New Dividend Tax CreditDraft legislation may lower personal taxes on dividend income.
In June, the Department of Finance released draft legislation designed to alter the taxation of eligible dividends in order to level the playing field for corporations paying tax on income subject to the high rate of income tax but not subject to integration (the types of income not subject to integration include public corporations' income and Canadian controlled-private corporations' (CCPC) active business income not subject to the small business deduction (SBD)).
The intent was to reduce the tax on dividends paid from these types of corporate income ("eligible dividends") by increasing the corresponding dividend gross-up to 45 per cent from 25 per cent and the dividend tax credit to 11/18 of the gross-up.
These tax changes treat the income earned through a corporation and then distributed as a dividend the same as income flowed through directly to the investor via an income trust; a decline of more than $5 per $100 of dividend income at the personal federal income tax level. The decision to reduce the tax rate on eligible dividends and simultaneously not to impose a new tax on income trusts was met with euphoria on the capital markets.
Draft Legislation Highlights
This draft legislation need only be considered if a corporation decides to pay its shareholders an eligible dividend subject to the reduced rate of personal income tax as opposed to taxable dividends subject to higher rates ("ineligible dividends") after 2005. The new rules introduce two new tax pools:
- General rate income pool (GRIP); and
- Low rate income pool (LRIP).
Even though the two pools sound similar, they perform very different functions. The GRIP is the "good pool" from which eligible dividends can be paid from a CCPC without any further tax implications. The LRIP is the "bad pool," which limits the eligible dividends that can be paid from non-CCPCs and public corporations until such pool is fully distributed to shareholders as ineligible dividends.
GRIP generally comprises 68 per cent of a CCPC's active business income not subject to the SBD and other eligible dividends received from other corporations. This represents the "high tax rate active business income" retained earnings pool of a corporation from which an eligible dividend can be paid. As a corollary, 32 per cent represents the combined federal and applicable provincial income taxes to which a corporation's high rate active business income is presently subject. Currently, the high rate federal active business income tax is approximately 22 per cent. Presumably, 10 per cent represents an average of the provincial high rate of active business income.
LRIP is the pool balance that may be present only in non-CCPCs and public corporations. An LRIP balance is an accumulation of tax-paid retained earnings that were subject to preferential rates of tax (active business subject to the SBD or investment income) when the corporation was a CCPC, and ineligible dividends received from other CCPCs. Public corporations and non-CCPCs must first pay ineligible taxable dividends from their LRIP pool before paying eligible dividends in order to avoid further tax consequences.
The corporation must, in writing, designate a dividend as eligible and notify all of the recipients at the time the eligible dividend is paid.
There shall be a new corporate distributions tax if, in most cases, a corporation pays an eligible dividend and such designation is made in excess of the GRIP pool (or for public corporations, the eligible dividend was designated at such a time when an LRIP balance existed) at a rate of 20 per cent of the excess amount designated. In a situation where a certain anti-avoidance rule applies, the penalty tax would be 30 per cent of the total eligible dividend designated. A non-arm's-length shareholder is jointly and severally, as well as solidarily, liable for the corporation's penalty tax.
Therefore, if a corporation notifies its shareholder of paying an eligible dividend and it is subsequently discovered that the corporation has designated and paid an excessive eligible dividend, it is the corporate payer alone who is subject to any kind of penalty tax; the shareholder shall still be entitled to the enhanced tax benefits. The result is equitable because the corporate distributions tax places the onus of responsibility for eligible dividends on the corporation and not the shareholder.
Any corporation resident in Canada that pays a taxable eligible or ineligible dividend in its taxation year ending after 2005 shall file an additional schedule with its regular T2 corporation tax return, such as Schedule 3, which calculates the Part IV tax liability of a corporation.
Parallel special rules apply to the computation of a corporation's GRIP or LRIP when it becomes or ceases to be a CCPC and when it has been party to an amalgamation or a wind-up. Further, the computation of both pools shall commence for corporations whose taxation years end after 2005.
Since the GRIP and LRIP serve different functions, it is not surprising that there are many differences between the two. The most notable are:
- Non-CCPCs and public corporations must first pay ineligible dividends from the LRIP and then pay eligible dividends from the default pool. No such ordering provision exists in CCPCs in respect of the GRIP from which eligible dividends would be paid and its default pool from which ineligible dividends would be paid.
- There is a one-time GRIP adjustment to the beginning balance of the GRIP pool for taxation years of the corporation that end after 2000 and before 2006. Generally speaking, this adjustment for CCPCs is 63 per cent of the active business income taxed at the high rate of corporate tax less any taxable dividends paid by the corporation for the aforementioned taxation years. The reason the after-tax high active business income retained earnings is 63 per cent for the one-time GRIP adjustment versus 68 per cent for the regular GRIP calculation is because the federal and provincial corporate tax rates were higher from 2000 to 2005 than they are now. There is no similar one-time LRIP adjustment for non-CCPCs and public corporations.
This significant difference between the two pools should be considered a gift from the Department of Finance, which is permitting CCPCs to increase prior years' GRIP from which more eligible dividends can be paid to shareholders after 2005. However, the department is not enacting similar legislation for the LRIP that would increase the barrier non-CCPCs and public corporations would have from paying eligible dividends.
- The GRIP is calculated only at the end of the corporation's taxation year, whereas the LRIP is calculated throughout the year. Thus, a CCPC with a nil GRIP balance can pay an eligible dividend at any point in the taxation year without incurring the corporate distributions tax if it anticipates having a GRIP balance at the end of the year. If a GRIP balance is not there at the end of the year, the dividend will be subject to a penalty tax. However, a non-CCPC or a public corporation cannot pay an eligible dividend at any point in the taxation year without incurring the corporate distributions tax if there is any amount of LRIP balance at that time.
These new rules will have widespread implications for all aspects of tax planning, particularly for owner-manager businesses. Conventional tax wisdom may have to be reconsidered in certain situations, such as:
- Owner-manager remuneration: Salary/ bonus versus dividend?
- Sale of assets versus sale of shares: Will there be still the same bias for the vendor to sell shares and trigger a capital gain?
- Post-mortem estate planning: Is it preferential for the estate to be taxed as a capital gain or a dividend on its liquidation of a private corporation's shares?
- Will interprovincial planning become even more widespread because of the eligible dividend rules?
The answers to these questions will not be available until all of the provinces confirm their responses to the federal eligible dividend legislation. At the time this article was written, the only provinces that had announced their intention regarding the federal eligible dividend legislation were Ontario, Quebec, Manitoba, and Nunavut. It shall be interesting to see what the other provinces introduce in terms of provincial legislation.
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