll receive a tax refund of $1 for every $2.61 of dividends paid, up to the balance of the respective RDTOH account. The taxable dividend received by the shareholder is included on their tax return and will be subject to a dividend gross-up and dividend tax credit.
Tip
Where a corporation realizes an increase in its CDA, it’s usually a good idea to pay out the CDA balance promptly (through a tax-free capital dividend). If the CDA balance isn’t paid out, 50% of any subsequent capital losses will reduce the CDA and potential capital dividend.
Taxation of investment income within a Canadian corporation
*Assumes corporate tax rate of 51%.
Taxation of interest income versus capital gains within a Canadian corporation
Taxation of investment income within a Canadian corporation
Interest ($) |
Capital gain ($) |
|
|---|---|---|
Amount |
10,000 |
10,000 |
Taxable income |
10,000 |
5,000 |
Tax payable (51%) |
(5,100) |
(2,550) |
Net income |
4,900 |
7,450 |
RDTOH (30.67% of taxable income) |
3,067 |
1,534 |
CDA (50% of capital gain not taxable) |
0 |
5,000 |
Corporation’s after-tax income
*For illustration purposes only
Comparing the taxation of the investment income flowed out to a shareholder
Taxation of investment income within a Canadian corporation flowed out to a shareholder
Interest ($) |
Capital gain ($) |
|
|---|---|---|
Net income (a) |
4,900 |
7,450 |
Capital dividend (b) (received tax free) |
0 |
5,000 |
Dividend tax refund (c) (NERDTOH) |
3,046 |
1,523 |
Taxable dividend (d): (a) - (b) + (c) |
7,946 |
3,973 |
Tax on dividend (e): 40% |
3,178 |
1,589 |
After tax income: (b) + (d) - (e) |
4,768 |
7,384 |
Shareholder’s after-tax income
*For illustration purposes only
Capital gains or investment income
Money that’s invested in a corporation, regardless of its source, should be invested as tax efficiently as possible to mitigate the high corporate tax rates that apply to investment income in a corporation. Just as with individuals, all other things being equal, capital gains are tax preferred over interest income, whether the corporation leaves the income invested to grow or pays it out to a shareholder through a dividend. Understanding the taxation of investment income within a corporation can have a significant impact on the corporation’s and the business owner’s bottom line.
1 This assumes the corporation is a Canadian-controlled private corporation (CCPC). The taxation of investment income within a corporation can be complex. Consult your tax advisor about how the rules apply to your specific situation. 2 All taxes paid on eligible Canadian dividend income are refundable (added to ERDTOH). Also, 30.67% of interest, foreign income, and taxable capital gains are refundable (added to NERDTOH). This assumes a corporate tax rate of 51%. 3 For this article, GIC refers to both an insurance company issued guaranteed interest contract, a guaranteed interest account (GIA) as well as a guaranteed investment certificate issued by other financial institutions.
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