Glossary of Tax Planning

Definition & Example

For non-tax professionals, AAII can be simply understood as a company’s “passive income,” which includes:

• Rental income
• Stocks, funds, and interest income from financial markets
• Dividends received from non-associated companies
• Capital gains from the sale of company assets
• And more…

Importance

If a CCPC receives more than $50,000 of AAII in a fiscal year, it will have an impact on the lower tax rate applicable to active business income. For example, if a company has $80,000 of passive income in a year, with $30,000 exceeding the $50,000 threshold, the calculation using a 1:5 ratio means that $150,000 of active business income would no longer be eligible for the Small Business Deduction (SBD) lower tax rate.

Active business income (ABI) typically refers to income derived from a business operation, including any income that is incidental to the business itself. ABI allows businesses to qualify for the Small Business Deduction (SBD), which is something small business owners are always pleased to see.

However, the following two types of income are not generally classified as ABI; as a result, they are not eligible for the SBD:

1. A personal services business
2. A specified investment business
   • A specified investment business is a business with the principal purpose of deriving income from property, including interest, dividends, rents, or royalties. 

Another however, the following outlines the circumstances under which income from these types of businesses may be considered ABI and thus qualify for the SBD:

1. The corporation employs more than five full-time employees in the business throughout the year, or
2. An associated corporation provides managerial, financial, administrative, maintenance, or other similar services to the corporation while carrying on an active business, and the corporation would have to engage more than five full-time employees to perform these services if the associated corporation were not providing them. 

A taxpayer’s business investment loss is basically a capital loss from a disposition of shares in, or a debt owing to the taxpayer by, a small business corporation (SBC) where the disposition is:

• to an arm’s-length person; or
• one to which s.50(1) applies.

One-half of this loss is an allowable business investment loss (ABIL).

Not just individual taxpayers, corporation taxpayers can also claim ABIL.

Definition

The adjusted cost base (ACB) is a concept used in taxation and investment to determine the cost of an asset for tax purposes. It refers to the original cost of acquiring an asset, adjusted for various factors such as capital expenses, improvements, and certain transactions.

Importance

Non-arm’s length relationship

As defined by the Income Tax Act, a non-arm’s length relationship exists between individuals who are connected by:

• Blood
• Marriage
• Adoption
• Other means – whenever the word “other” appears in legal language, it makes me a bit anxious, as it leaves room for relatively flexible interpretations of the law. In this context, I believe the term “other means” generally includes the following situations:

  • Common-law relationships – Individuals living together in a conjugal relationship without being legally married, especially if recognized by law as common-law partners.

  • Business partners – Individuals who are long-term business partners or who have a significant financial relationship that creates a close personal or professional connection.

  • Close personal relationships – Individuals with long-standing close personal relationships that, while not family or marital, involve significant shared decision-making or mutual benefit, such as close friends who frequently conduct business together.

  • Trustees and beneficiaries – The relationship between a trustee and a beneficiary of a trust could be considered non-arm’s length, as there is a fiduciary duty and an obligation to act in the beneficiary’s best interest.

  • Control through corporate structures – Individuals who may control or influence each other through directorships, significant shareholdings, or other roles in corporations, creating an indirect but substantial connection.

Arm’s length relationship

Explaining arm’s length is quite simple: any relationship that is distant enough and falls outside the scope of non-arm’s length is considered arm’s length.

Non-arm’s length transaction

This typically refers to a transaction or relationship between related individuals. However, a non-arm’s length relationship can also exist between unrelated individuals, partnerships, or corporations, depending on the specific circumstances.

Definition

When a shareholder takes money out of a company for personal use and treats it as a dividend, they are required to pay taxes on the full amount.

However, if there is a way to categorize the money taken by the shareholder as capital gains, only half of the amount is treated as taxable income. This strategy of minimizing taxes by stripping dividends as capital gains is known as capital gain surplus stripping.

Example

In a given year, a shareholder withdraws $1 million from the company’s retained earnings for personal use:

• When it is treated as a non-eligible dividend as usual, the shareholder would have to pay $470k in taxes.
  • The shareholder would receive $530k after all.
• If the capital gain surplus stripping is implemented, the shareholder would pay approximately $270k in taxes, along with around $30k for accounting and legal fees.
  • The shareholder would receive $700k after all. 

Importance

Currently, there are two commonly recognized methods to reduce taxes for shareholders:

1. Distributing funds from the Capital Dividend Account (CDA) to shareholders, which is tax-free, and
2. Capital gain surplus stripping, as mentioned in this article, which can be an accepted practice by the CRA, provided that the accounting and legal aspects are handled properly.

The main difference between cash dividends and stock dividends lies in their form of payment and tax treatment.

Cash dividends are when a company distributes its earnings to shareholders in the form of cash, which is the most common type of dividend. In Canada, these dividends are subject to taxation under the Canadian Income Tax Act, with the tax rate potentially ranging from 30% to 50%. However, the tax rate may vary depending on the type of dividends. Generally, the value of cash dividends distributed by a company depends on the company’s income and investment activities. Dividend cuts may occur when the company experiences persistent net losses. For instance, during the Covid time, many companies in hard-hit industries had cuts or reductions in cash dividends.

On the other hand, if the company doesn’t have enough liquid cash, it may opt to distribute stock dividends. Stock dividends are distributed as a percentage of existing shares. For example, if a company declares a 10% stock dividend, a shareholder with 100 shares will receive an additional 10 shares. This could also occur in the case of stock splits. It’s important to note that stock dividends are not taxable upon distribution. However, taxes will be applicable when the owner sells their shares.

In summary, cash dividends are a direct return of profit to shareholders in the form of cash, whereas stock dividends are distributed to shareholders in the form of additional shares. Both are methods of profit distribution by a company, but they differ in tax treatment and impact on the company’s cash flow.

Capital cost allowance (CCA) is a deduction that can be claimed over a number of years for the cost of depreciable assets. These are assets that deteriorate or lose value over time, such as buildings, furniture, or equipment, which are used in the course of your business or professional activities.

Undepreciated capital cost (UCC) refers to the remaining balance of a capital asset’s cost that is still available for depreciation at any point in time. Each year’s capital cost allowance (CCA) claim reduces the UCC of the asset. So in other words, UCC = ACB minus CCA.

Definition

The corporation is a CCPC if it meets all of the following requirements at the end of the tax year:

• it is a private corporation
• it is a corporation that was resident in Canada and was either incorporated in Canada or resident in Canada from June 18, 1971, to the end of the tax year
• it is not controlled directly or indirectly by one or more non-resident persons
• it is not controlled directly or indirectly by one or more public corporations (other than a prescribed venture capital corporation, as defined in Regulation 6700 of the Income Tax Regulations)
• it is not controlled by a Canadian resident corporation that lists its shares on a designated stock exchange outside of Canada
• it is not controlled directly or indirectly by any combination of persons described in the three previous conditions
• if all of its shares that are owned by a non-resident person, by a public corporation (other than a prescribed venture capital corporation), or by a corporation with a class of shares listed on a designated stock exchange were owned by one person, that person would not own sufficient shares to control the corporation
• no class of its shares of capital stock is listed on a designated stock exchange

Example

Let’s say Company X is incorporated in Canada and has multiple shareholders. In order for Company X to be classified as a CCPC, it must meet the criteria of Canadian Ownership, which means the company must be controlled, directly or indirectly, by Canadian residents. This means that the majority of the voting shares should be owned by Canadian individuals or Canadian-controlled corporations.

For instance, if 75% of the voting shares of Company X are owned by Canadian individuals or Canadian-controlled corporations, it satisfies the Canadian ownership requirement.

Importance

There are lots of advantages that a CCPC can enjoy in relation to the following aspects:

1. Small Business Deduction (SBD):
   • The SBD allows CCPCs to benefit from a lower tax rate on their active business income up to a certain threshold.
   • Currently, eligible CCPCs can claim a reduced federal tax rate on the first CAD 500,000 of qualifying income.
2. Lifetime Capital Gains Exemption (LCGE):
   • The LCGE allows eligible individuals to shelter a portion of capital gains from the sale of qualified small business shares or qualified farm or fishing property.
   • The exemption amount is adjusted annually and can provide significant tax savings upon the sale of qualified assets.
3. Scientific Research and Experimental Development (SRED) Tax Incentive:
   • CCPCs engaging in eligible scientific research and experimental development activities can claim tax credits or deductions for qualified expenditures.
   • The SRED program encourages innovation and provides financial support for technological advancements within CCPCs.
4. Refundable Tax:
   • CCPCs may be eligible for refundable tax credits, such as the RDTOH, which is used to keep track of the taxes that will be eligible for a refund on the dividends.

PS. There is also a concept of “a corporation resident in Canada”, which means a company has not registered in Canada, but due to a large amount of business activities it conducts in Canada, or its management and control are all in Canada, it is also considered to have tax resident status in Canada.

Definition & Importance

The Capital Dividend Account (CDA) is a crucial concept within the realm of tax optimization. In simple terms, the CDA serves as a notional account that records funds that can be distributed to shareholders without incurring personal taxes.

When it is possible to legally increase the capacity of the company’s CDA while ensuring that there is sufficient cash available in the company’s accounts, shareholders would undoubtedly be delighted.

However, there are certain limitations and conditions associated with the CDA.

Firstly, only CCPCs are eligible to enjoy the tax advantages of the CDA.

Furthermore, there are three common ways to increase the capacity of the company’s CDA:

1. Capital gains: When a CCPC earns income from investments or capital gains, half of the amount is subject to taxation, while the other half can be allocated to the CDA.
2. Insurance proceeds: If a company purchases insurance for its shareholders or directors, the proceeds paid out upon the death of the insured individual can be directed to the CDA.
3. Capital dividends from subsidiary companies: When a parent company receives capital dividends from its subsidiary, those dividends can be allocated to the CDA.
   • It is important to be aware that only capital dividends from the subsidiary’s CDA are eligible. This means the regular retained earnings of the subsidiary won’t work.

Example

Here’s an example using the first method above:

• A company invested $100,000 in AAPL stock (Apple Inc.) in 2021.
• In 2023, the company sold the Apple stock for $180,000, resulting in a profit of $80,000.
• Out of this $80,000 profit, half ($40,000) is subject to taxation at the company’s passive income tax rate (let’s ignore the term of RDTOH for now)
• The remaining $40,000 can be allocated to the CDA, thereby increasing the CDA’s balance by $40,000.

General Procedure

Using the example of $40,000 going into CDA above, now let’s consider the actual distribution a tax-free dividend of $40,000 to shareholders:

1. The company holds a board meeting and records the resolution to distribute dividends in the company’s minute book.
2. The accountant prepares Form T2054 in accordance with s.83(2) ITA and submits it to CRA to apply for the dividend distribution.
   • It is important to ensure that the dividend amount does not exceed the available balance in the CDA, otherwise, heavy penalties from CRA will apply.
   • Additionally, timely submission of Form T2054 is essential to avoid penalties.

Definition

s.95(1) ITA provides a definition for CFA (Controlled Foreign Affiliate), which can be very roughly described as a foreign corporation that is controlled by Canadian shareholders can be considered a CFA.

Example

A Canadian company establishes a new company in Cyprus and transfers all its passive income to the Cyprus company. In this case, the passive income under the CFA may allow the CCPC to be taxed at a much lower rate than the 50% high tax rate.

Importance

This is an important part of traditional CCPC FAPI Planning, which aims to transfer the CCPC’s passive income to a foreign subsidiary in order to avoid paying the high 50% passive income tax.

Definition

By virtue of s.186(4) ITA:  

• If a company holds 10% or less of the common shares of another company, then these two companies are not considered to be connected.
• If a company holds more than 10% of the common shares of another company, then these two companies are considered to be connected.

Importance

The connected status of two companies is very important when one company pays dividends to another because it determines how the recipient of the dividends calculates the tax payable.

Definition

Depreciable Capital Property: This type of property is typically something used for the purpose of earning income from a business or property, and it has a limited lifespan (it wears out or becomes obsolete over time). As such, the cost of these assets is not fully deductible in the year of purchase, but rather, it’s spread over the useful life of the asset through a process known as depreciation. The portion of the asset’s cost that’s deducted each year is called Capital Cost Allowance (CCA). Examples of depreciable property include machinery, buildings, vehicles, and equipment used in a business.

Non-depreciable Capital Property: This refers to capital property that does not wear out or become obsolete, and thus, its cost cannot be depreciated over time for tax purposes. Instead, when the property is sold or otherwise disposed of, the difference between the proceeds of disposition and the cost of the property is treated as a capital gain or loss. Examples of non-depreciable property include land, shares of a corporation, or an ownership interest in a partnership.

Importance

The distinction between depreciable and non-depreciable capital property is important primarily for tax purposes. Here’s why:

1. Tax Treatment: The tax treatment of these two types of properties is different. For depreciable capital property, you can claim a portion of its cost each year as a tax deduction, known as Capital Cost Allowance (CCA). This is meant to reflect the wear and tear on the property over time, reducing its value. On the other hand, for non-depreciable capital property, you cannot claim CCA. Instead, when you sell or otherwise dispose of the property, you may realize a capital gain or loss, which has tax implications.

2. Capital Gains and Losses: When non-depreciable capital property is sold, the difference between the proceeds of disposition and the adjusted cost base (ACB) of the property (essentially, what you paid for it, including acquisition costs) is considered a capital gain or loss. Only 50% of capital gains are taxable in Canada. If you sell depreciable capital property for more than its undepreciated capital cost (UCC, essentially the cost of the property less any CCA claimed in previous years), the excess is considered a recapture of CCA and is fully taxable. If you sell it for more than its original cost, the excess is a capital gain. If you sell it for less than its UCC, the difference is a terminal loss, which is fully deductible.

3. Impact on Business Decision-Making: Understanding the difference between these two types of properties can help businesses make informed decisions about purchasing assets. For instance, a business might prefer to purchase assets that qualify as depreciable property if it wants to reduce its taxable income in the short term through CCA deductions. Conversely, a business expecting to sell the asset in the future might prefer non-depreciable property in order to take advantage of the preferential tax treatment of capital gains.

Definition & Importance

Eligible and non-eligible are two commonly used concepts when it comes to dividend distributions. Now, let’s address 3 key questions:

First, what makes a dividend “eligible”

• When a company earns profits, the company cannot distribute dividends to the shareholders until it has paid income tax first for the profit it earned. If the company has paid income tax at a higher tax rate, then the dividends distributed to shareholders are considered eligible dividends.
• On the other hand, if the company has paid the income tax at a lower tax rate, such as using the CCPC’s SBD tax advantage, then the dividends distributed to shareholders are classified as non-eligible dividends.

Second, for shareholders, what is the difference between receiving eligible or non-eligible dividends?

To understand the difference, let’s consider a hypothetical scenario where a shareholder receives $100k/$1million in eligible/non-eligible dividends in a year. We’ll use the tax rates for the year 2022, assuming the shareholder has no other income in that year:

• Dividend amount: $100,000
  • For eligible dividends, the shareholder would need to pay approximately $5,000 in personal taxes.
  • For non-eligible dividends, the shareholder would need to pay approximately $12,000 in personal taxes.
• Dividend amount: $1,000,000
  • For eligible dividends, the shareholder would need to pay approximately $250,000 in personal taxes.
  • For non-eligible dividends, the shareholder would need to pay approximately $380,000 in personal taxes.

The difference in tax amounts for shareholders is primarily influenced by two factors: the different gross-up ratios between eligible and non-eligible dividends, and the varying tax credit amounts.

Third, what is the difference for the company issuing eligible or non-eligible dividends? The key term to consider here is RDTOH (Refundable Dividend Tax On Hand):

• Eligible Dividend:
  • Suppose a CCPC (Canadian Controlled Private Corporation) purchases AAPL (Apple Inc.) stocks for $100,000 and sells them for $180,000 a few years later. The company pays taxes at a higher tax rate on 50% of the $80,000 capital gain, and then distributes the remaining funds as eligible dividends to shareholders. This dividend distribution triggers an RDTOH refund from the CRA (Canada Revenue Agency) for the previously paid taxes at the higher rate. In other words, the taxes paid earlier at a 50% higher rate are now reduced to around 20% through RDTOH.
• Non-eligible Dividend:
  • When a CCPC pays taxes at a lower tax rate on its active business income of $400,000 and distributes dividends to shareholders using the after-tax funds, there is no RDTOH refund involved.

Example

Eligible Dividend:

• Dividends distributed by publicly listed companies
• Dividends distributed by CCPCs after paying taxes at a higher rate on passive income.

Non-eligible Dividend:

• Dividends distributed by CCPCs after paying taxes at a lower rate on active business income.

Definition

• FAPI (Foreign Accrual Property Income) is the passive income earned by a CCPC through its CFA (Controlled Foreign Affiliate).
• FAT (Foreign Accrual Tax) is the tax amount accrued on the passive income by the CFA.
• RTF (Relevant Tax Factor) is an index number set by the government. Prior to 2021, the value of RTF was 4 for corporations, but in the 2022 August proposals, it was reduced to 1.9 (aligned with individual tax rates). RTF is used as a multiplier in FAPI Tax Planning.

Combining these three concepts, we have the following formula:

• Deduction from FAPI = FAT x RTF

Example

A CCPC established a new company in Cyprus and transfers a significant amount of passive income to the Cyprus company (CFA). Let’s say in 2021, the passive income (FAPI) amounts to $10,000, and the CFA has already paid $2,500 in Foreign Accrual Tax (FAT). If the RTF value is 4, then:

• Deduction from FAPI would be $2,500 x 4 = $10,000
• This $10,000 offsets the FAPI amount of $10,000
• Resulting in FAPI becoming zero
• Since FAPI is zero, no further tax is payable.

In summary, the company only pays tax at a rate of 25% on the passive income, which is much lower than the CCPC’s 50% tax rate.

Importance

This is how the traditional CCPC FAPI Planning plays, aiming to transfer the CCPC’s passive income to a foreign subsidiary to avoid the high 50% tax rate on passive income.

Definition

The General Anti-Avoidance Rule (GAAR) is a legal principle in tax law aimed at preventing taxpayers from engaging in abusive tax avoidance schemes by exploiting loopholes in the tax legislation.

Importance

It is so important that I have to come up with another two blogs to explain:

• Tax Avoidance Methods Prohibited by GAAR
• Legitimate Tax-Saving Strategies

Definition

There is a concise explanation of GRIP on the government’s official website:

GRIP is a notional account used to record taxable income within a CCPC that has not benefited from the small business deduction or any other special tax rate.

In contrast to the General Rate Income Pool (GRIP) is the Low Rate Income Pool (LRIP). The LRIP is a tax account that tracks a corporation’s income taxed at a lower rate, affecting how dividends are paid to shareholders.

Example

In various scenarios, several types of income may enter the GRIP within a CCPC, such as:

• If a CCPC generates $800,000 in active business income in a fiscal year, $500,000 of it benefits from SBD’s low tax rate, which is the portion that cannot go into the GRIP; however, the remaining $300,000 can be allocated to the GRIP account.

• CCPC’s passive income, whether earned domestically or through a CFA’s dividends after earning FAPI and having paid FAT, etc.

Importance

Shareholders who receive dividends prefer a larger GRIP balance because dividends issued from the GRIP account are eligible dividends, which are subject to a lower personal tax rate for shareholders.

Definition

“Inter-Corporate Dividends” typically refer to the dividends paid by Company B to Company A, which holds shares in Company B. This usually occurs between companies that are operated by the same person or a group of individuals, such as in a holding company structure. It is the most effective and direct way for companies to share profits or distribute earnings among each other.

Example

• John Doe owns 100% shares of Company A.
• Company A owns 100% shares of Company B.
• At the end of the year, Company B generated profits and declared to pay a dividend to its sole shareholder, Company A.
• This way, the inter-corporate dividends serve as a means for the profits earned by Company B to be passed on to Company A, benefiting John Doe as the ultimate owner of both companies.

Importance

Different from “individual receiving dividends from a company,” if Company A’s income is dividends received from Company B, according to s.112 ITA, this income can be deducted from Company A’s total income, which is equivalent to “no tax” for inter-corporate dividends.

“Integration” is just a fancy word for “refund”. 

The two levels of taxation drive the need for integration, because the term “integration” actually means the overall taxes that will be paid at both corporation and personal level should be (almost) the same as the individual himself is the sole taxpayer.

Over-integration

Sometimes it is over-integrated by the government, meaning after the two level taxations, the amount of tax is actually less than a sole individual taxpayer should have paid (because of too much refund, for example RDTOH). Basically over-integration occurs where the individual pays less tax by flowing the income through a corporation.

Under-integration

Sometimes it is under-integrated, meaning the individual ends up paying more tax on income earned through a corporate structure than if the same income were earned directly as an individual. This could be due to various factors, including provincial tax rates and surtaxes that affect the integration mechanism. 

Why are there such results?

This is simply because not all the formulas are perfect, especially when we have two levels of governments, federal and provincial, and they both have their own tax rate for both corporate level and individual level.  

Definition

LCGE refers to a tax exemption in Canada that allows individuals to exclude capital gains from the sale of qualified small business corporation shares from their taxable income. 

Importance

It is so important that I have to come up with a separate blog LCGE Briefly Explained.

Definition

You can find the definition of CCPC above. Any company that does not meet the CCPC criteria is considered a Non-CCPC.

Example

• A company registered in Canada, but the majority of its shareholders are non-residents of Canada.
• A Canadian (branch) company controlled by a foreign publicly traded company.

However, conversely, for example, if a Canadian company’s 10% shareholder sells their shares on the OTC market in the United States (formerly Pink Sheets), the company can still be classified as a CCPC, because The CCPC status is determined based on factors such as Canadian residency of shareholders, control of voting rights, and the nature of the company’s activities. The specific stock exchange where the company’s minority shares are traded is not the sole determinant of CCPC classification.

Importance

This is commonly referred to as the “incorporated employee”, the legal test is: But-for the corporation, the individual would be just an employee. 

• Not entitled to SBD
  • A PSB is not entitled to the federal rate of reduction and therefore subject to a higher corporate tax rate than the general corporate rate → combined 44.5% tax rate vs the combined general corporate rate of 26.5%

• Limitation on deductions when filing the personal corporation’s income tax, e.g., overhead expenses
  • Only these expenses are allowable:
    • salary, wages, and 
    • benefits paid to the individual himself

• Exceptions to exclude itself from being a “personal services business”
  • If there are more than 5 employees in the “personal services business”, OR
  • If this personal services business also provides services to another corporation (could be an associated association, which is controlled by the owner of the personal business himself)

Definition

The term “Paid-up capital” (PUC) means “paid-up shares”, which is the counterpart to “called-up shares”. PUC denotes the shares for which shareholders have made full payment. In the Canadian tax system, PUC is a fundamental concept that reflects the consideration received by the corporation in exchange for the issued shares. The consideration can be in the form of cash contributed by the shareholders or other equivalents, such as equipment or real property.

Example 1

• When a company was newly incorporated, the incorporator subscribed to 100 common shares, he paid $1 for each share, so the $100 goes into the company’s Share Capital Account, which is a notional account the company must maintain for all share classes.
  • At this moment, the PUC for each share is $1.
• The business develops well.
• Later the company allotted another 100 common shares to a new investor at the market price of $1.50 for each share, this allotment is supposed to bring $1.50 x 100 = $150 to the company, but the new shareholder only paid $50 ($.50 per share for his 100 shares) with the rest due later (the balance is the “called-up shares” meaning the outstanding $50 is called for).
• At this moment:
  • the “Stated Capital” is $100 + $150 = $250 showing on the company’s Financial Statements
  • the PUC = ($100 + $150 $50) ÷ 200 shares = $0.75

Example 2

• When a company was newly incorporated, the incorporator subscribed to 100 common shares, he paid $1 for each share, so the $100 goes into the company’s Share Capital Account, which is a notional account the company must maintain for all share classes.
• The business has been worse, unfortunately
• Later, the company allotted another 100 common shares to a new investor at a market price of $0.50 per share; a person subscribed to these 100 shares and paid the full price of $50.
• At this moment:
  • the “Stated Capital” = $100 + $50 showing on the company’s Financial Statements
  • the PUC = ($100 + $50) ÷ 200 shares = $0.75
• Finally, the company is dissolved, assuming there is no debt on the company, the company will pay back $0.75 per share too all shareholders.
  • The initial shareholder will be unhappy, because he loses money in the share value ($100 → $75)
  • The new shareholder will be happy, because he gets back $0.75 per share tax free ($50 → $75)

Implication and Importance

Definition

The concept is called “dividend refund” in s.129 ITA, which is very appropriate.

Example

• An Ontario CCPC earns $10,000 of passive income. At this point, the corporation faces two tax rates:
  • One is the actual tax rate on passive income, which is 50.17%, meaning $5,017 is payable, leaving $4,983.
  • The other is RDTOH, a “notional” account with a rate of 30.67%, creating a refundable space of $3,067 for this $10,000 of passive income ($10,000 x 30.67% = $3,067).
• This year, the company made profits and is ready to distribute dividends to shareholders. RDTOH now comes into play to provide a tax refund for the company.
  • There is a “ratio” here, simply referred to as the “refundable rate” (income tax refundable rate). s.129 ITA provides that for every dollar of dividend paid to shareholders, the company can receive a 38.33% tax refund from the CRA.
    • Therefore, in order to fully recover the $3,067, the company distributes $8,000 in dividends to shareholders because $8,001.57 x 38.33% = $3,067.

Importance

RDTOH is an important part of the tax integration mechanism, which can be understood as compensation from the CRA to the corporation after paying a high tax rate on passive income.

Definition

“Retained earnings” is an accounting term. It represents the amount of profit a company has left over after paying

• all its direct costs, and
• indirect costs, and
• income taxes, and
• its dividends to shareholders

Retained earnings are an accumulation of a company’s net income and net losses over all the years the business has been operating.

Example

• In year 0, a company was incorporated.
• In year 1, the company’s revenue is $50; its costs and income tax are $20; the retained earning on the balance sheet for this year is, therefore, $50 – $20 = $30.
• In year 2, the company’s revenue is $40; its costs are $50, so the business loss of $10 made the retained earnings on this year’s balance sheet $30 – $10 = $20.
• In year 3, the company’s revenue is $100; its costs and income tax are $30; therefore, the net profit of $70 made the retained earnings $90 on this year’s balance sheet.

Importance

Retained earnings are a key component of shareholder equity and the calculation of a company’s book value.

Definition

Very similar to “retained earnings”, which is an accounting term representing the accumulated amount of profit a company has left over after paying all expenses, SIOH (safe income on hand) is a taxation term denoting almost the same thing.

Example

Scenario 1

• In a fiscal year, a company has
  • $1,000 income
  • $200 expense for meals
• The retained earning before income tax is
  • $1,000 – $200 = $800
• The SIOH before income tax is
  • $1,000 – ($200 x 50%) = $900 because only 50% of the cost of meals can be deducted pursuant to s.67.1(1) ITA. 
• In scenario 1, the SIOH is greater than retained earnings.

Scenario 2

• In a fiscal year, a company has $2,000 income
• The company spent $1,000 on buying a new computer
• The retained earning before income tax is
  • $2,000 – ($1,000 / 5) = $1,800 because in the accounting realm, the computer has been decided to have a 5-year flat rate depreciation, which means in each year, the computer loses $200 of its value.
• The SIOH before income tax is
  • $2,000 – ($1,000 x 30%) = $1,700 because in the taxation realm, CRA provides a computer (Class 10) loses 30% of its value in the year.
• in scenario 2, the SIOH is less than retained earnings.

Importance

SIOH is extremely important due to s.55(2) ITA. 

A corporation’s safe income can be used to move excess cash out of one related company and into another related company before the company is sold. The cash is moved by issuing a tax-free inter-company dividend from the subsidiary up to the holding/parent company.

Definition

Substantive CCPC (Draft Legislation) means a private corporation (other than a Canadian-controlled private corporation) that

1. is controlled, directly or indirectly in any manner whatever, by one or more Canadian resident individuals, or
2. would, if each share of the capital stock of a corporation that is owned by a Canadian resident individual were owned by a particular individual, be controlled by the particular individual.

Objective

The recent legislative measures introduced by the Canadian government have coined this new term due to some savvy business owners who deliberately convert their CCPCs into Non-CCPCs in order to reduce taxes.

The background is that in certain specific situations, such as when a company sells an investment property and generates significant capital gains, the tax rates for passive income under Non-CCPCs can be considerably lower than those for CCPCs.

However, even if a company has been converted into a Non-CCPC, the government has the authority to reclassify the entity back into a CCPC using this newly established term, Substantive CCPC.

Example

When a company, which has already been classified as a Non-CCPC, is

1. effectively controlled by either Canadian individuals or Canadian corporations in terms of shareholder voting rights (de jure control), or
2. even if it appears that they lack voting rights in the general meetings but still exert de facto control over the company, then such a Non-CCPC entity will be designated as a Substantive CCPC.

Importance

Definition

TOSI is a new measure introduced in the 2018 Canadian tax legislation aimed at limiting individuals’ ability to reduce their tax burden by splitting income with family members.

Example

Let’s say a guy (self-employed) has $100,000 in self-employment income in 2023.

• he would owe approximately $28,000 in personal taxes,
• with a marginal tax rate of 31.48%.

Feeling a bit uneasy about the amount of taxes, he comes up with an idea to split the income with his wife, resulting in each of them having $50,000 of income.

• each person would owe $12,000 in taxes,
• totalling $24,000, saving $4,000 in tax
• both individuals now have a marginal tax rate of only 20%.

However, this is wishful thinking because TOSI states that if family members’ income falls under split income, it is subject to the highest tax rate. In this case,

• the husband’s marginal tax rate remains 20% and he still owes $12,000 in taxes,
• the wife is subject to the highest personal tax rate of 53.53% and owes $26,000 in taxes.
• Together, they would owe $38,000 in taxes.

Importance

Income splitting among family members, relatives, or even friends is common. Whether or not TOSI applies depends on whether the taxpayer’s employment of family members is reasonable. For example, a successful real estate agent hiring their own child for administrative work during the summer with specific job descriptions, work accomplishments, and fair market compensation would be considered a reasonable operation and could avoid being subject to TOSI. In other words, it all depends on whether the taxpayer has done their homework thoroughly.

Definition

The term “year-end” here is not referring to the common business practice when there is a date on which a company finishes a 12-month business cycle. Instead, in mergers and acquisitions (M&A), on a share transaction that leads to the acquisition of control of the target corporation, a deemed tax year-end is triggered immediately before the acquisition.

Example

A CCPC always has September 30th as its fiscal year-end.

In October, this CCPC sold its 80% of common (voting) shares to a foreign company by a PSA (purchase & sale agreement).

On October 15th, the PSA has been duly signed by all parties, and the company being acquired is now immediately having October 15th as a year-end for tax filing purposes:

• the company must file a tax return for the previous period of Oct 1st – Sep 30th
• the company must file another tax return for this particular 15 days (Oct 1st – Oct 15th)

Importance

Example: A CCPC signed a contract to sell the majority of its shares to a foreign company. Even though the closing day of the transaction is several months away, the CCPC ceases to be classified as a CCPC on the day the contract is binding, thus losing its eligibility to continue enjoying the low tax rate benefits of a CCPC.

The tax rates will be changed; therefore, the act of filing taxes needs an added distinction, which triggers a “year-end” to differentiate between the CCPC and non-CCPC.