Our tax system is based on the concept of “tax integration”, whereby taxpayers should be indifferent as to whether they earn income personally or through a corporation. In theory, after a corporation has paid personal tax on its income and distributed the after-tax profits as dividends to its shareholders, who in turn pay personal tax on the dividend, the end result should be the same as if the individual had earned the income personally in the first instance and simply paid personal tax. Given the number of tax jurisdictions within Canada (federal, ten provinces and three territories) and that each may have its own fiscal issues and policies, this can be difficult to achieve. For the most part though, our tax system is fairly close to perfect tax integration in most cases.
In the case of business income, when considering an Ontario-resident individual who is in the highest personal tax bracket, there is a very slight cost to earning business income through a corporation and then distributing dividends to the individual. However, there is a significant deferral of personal tax in these cases, such that the benefits of being able to invest/reinvest this deferred tax will typically easily exceed the tax cost of incorporating the business activity. This tax deferral and ability to accumulate investment capital at a faster pace is one of the key tax advantages of incorporating a business activity.
In the case of investment income earned through a corporation, there is a tax cost once the corporation pays its after-tax income out to shareholders as dividends, as follows:
- dividends from Canadian corporations – no cost;
- capital gains – cost of 2.2%;
- interest income – cost of 4.4%;
- rental income – cost of 4.4%; and
- dividends from foreign corporations – 10.4%.
Despite the added tax burden associated with earning investment income through a corporation, there are many reasons why one may be willing to bear this cost, including:
- allows for the implementation of an estate freeze, which may defer tax that would otherwise arise on death;
- provides more certainty as to one’s eventual tax liability upon death;
- allows for planning to avoid probate fees on the underlying investments;
- provides the ability to better manage one’s personal income level; and
- if the capital that has been invested originated from an operating company, a significant tax deferral is maintained so long as the investments remain in a corporation.
Using a corporation to hold investments is a common tax and estate planning tool, but people are often surprised at the cost associated with earning foreign dividend income through a corporation. While the “tax tail” should not necessarily wag the “investment dog”, having an understanding of the tax impact may help in planning how to optimally hold different types of investments. Speak to your Welch LLP advisor to discuss how this may impact your situation.
