Understanding Corporate Taxation and Investment Efficiency

Key Concepts

• Corporate Taxation:

  • Corporations earn income taxed at a lower corporate tax rate, creating a larger pool for investment.
  • Advantage: Smoothing cash flow by spreading tax payments over time through dividends.

• Investment Through Corporations:

  • High upfront tax on extra income to prevent using corporations solely for investment.
  • Refundable Dividend Tax on Hand (RDTOH) allows some tax to be refunded when dividends are paid.

Important Points

• Cash Flow Management:

  • To be efficient, corporations must save and invest money while also paying out enough dividends to keep RDTOH flowing back.
  • Failing to do so results in paying the top tax rate immediately.

• Tax Drag vs. Tax Deferral:

  • Tax drag occurs when tax paid on investment income through a corporation is not fully refunded, leading to inefficiency.
  • Tax integration aims to make corporate and personal taxes add up to what would be paid individually, but is not always perfect.
  • Investing personally can be more tax-efficient than through a corporation.

• Dividend Trapping:

  • Occurs when high upfront tax is paid, but without paying dividends, the refundable portion remains trapped.
  • It's inefficient if tax isn't released back to the corporation through dividends.

Practical Implications

• Personal vs. Corporate Tax Rates:

  • Personal tax rates can sometimes be higher than corporate rates, making personal investment more efficient.
  • Depending on income levels, paying dividends even when not needed can release trapped RDTOH, making it more efficient.

• Provincial Variations:

  • Efficiency of corporate investment varies by province, with some having higher personal tax rates.
  • Example: In BC and Ontario, high personal tax rates may favor leaving money in corporations in the short term but not long term.

• Dividend Efficiency:

  • Eligible dividends (from Canadian companies) are highly tax-efficient for both corporations and individuals.
  • Interest and foreign dividends are generally less efficient within corporations.

Recommendations

• Consult with Accountants:

  • Ensure RDTOH is being managed properly.
  • Regularly review whether leaving money in the corporation or paying it out as dividends is more efficient.
  • Be aware of potential inefficiencies and adjust strategies accordingly.

• Personal Financial Planning:

  • Consider using extra funds from dividends for TFSA, RRSP, or personal accounts.
  • Plan for major expenses or retirement by managing how and when dividends are paid.

Summary

• Main Takeaway:
  • Efficient tax management within corporations requires careful planning and regular consultation with accountants to ensure refundable taxes are optimized and inefficiencies are minimized.