Canadian Controlled Private Corporations

When preparing your T2 corporate income tax return, you may come across references to subsection 20(12) of the Income Tax Act (ITA) as it pertains to foreign non-business-income taxes paid by a taxpayer.

This section deals with income tax withholdings of foreign income. The deduction under this section allows a tax payer to deduct the foreign tax paid on non-business income such as foreign dividends income, interest income, rental income, or royalty income. Under this paragraph,  you have the option to choose to deduct only a portion of the foreign tax paid under subsection 20 (12) or not deduct any. 

The main purpose of the refundable Part IV tax calculated on a T2 corporate income tax return in Canada is to address tax integration and prevent tax deferral through the use of private corporations. Specifically, this tax applies to certain dividends received by Canadian controlled private corporations (CCPCs) from other corporations. Let's look at the three principles that affect the Part IV tax.

1. Integration Principle: The Canadian tax system aims to ensure that income earned by a corporation and then distributed to shareholders as dividends is not taxed more heavily than if the income were earned directly by an individual. This is known as the integration principle. The refundable Part IV tax helps maintain this balance by ensuring that certain dividends received by a corporation are effectively subject to the same tax burden as if they were received directly by an individual.
2. Preventing Tax Deferral: Without this tax, a corporation could accumulate earnings by investing in other corporations and avoid paying tax on dividends until those earnings are distributed to individual shareholders. The refundable Part IV tax addresses this by applying a tax on dividends received from non-connected corporations (those in which the recipient corporation does not have a significant ownership interest). This discourages using corporations to indefinitely defer taxes on passive investment income.
3. Refundable Nature: The Part IV tax is refundable from the RDTOH (refundable dividend tax on hand) account when the corporation pays taxable dividends to its shareholders. When the corporation distributes dividends, it effectively passes the tax burden to the individual shareholder, who would then be taxed on that dividend income. This ensures the tax integration and prevents corporations from using their structure to gain a tax advantage over individual investors.

The refundable Part IV tax is calculated on Schedule 3 and carried forward to the T2 jacket on line 712 Part IV tax payable from Schedule 3. Section 186(1) of the ITA lays out the calculation. Capital dividends are not affected under section 186(1) of the ITA.

T2 Schedule 3 - Dividends Received, Taxable Dividends Paid, and Part IV Tax Calculation is used by Canadian controlled private corporations to calculate their dividend deductions under sections 112, 113, and 138(6). On this schedule, corporations report the dividends received and indicate under which section of the ITA the deduction is claimed (e.g., section 112 for dividends from taxable Canadian corporations, section 113 for dividends from foreign affiliates, or section 138(6) for dividends related to insurance corporations).

When completing a T2 Schedule 3, if you received or paid dividends, the tax program usually asks what section of the ITA the dividend pertains to: Section 112, Section 113, or Section 138 (6). Here's what it is referring to:

• Section 112: Dividends from Taxable Canadian Corporations

This section "permits the receiving corporation to deduct from income an amount equal to the dividend for the purpose of computing its taxable income."* The purpose of this section is to prevent the same income from being taxed multiple times within the corporate structure. It provides an inter-corporate dividend deduction, making the dividends received by the corporation non-taxable. Essentially, this means the income is taxed once at the corporate level and not again at the shareholder level

Example Scenario:

Basic Context:
Let’s imagine Corporation X owns shares in Corporation Y, both of which are taxable Canadian corporations.

Dividend Payment:
1. Corporation Y declares and pays a dividend of $500,000 CAD to Corporation X.
2. Corporation X receives these dividends as part of its investment income.

Tax Treatment:

• Under Section 112(1) Corporation X can deduct the amount of dividend received from its taxable income. This deduction ensures that the dividend is not taxed again at Corporation X's level.

Calculation Example:
1. Income Inclusion:

• Corporation X will include $500,000 CAD as income in its financial accounts.

2. Section 112 Deduction:

• Corporation X can claim a deduction for the full amount of the dividend received, which is $500,000 CAD. The effect is that Corporation X's taxable income for this transaction is reduced by the same amount, effectively excluding the dividend from taxable income.

Journal Entries (for understanding):

Let's say Corporation X’s taxable income before considering this dividend was $1,000,000 CAD.

• Before Deduction: Taxable Income: $1,000,000 CAD + $500,000 CAD (dividend) =  $1,500,000 CAD
• After Applying Section 112 Deduction: Deduction: $500,000 CAD
• Adjusted Taxable Income: $1,500,000 CAD - $500,000 CAD = $1,000,000 CAD

Thus, Corporation X’s taxable income remains the same, effectively neutralizing the tax impact of the dividend received from Corporation Y.

Summary:

Section 112 allows Canadian corporations to deduct intercorporate dividends from taxable Canadian corporations, thereby preventing double taxation in corporate structures. This is often utilized in corporate groups where parent and subsidiary entities both operate as separate taxable entities but share profits through dividends. It also arises if a corporation has, for example, a retirement investment portfolio (owns arms length shares) in publicly traded Canadian corporations.

• Section 113: Dividends from Foreign Affiliates

Section 113 deals with the deduction of dividends received from foreign affiliates. "Where the corporation has received a dividend from a foreign affiliate, an amount, as calculated under section 113, may be deducted from the corporation's income for the purpose of computing its taxable income."*  I understand that to mean companies in Canada that receive dividends from their foreign affiliates can deduct a portion of these dividends from their taxable income. The amount of the deduction is dependent on various factors including the type of surplus from which the dividend is paid (e.g., exempt surplus, taxable surplus, hybrid surplus, pre-acquisition surplus).

More >> Surplus Accounts and Foreign Affiliate Tax Traps

Example Scenario:

Suppose Company C, a Canadian corporation, owns 100% of the shares of Company F, a corporation based in a foreign country. During the fiscal year, Company F pays a dividend to Company C.

To illustrate how Section 113 operates:

1. Dividend Repatriation:

• Company F declares and pays a dividend of $1,000,000 CAD to Company C.

2. Deduction under Section 113:

• Under subsection 113(1), Canadian corporations can deduct in computing their taxable income an amount equal to certain dividends received from a foreign affiliate. The specific subsection of 113 under which the deduction is claimed depends on various conditions such as whether the foreign corporation is a foreign affiliate as defined and the level of foreign tax paid.

3. Calculation of Deductible Amount:

• Assume the foreign country levied a tax of $200,000 CAD on the profit before Company F paid the dividend. Under subsection 113(1)(b), if that foreign tax qualifies as a "foreign accrual tax" (FAT), Company C can deduct the foreign tax amount in calculating its taxable income.
• Therefore, Company C would include the gross dividend of $1,000,000 CAD in its income but would also be able to deduct $200,000 CAD under subsection 113(1)(b).
• The net amount included in Company C's taxable income would be $800,000 CAD.

In practical terms, Section 113 helps avoid double taxation on income that has already been taxed in a foreign jurisdiction by allowing the Canadian recipient to deduct certain amounts from its taxable income.

Summary:
Section 113 ensures that Canadian corporations are not adversely taxed on the repatriation of foreign-earned profits by allowing them to deduct certain amounts, such as foreign taxes paid, when those earnings are brought back into Canada as dividends. This is particularly beneficial for multinational Canadian corporations with foreign operations.

• Section 138(6): Dividends from Insurance Corporations

This section applies to assessable dividends. Assessable dividends are dividends subject to Part IV tax, specifically to dividends received by insurance corporations. It allows insurance companies to deduct dividends received from shares they hold in other insurance corporations. 

If you come across the term "assessable dividends" in relation to section 138(6), it's referring to the income from dividends that an insurance company must recognize and potentially can deduct under the specified conditions.

Example Scenario:

Let's say Life Insurance Company A holds shares in Life Insurance Company B. During the fiscal year, Company B pays a dividend to Company A. Under Section 138(6), Company A may be allowed to deduct that dividend from its taxable income, provided it meets the specific conditions and requirements set forth in this section.

This deduction prevents the double taxation of intercorporate dividends within the insurance industry, ensuring that the income is not taxed multiple times as it moves between related entities.

• In Summary:

These provisions ensure that dividends received under these categories may be deducted to avoid multiple layers of taxation.

1. Section 112: Deals with intercorporate dividends within Canada.
2. Section 113: Covers dividends from foreign affiliates of Canadian corporations.
3. Section 138(6): Pertains specifically to dividends received by insurance corporations.

*Reference: CRA IT269R4 ARCHIVED - Part IV Tax on Taxable Dividends Received by a Private Corporation or a Subject Corporation

The RDTOH (Refundable Dividend Tax On Hand) is a mechanism in the Canadian tax system designed to achieve tax integration and prevent the deferral of tax on investment income by Canadian-controlled private corporations (CCPCs). It is used to track taxes that will be eligible for a refund on dividends. Here’s an explanation of how it works:

Purpose of RDTOH: The primary purpose of RDTOH is to ensure that the investment income earned by Canadian controlled private corporations and then distributed as dividends is taxed at a rate similar to the rate that would apply if the income were earned directly by an individual. It prevents corporations from indefinitely deferring tax on investment income by holding it within the corporate structure. It is not available to public companies; only CCPCs that pay part IV tax on dividends from passive income.

How RDTOH Works

1. Accumulation: When a CCPC earns certain types of income, such as interest, taxable capital gains, or dividends from non-connected corporations, it has to pay Part I or Part IV tax. A portion of these taxes is added to the corporation’s RDTOH account.

2. Tracking RDTOH: Corporations need to track two components of RDTOH:

• Eligible RDTOH: Relates to eligible dividends which qualify for the more favorable tax treatment.
• Non-eligible RDTOH: Relates to non-eligible dividends which don’t qualify for the favorable personal tax-treatment rates.

3a. Tax Calculation for an eligible RDTOH per section 129(4) of ITA:

• Eligible RDTOH opening balance
• - Eligible dividend refund from the prior year
• + Part IV tax paid on eligible dividends received
• Eligible RDTOH closing balance

3b. Tax Calculation for an non-eligible RDTOH per section 129(4) of ITA:

• Non-eligible RDTOH opening balance
• - Non-eligible dividend refund from the prior year
• + Refundable part I tax: the lessor of (i) 30 2/3% of aggregate investment income, or (ii) 30 2/3% x (taxable income - SBD), or (iii) Part I tax payable
• + Part IV tax paid on non-eligible dividends received
• Non-eligible RDTOH closing balance

4. Refundability: Canadian controlled private corporations can get a refund from their RDTOH account when it pays taxable dividends to its shareholders. Specifically, the refund is calculated as the lessor of: (i) $38.33 for every $100 of taxable dividends paid, or (ii) the RDTOH balance available for that type of dividend. This refund ensures that when corporations pay dividends, the tax burden is ultimately passed to the individual shareholders, maintaining tax neutrality.

Conclusion: RDTOH is a feature of the Canadian tax system that helps maintain fairness and tax neutrality. It ensures corporations do not gain an undue advantage by accumulating investment income and encourages the timely distribution of earnings for taxation at the shareholder level. You can find the RDTOH calculation and any dividend refund on page 7 of your T2 jacket.

The Capital Dividend Account (CDA) in Canada is a notional account used by Canadian controlled private corporations to track certain tax-free earnings that can be distributed as dividends to shareholders on a tax-free basis. These earnings generally arise from non-taxable capital gains and certain other tax-free transactions.

Key Items Found in and Affecting the CDA

1. Non-Taxable Portion of Capital Gains: When a corporation realizes a capital gain, typically only 50% of the gain is taxable. The non-taxable portion (the remaining 50%) is credited to the CDA.

2. Life Insurance Proceeds: Proceeds from life insurance policies received by the corporation upon the death of the insured person, minus the adjusted cost basis (ACB) of the policy, are added to the CDA.

3. Capital Dividends Received: Capital dividends received from other corporations are also added to the CDA.

4. Capital Loss Utilization: Reductions occur in the CDA when capital losses realized by the corporation offset previous capital gains.

5. Capital Dividends Paid: Payment of a capital dividend reduces the CDA balances.

Purpose of the CDA

The purpose of the Capital Dividend Account is to permit Canadian controlled private corporations to distribute certain types of earnings to shareholders tax-free. This helps avoid double taxation, where the same income might otherwise be taxed at both the corporate and personal levels.

Administration and Reporting

1. Form T2054: To declare a capital dividend, the corporation must file Form T2054, "Election for a Capital Dividend Under Subsection 83(2)," with the CRA. The form must be filed on or before the date the dividend is paid.

2. Maintaining Records: Accurate records must be kept to track the CDA balance accurately. This is crucial for compliance and to ensure that dividends do not exceed the available CDA balance. The easiest way to do this is use Schedule 89 found in your corporate tax return.

3. Confirming CDA Balance: It's advisable to confirm the CDA balance with the CRA before paying out a capital dividend to avoid any potential penalties or mistakes. You do this by filing a Schedule 89.

Benefits

1. Tax-Free Dividends: Shareholders (Canadian residents) receive dividends from the CDA tax-free, which can be a significant tax planning advantage.
2. Efficient Distribution: It allows for the efficient distribution of non-taxable portions of gains and tax-free life insurance proceeds to shareholders.

In summary, the CDA provides a mechanism for Canadian controlled private corporations to pass certain tax-free earnings to shareholders without additional tax burdens, thereby enhancing the overall tax efficiency for the corporation and its shareholders.

To confirm the balance in your Capital Dividend Account (CDA) with the Canada Revenue Agency (CRA), follow these steps:

1. Review Internal Records: Verify your own records to ensure that the calculations and transactions contributing to the CDA balance have been accurately documented. You would normally find this information on Schedule 89 of your T2 return, not in your financial statements.

2. Request a CDA Balance Verification: File a Schedule 89 - Request for Capital Dividend Account Balance Verification. Confirming your CDA balance with the CRA before declaring and paying a capital dividend is crucial to ensure compliance and avoid significant (some would say severe) penalties associated with paying in excess of your CDA.

3. Filing an Election (T2054): If you are planning to pay a capital dividend, you need to file an election using Form T2054, "Election for a Capital Dividend Under Subsection 83(2)"  on or before the date the dividend becomes payable or when any part of the dividend is paid.

• You file this form separately from your corporate tax return.
• When you file this form, the CRA will review your account and either confirm the balance or issue a notice of assessment or determination.
• You must include (1) a Schedule 89 which supports your CDA balance calculation; and (2) attach a certified copy of the capital dividend resolution as required by Regulation 2101.
• Part 8 - Late Filing Penalty must be completed on Form T2054 with payment attached if you paid your capital dividend and are filing the election after its due date instead of before.

4. My Business Account (or Represent a Client:) You can also access CRA's online portal "My Business Account" to view your account balances and transactions under the RC Corporate section. Ensure you or your authorized representative have set up access to your account.

By following these steps, Canadian controlled private corporations (CCPCs) should be able to accurately confirm their CDA balance with the CRA.

In the context of Canadian tax, particularly for Canadian Controlled Private Corporations (CCPCs), the terms "passive income" and "Specified Investment Business Income (SBI)" relate to different types of corporate income that have distinct tax treatments. Here are the differences between the two:

Passive Income

1. Definition: Passive income generally refers to income that is not earned from active business operations. Common examples include interest, dividends, rental income from real property, and royalties.

2. Tax Rate: Passive income earned by Canadian controlled private corporations is subject to a high rate of tax compared to active business income. This is because, under Part IV of the Income Tax Act, a refundable tax is levied on investment income.

3. Refundable Dividend Tax on Hand (RDTOH): A portion of the tax paid on passive income may be refunded when the corporation pays taxable dividends to its shareholders. The refundable tax is tracked in the corporation's RDTOH account.

4. Impact on Small Business Deduction (SBD): Passive income in excess of $50,000 can impact the CCPC’s ability to claim the SBD. Once passive income exceeds this threshold, there is a reduction in the corporation's SBD limit, leading to a higher tax rate on active business income.

Specified Investment Business Income (SBI)

1. Definition: SBI is a type of passive income earned by a business that principally derives its income from property, such as real estate, rentals, or investments. A business whose principal purpose is to earn income from property and that does not employ more than five full-time employees throughout the year is classified as a Specified Investment Business.

2. Active vs. Passive Distinction: While this income might seem passive, it is categorized separately because it comes from business activities specifically aimed at generating income from investments.

3. Tax Rate: SBI earned by Canadian controlled private corporations is also subject to high tax rates similar to other forms of passive income. It does not qualify for the small business deduction.

4. Number of Employees Condition: If the business has more than five full-time employees, it may qualify as an active business and not as a Specified Investment Business, which could then allow access to the lower active business income tax rates.

5. Excluded from Active Business Income: Income from a SBI does not qualify as active business income and, therefore, cannot take advantage of the lower corporate tax rate available to active business income eligible for the small business deduction.

Key Takeaway

• Passive Income includes various forms of non-operating revenue such as interest, dividends, and rentals, subject to high tax rates and potential refundable taxes under RDTOH.
• Specified Investment Business Income (SBI) is a subset of passive income earned by businesses focusing primarily on investment-type revenue, also generally subject to high tax rates but with specific conditions like the number of employees defining its classification.

SCI and SBI are different types of business income that can impact how income is taxed for corporations. It's important not to confuse the two.

Both specified corporate income and specified investment business income are terms that relate to the application of the small business deduction (SBD), which is a beneficial tax rate applied to the first $500,000 of active business income for Canadian-controlled private corporations (CCPCs). Here's a breakdown of these terms and their implications:

Specified Corporate Income (Anti-avoidance Rule)

SCI is primarily concerned with preventing fragmentation of a business's operations to claim the SBD multiple times improperly. This anti-avoidance rule is designed to address circumstances where a corporation provides services or property to another corporation with which it does not deal at arm’s length and the income derived is not considered active business income (ABI).

Key Features:

• The specified corporate income applies where a CCPC earns income from providing services or property to a non-arm's length entity that could have directly earned such income.
• This income is generally ineligible for the small business deduction unless both parties elect to have the income deemed active business income within certain prescribed limits.

Impact on Small Business Deduction:

• Without proper structuring, such income could be excluded from the SBD, impacting a CCPC's ability to benefit from the lower tax rates on small business income.

Specified Investment Business Income

SBI refers generally to income derived from a corporation that earns income primarily from property unless the corporation employs more than five full-time employees throughout the year or is otherwise actively engaged in business activities. Typical sources of specified investment business income include:

• Rent
• Interest
• Dividends
• Royalties

Impact on Small Business Deduction:

• A corporation that earns such income will not benefit from the small business deduction on this income because it is not considered active business income. This means it will be taxed at the higher general corporate tax rate unless the corporation meets the exceptions (more than five full-time employees or active engagement in business activities).

Key Takeaway

Both specified corporate income address and specified investment business income different aspects of income classification for tax purposes. Specified corporate income targets potential intra-group arrangements aimed at unfairly maximizing the SBD. Specified investment business income affects the active/passive income distinction and eligibility for the SBD based on the nature of the income. Understanding and managing these distinctions is important for tax planning to ensure a corporation optimizes its tax liabilities. As tax rules are complex and subject to changes, consulting with a tax professional is advised for guidance on these two different types of business income.

No, specified corporate income is not the same as income splitting or income sprinkling, although they are related in terms of tax planning and avoidance strategies.

Specified Corporate Income

Purpose: The specified corporate income rules are primarily an anti-avoidance measure targeting corporate income that might be inappropriately classified to claim the small business deduction. This rule prevents corporations from artificially splitting business operations to multiply access to lower tax rates on active business income via the small business deduction.

Application: It affects transactions or arrangements where income is passed between corporations under non-arm's length relationships to claim multiple deductions improperly.

Income Splitting (or Income Sprinkling)

Purpose: Income splitting, or income sprinkling, involves distributing income among family members (often through dividends), who might be in lower tax brackets, to reduce the overall tax burden. This strategy tries to take advantage of the progressive tax rate system.

Application: Typically, income splitting involves the use of family trusts, partnerships, or directly paying dividends to family members, such as children or spouses, to shift income.

Recent Tax Changes:
The Canadian government implemented rules in 2018 to address income splitting, notably through Tax on Split Income (TOSI) rules. These rules limit income sprinkling benefits, particularly for individuals aged 18 and over receiving income from a family business.

Key Differences

• Nature of Target: Specified corporate income targets inter-corporate transfers and deductions; income splitting targets distribution among individuals.
• Rules and Impact: Specified corporate income affects corporate tax rates through eligibility for the small business deduction. In contrast, income splitting involves personal tax rates and family tax planning.

Both strategies have been scrutinized by tax authorities given their potential for abuse, leading to ongoing evaluations and updates in tax legislation to prevent tax avoidance. These are complex tax issues.  To ensure you are not offside the current tax laws, it is always prudent to chat with your accountant about how these issues affect you both from a business perspective and a personal perspective.