January 2008: by Jos Herman

Are you used to bonuses or dividends?

Standard practice for Canadian Controlled Private Corporations (CCPC's) has been to pay bonuses to owners to reduce active business income to the maximum amount eligible for the small business deduction (now sitting at $400,000). This strategy sought to avoid the double-taxation inherent in paying the highest corporate tax rate.

As we head toward year-ends, now is the time to start thinking about how changes to the dividend rules will have an impact on your personal and corporate tax planning.

Overview of the Rule Changes
The tax rate on dividend income will depend on whether a dividend has been designated as an eligible dividend by the corporation paying it. Eligible dividends are subject to an enhanced dividend gross-up. From the standpoint of an individual taxpayer, an eligible dividend under the federal tax regime increases both:

• the dividend gross up (from 25% to 45% of dividends received), and
• the federal dividend tax credit (2/3 of the 25% gross up to 11/18 of the 45% gross-up).

A corporation's capacity to pay eligible dividends depends mostly on its status. If the corporation is a CCPC, it can pay eligible dividends only to the extent of its "General Rate Income Pool" ("GRIP"). In general terms, it is the balance reflecting taxable income that has not benefited from the small business deduction or any other special tax rates. This also includes eligible dividends received from other corporations.

Corporate income from which eligible dividends cannot be
paid will include:

• non-eligible dividends received,
• income taxed at the small business rate, and
• investment income (other than eligible dividends from other corporations) for which existing rules already refund a portion of the high-rate corporate tax when dividends are paid.

There is some work required in calculating GRIP. At each year-end, CCPC's will need to calculate a GRIP from which eligible dividends can be paid. The GRIP is calculated for taxation years ending after 2000. A new reporting obligation has been introduced that will require the payer to notify the dividend recipient, at the time of payment, that the dividend has been designated as an eligible dividend. This may take the form of letters to shareholders, dividend cheque stubs, identification on T3 and T5 slips, or where all the shareholders are directors of the corporation, a notification in the minutes.

Corporations that designate dividends as eligible, and discover they have an excess designation, will be subject to an additional 20% tax on the excess amount. The status of the dividend to the recipient is not affected. With consent of the recipient shareholders, corporations can elect to treat all or part of an excess designation as a separate non-eligible dividend, thereby avoiding the 20% tax and altering the taxation to the recipient. The tax increases to 30% and applies to the entire dividend in certain tax-avoidance situations.

Planning Opportunities
It appears that the customary rules with respect to tax planning for salary vs. dividends to the owner-manager of a CCPC have changed, particularly for businesses with active business income in excess of the Small Business Deduction limit. Planners will now have to consider the new dividend rules and make an assessment. Do you leave higher-taxed income in retained earnings for future distribution? Will owner-managers be motivated to leave income that is not required personally in their corporations because the general corporate tax rate is approximately 35% compared to 44% at the personal level?

Given that the net income earned by an owner-manager is subject to two levels of taxation, it is important to understand how the new dividend taxation rules will affect the owner-manager should they require funds personally from the corporation.

As this articles lays down the basic foundation of the dividend regime, the next article will focus on how tax planning opportunities for owner-managers may be affected.

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About the author
Jos Herman, CA, is a Financial Advisor with Assante Financial Management Ltd.

Disclaimer
Please contact a professional advisor to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

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