Income and Taxes in a Corporation

We look at the benefits of operating a business inside a corporate structure and explain the taxation rules of investment income and capital gains inside a corporation.

Taxation of Active Business Income (Ontario 2017 rates)

 

Canadian-controlled private corporations (CCPCs) have a tax rate of approximately 26.5% on annual active business income. As shown in the following chart, CCPCs benefit from a small business deduction that lowers their tax rate to 15.0% on the first $500,000 of annual active business income.

 

Federal (A)

Ontario Tax Rate (B)

Combined Tax Rate (A+B)

Active business income tax rate

11.0%

4.5%

15.0%

 

Active business income is income generated from the core business activities of a CCPC. Consider the hypothetical example of John, who owns a CCPC that operates a restaurant. The corporation’s business income derived from the restaurant is considered active business income. But if John’s corporation invested its retained earnings in a guaranteed investment certificate (GIC), income generated by these investments would be passive income and subject to a higher level of taxation.

As shown on the following chart, the low active business income tax rate confers a significant advantage on the entrepreneur who operates his business within a corporation and does not need to withdraw all income for personal use. It allows the owner to defer personal taxation on the income until received from the corporation in the form of a dividend:

 

Small Business Tax Rate on first $500 000 of income (A)

Maximum Marginal Rate on personal income (B)

Tax Deferral Available in Canada (B-A)

Average Tax Rate

15.0%

53.5%

38.5%

 

Returning to the example of John, the corporation generates active business income of $100,000. He doesn’t need this income because he receives a salary that covers his cost of living expenses; he also has other sources of income. He can defer approximately $31,300 in taxes annually—money that can be invested to earn extra income.

If he operated his restaurant personally John would be taxed at his personal maximum marginal tax rate on all income generated by the restaurant.

Let’s now examine how passive income (investment income) is taxed inside a corporation.

Taxation of Investment Income Within a Corporation

 

Since there is a strong incentive for business owners to accumulate profits inside their corporation, business owners will accumulate investment assets within their corporations.

The conundrum is that while active business income receives favorable tax treatment, the same cannot be said for investment income. As shown on the chart below, interest income and the taxable portion of capital gains earned within a corporation will be taxed at a rate of 50.2%.

 

Federal Tax Rate (A)

Provincial Rate (B)

Combined Tax Rate (A+B)

Tax Rate on Investment Income Earned inside a Corporation

38.7%

11.5%

50.2%

 

On the other hand, the 50% non-taxable portion of capital gains earned inside a corporation will be payable tax-free to shareholders through the corporation’s capital dividend account (CDA), while the taxable portion (50%) is taxed at the same rates that apply to interest income.

Example: Land and buildings with an ACB of $500,000 are sold for $1,250,000. The gain is $750,000 but the taxable gain is 50% of the gain or $375,000. Tax at 50.2% = $188,250 leaving $186,750 of the taxable gain. The non-taxable half of the gain ($375,000) can be paid to the shareholder(s) tax free and the remaining $186,750 can be reinvested or paid out as a normal dividend taxable in the hands of shareholder(s). The effective corporate tax rate on the capital gain in the corporation is 26.1%.

Note: If the building was used for the active business and a new building is purchased within the specified time limit (as when larger premises are needed) it may be possible to defer capital gains altogether through a rollover. Seek professional help before making such a move.

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Until next time,    

 

Ian