We have previously written about how Canada’s small business deduction options enable entrepreneurs to lower their tax bills. When it was implemented in the early 1970s, the original intent of the deduction was to provide an avenue that would enable small businesses to grow more quickly. The reduction in the amount of taxes that have to be paid would, in theory, free up more cash which could then be reinvested into the organization, helping it build over time.
Changes to the Allowable Small Business Deduction
Originally, the small business deduction was applied to a business’s total net income. Changes to the tax laws in recent years have resulted in a reduction of the small business deduction amount allowed based on the amount of investment income. As well, from 2016, Canadian-Controlled Private Corporations (CCPCs) that have taxable capital of between $10 million and $15 million in a single tax year are still eligible for the small business deduction, but their business limit is reduced on a straight-line basis. All of this means that it is very important for CCPCs to have a well-established strategy to allow them to optimize their benefits from the small business deduction.
The Impact on Taxable Capital
What is taxable capital? A corporation’s taxable capital is, broadly speaking, the total of its:
- shareholder’s equity, surpluses and reserves, as well as loans and advances to the corporation,
- less certain types of investments in other corporations.
The taxable capital employed in Canada is for informational purposes only, to be used to determine a corporation’s eligibility as a small business. It is drawn from a corporation’s previous year’s Schedule 33, Line 690 (roughly equivalent to the Retained Earnings) and will only have an impact when it exceeds $10 million.
When the taxable capital employed by a CCPC exceeds $10 million, the business limit of $500,000 as applied to the small business deduction is reduced and is totally eliminated once taxable capital reaches $15 million. The business limit is reduced on a straight-line basis for CCPCs that have taxable capital employed in Canada between $10 million and $15 million in the previous year. The formula to calculate the business limit reduction is:
$500,000 x 0.225% x (taxable capital amount – $10 million) / 11,250
The Impact of Investment Income
Secondly, let’s talk about investment income earned by a CCPC. The business deduction limit of a CCPC is also reduced if the CCPC, and any other corporation it is associated with, earn combined income from $50,000 to $150,000 from passive investments within a fiscal year. The business limit is reduced to zero once the combined income from passive investments exceeds this amount. The formula to calculate the business limit reduction is:
5 x (aggregate investment income – $50,000)
Managing Retained Earnings and Taxable Capital Amounts Through Dividends
How can a business manage its retained earnings and taxable capital amounts? The first item to look at is paying dividends to the shareholders if there are any. If a business has investments that are not necessary, it might consider declaring a property dividend to pass the dividend to the shareholders. This will help reduce the investment income.
Eligible vs. Non-Eligible Cash Dividends
Secondly, look at paying cash dividends to shareholders. A CCPC can issue either non-eligible or eligible dividends. An eligible dividend is one that has been paid out of earnings that have been taxed at the higher tax rate (i.e. no small business deduction has been applied). This type of dividend allows the corporation to claim the full dividend tax credit.
A business designates a dividend as an eligible dividend by notifying, in writing, each person to whom any dividend is paid that the dividend is an eligible dividend so that the recipient individual can claim the appropriate gross-up and Dividend Tax Credit. As investment income does not qualify for the small business deduction, any investment income would be an eligible dividend by default.
Non-eligible dividends are made from income taxed at the lower tax rate (i.e. the small business deduction is applicable). The dividend tax credit for non-eligible dividends is not as high as that for eligible dividends.
What happens if a CCPC receives a non-eligible dividend from another CCPC? Refundable Dividend Tax On Hand (RDTOH) is a tax integration mechanism, meaning that it is one of several provisions designed to tax corporations and the subsequent distributions of dividends to shareholders at the same rate as if the income was earned directly by an individual. In other words, it aims to eliminate certain tax advantages received by a corporation while not penalizing individual taxpayers who earn corporate income. RDTOH accumulates in a CCPC that earns investment income until a taxable dividend is paid out to shareholders. The business will get a refund of the dividends paid from its RDTOH account.
CONSULT WITH A FINANCIAL PROFESSIONAL AT EDELKOORT SMETHURST SCHEIN CPAS LLP IN BURLINGTON FOR MORE INFORMATION
As mentioned before, having a well-established long-term operating strategy is very important for a CCPC. This strategy will need to include actions that will help make the most efficient usage of the small business deduction. A skilled accountant will help your business ensure it maintains the optimal amount of taxable capital, as well as manage retained earnings and the amount of investment (passive) assets in your business.
If you are a small business owner or a self-employed individual and wish to learn more about how to maximize tax benefits for your business, please contact the Chartered Professional Accountants at ESS CPAs LLP in Burlington at 905-517-2297 or by contacting us online.