CHAPTER 9 TOBIAS INTEGRATION OF CORPORATION AND SHAREHOLDER TAXES

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CHAPTER 9 TOBIASINTEGRATION OF
CORPORATIONAND SHAREHOLDER TAXES

• FRANK LAVITT
• Section 9.4 of Tobias (Pages 286 to 292 is not
  part of the examinable materials)

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• The Canadian Income Tax System is one of the few
  in the world which attempts to successfully
  achieve integration.
• Integration refers to ensuring that the combined
  corporate and personal tax on income earned
  through and distributed by a corporation, is
  equal to the tax that would have been paid if
  income had been earned directly by the individual
  (living person) taxpayer.

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• Many students and practitioners, have a difficult
  time with the taxation of the investment income
  of a CCPC particularly with the mechanics of the
  various tax calculations involved and how they
  inter-relate.
• Unique terminology and special tax accounts such
  as refundable dividend tax on hand, dividend
  refunds, Part IV tax, refundable tax levies and
  refundable Part I taxes confuse rather than aid
  in understanding.

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• It is not nearly as difficult as it first
  appears.
• If you grasp the fundamental concept of
  integration and focus on that, the materials that
  we will be discussing today will be less
  challenging.

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• Elements of Integration System
• The integration framework is composed of
  different elements, which we call "integration
  tools".
• The following is an introductory summary.
• (1) The first element is the refundable portion
  of Part I tax. The refundable tax is 20 of
  Canadian investment income.

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• Why levy a tax if it is only going to be
  refunded?
• The refund is only available when the corporation
  pays a taxable dividend to the shareholders.
• As long as the money is retained in the
  corporation, tax must be levied to prevent
  inappropriate tax deferral.

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• (2) The second element is a separate refundable
  tax on the investment income of a CCPC.
• The tax is levied at 6 2/3. This is the
  Additional Refundable Tax.
• Without this Additional Refundable Tax, the
  combined federal and provincial corporate tax
  rate is less than the highest marginal personal
  tax rate.

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• This tax is levied to prevent any opportunity for
  tax deferral by receiving investment income
  through a corporation rather than personally.
• This tax is refunded when the corporation pays a
  taxable dividend.

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• (3) The third element is Part IV tax on dividend
  income.
• Recall that dividends are deductible in
  determining a corporation's taxable income.
• Were it not for Part IV tax, dividends would be
  completely tax free to the corporation.
• Individual investors would pay personal tax on
  dividends received.
• Part IV tax is levied at 33 1/3, which is
  approximately the rate individuals pay on taxable
  dividends.

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• In Manitoba, the combined top marginal tax rates
  on dividends is
• Eligible - 23.83
• Non-Eligible - 37.40
• The Part IV tax then prevents any opportunity for
  tax deferral by receiving dividends through a
  corporation rather than personally.
• To prevent double taxation, Part IV tax is
  completely refundable (at a rate of 1 for every
  3 of dividends paid) when the corporation pays
  taxable dividends to the shareholders.

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• (4) While the foregoing three taxes are
  refundable, the refund only occurs when the
  corporation pays a taxable dividend out to its
  shareholders.
• A tax account - the Refundable Dividend Tax On
  Hand Account ("RDTOH") - is used to "inventory"
  these refundable taxes.
• The RDTOH account is a running accumulation, net
  of any refunds paid, of refundable taxes paid -
  or, "on hand", as the name implies.

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• Do not be confused by the name "refundable
  dividend tax on hand".
• This account houses all three types of refundable
  taxes, not just those (i.e. Part IV) levied on
  dividend income.
• The word "dividend" in the account name refers to
  the fact that these taxes are refundable on
  paying a dividend.

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• (5) The next-to-last element is the dividend
  refund.
• This is the amount of refundable taxes,
  accumulated in the RDTOH account, which are
  actually refunded when a taxable dividend is
  paid.
• The rate at which the taxes are refunded is 1
  for every 3 in taxable dividends paid.
• The refundable taxes refund is called a "dividend
  refund".
• The logic of the 13 ratio will be covered later.

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• (6) The last integration element is the dividend
  tax credit. The dividend tax credit prevents
  double taxation as any taxable dividend is a
  distribution of after-tax corporate income.

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• AGGREGATE INVESTMENT INCOME
• One of the items involved in the RDTOH account is
  aggregate investment income.
• There is no small business deduction on
  investment income, nor does it qualify for the
  general rate reduction.
• Under Part I, investment income is effectively
  taxed at a high rate.

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• By paying a taxable dividend, a private
  corporation may get a significant portion of this
  tax back through a dividend refund.
• By paying a dividend, the investment income flows
  through the corporation.
• The resulting dividend refund may result in a
  relatively low effective tax rate on the
  investment income.

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• The dividend received is then included in income
  by the corporate recipient but then deducted in
  arriving at taxable income, hence there is no
  Part I tax paid by the corporate recipient on the
  dividend.
• This would create the possibility of a long-term
  deferral of tax when the income is not
  distributed to shareholders.
• This is known as "dividend parking".

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• If the recipient of the dividend was an
  individual (i.e. a living person) instead of a
  corporation, the individual would have to pay tax
  on the amount of investment income as it was
  received or accrued.
• The tax system offsets this form of bias by
  ensuring the investment income is continuously
  taxed at a high rate within the corporate
  structures until it is eventually distributed to
  the individual shareholders.

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• This is part of the integration system.
• It acts as a disincentive to accumulate passive
  income in a private corporation.
• Where the recipient corporation is connected to
  the payer corporation, the recipient corporation
  had either influence or control over the payment
  of the dividend.
• Therefore, the companies may wait until there is
  a balance in the RDTOH account and then elect to
  pay a dividend in order to trigger a dividend
  refund.

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• Once the dividend refund is triggered, the
  federal government refunds part of the previous
  taxes paid under either Part I or Part IV or
  both.
• For corporations not connected, the assumption in
  the integration system is the payer received 1
  as a dividend refund for every 3 in taxable
  dividends paid.

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• REFUNDABLE PORTION OF PART I TAX
• The refundable portion of Part I tax is 20 of
  CCPC's investment income.
• Investment income is all income from property,
  both Canadian and foreign.
• Income from property includes rents, taxable
  capital gains (net of losses), and interest.

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• Taxable dividends from Canadian and foreign
  affiliate corporations are excluded, where these
  were deductible in determining taxable income and
  a separate tax is levied, as applicable, under
  Part IV.
• Only a corporation that was a CCPC throughout the
  year qualifies for the Part I refundable tax.
• Investment income also includes any income from a
  specified investment business carried on in
  Canada.

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• Any refundable portion of Part I tax is
  accumulated in (added to) the RDTOH account.
• The 7 general rate reduction for taxation years
  after 2003 (and other planned rate reductions in
  the future) do not apply to a CCPC's investment
  income.
• This is because the tax/income already benefits
  from the refundable tax provision.

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• AGGREGATE INVESTMENT INCOME
• Aggregate investment income is broadly defined to
  include income from property, plus net taxable
  capital gains, less certain adjustments.
• Property income, for the purposes of this
  definition, includes net income from all
  property, other than
• (a) exempt income and
• (b) dividends which are deductible in computing
  taxable income.

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• The meaning of the term "income from property" is
  amplified by the definition "income" or "loss"
  which includes income from a specified investment
  business carried on in Canada, but excludes
  income from the following sources
• (a) from any property that is incident to or
  pertains to an active business carried on by a
  corporation, or
• (b) from any property used or held primarily for
  the purpose of earning income from an active
  business carried on by the corporation.

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• Net losses from property are deducted from the
  foregoing amounts of property income.
• Foreign investment income is calculated as
  aggregate investment income from foreign sources.
• Hence, aggregate investment income includes that
  income from both Canadian and foreign sources.

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• As part of the system of integration, one-half of
  the capital gains and capital losses that is not
  included in income, is included in the
  corporation's capital dividend account.
• As mentioned last week, the Act permits the
  corporation to pay a tax free dividend out of the
  capital dividend account.
• The capital dividend is received free of tax by
  the Canadian Resident shareholder.

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• This completes the full integration of capital
  gains through a private corporation or
  Canadian-controlled private corporation and, with
  respect to the tax-free portion of the capital
  gains, places the shareholder in the same
  position as if he or she received the gain
  directly.

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• ADDITIONAL REFUNDABLE TAX
• Basic Rules
• For Canadian-controlled private corporations, a
  refundable tax is imposed on "aggregate
  investment income".
• This tax can be summarized as follows
• 6 2/3 X the lesser of

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• (a) aggregate investment income, and
• (b) taxable income minus the amount on which the
  small business deduction is based.

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• Aggregate investment income (AII) can be
  summarized as follows
• Net taxable capital gains for the year,
• Less net capital losses deducted under Division
  C,
• Plus income from property (Canadian and
  foreign),
• Includes interest, royalties, rents and
  dividends.
• Less dividends deducted under Division C,
• Less losses from property (Canadian and foreign).

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• REFUNDABLE DIVIDEND TAX ON HAND (RDTOH)
• The Concept
• "Refundable dividend tax on hand" (RDTOH) may be
  viewed as an account which accumulates all of the
  tax paid by a private company on its portfolio
  dividend income (i.e., Part IV tax at 33 1/3)
  and a portion of the Part I tax paid by a
  Canadian-controlled private corporation on other
  investment income.

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• The principal components of the account are as
  follows
• the refundable portion of Part I tax (including
  the ART) that is paid on investment income
• the amount of Part IV tax that is paid on taxable
  dividends and
• the RDTOH balance at the end of the previous
  year, less "dividend refunds" of the previous
  year that arise when the corporation pays taxable
  dividends.

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• The taxes that are accumulated in the RDTOH
  account are refundable to the company at the rate
  of 1 of refund for every 3 of taxable dividends
  paid.
• These refunds are commonly referred to as
  "dividend refunds", which reduce the balance in
  the refundable dividend tax on hand account.

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• RDTOH Continued
• The basic purpose of the RDTOH calculation is to
  aggregate the two types of refundable taxes
  (i.e., refundable portion of Part I tax for
  investment income and Part IV tax for portfolio
  dividends), net of the amount of refundable taxes
  actually received.
• The refundable portion of the Part I tax is
  designed to produce a refundable tax equal to 26
  2/3 of investment income (excluding most
  dividends).

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• The refundable portion of Part I tax is limited
  by the amount of tax payable under Part 1,
  because there should not be a potential refund of
  a portion of Part I tax that has not been paid.

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• Such non-payment of Part I tax may be due to the
  carryover of losses, deductions such as the small
  business deduction and the MP profit deduction,
  or credits such as foreign tax credits and
  investment tax credits.

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• DEEMING RULES OR ANTI AVOIDANCE RULES
• What are known in practice as "deeming rules" are
  provided as an anti-avoidance provision that
  converts what would be property income (e.g.,
  rent and interest) into active business income.
• However, this deeming provision only applies in
  situations where the income was derived from an
  associated corporation that had deducted the same
  amount in determining its active business income.

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• Were it not for these deeming rules, it would be
  possible for a corporation that was approaching
  the 400,000 business limit for its small
  business deduction to transfer certain of its
  assets to a new associated corporation which
  would rent the assets back to the original
  corporation.
• The rental expense incurred by the original
  corporation would be deductible, thereby reducing
  its active business income and preventing income
  in excess of 400,000 from being taxed at full
  corporate rates.

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• The rental income to the new corporation would be
  considered income from property or income from a
  specified investment business and would,
  therefore, be eligible for refundable treatment.
• However, as a result of the deeming rules, the
  amounts received are deemed to be active business
  income of the recipient.

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• As a result, the combined active business income
  of the original corporation and of the new
  corporation, which receives rent deemed to be
  active business income is the same as it would
  have been if the new corporation had not been set
  up.

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• The fact that the two corporations must share the
  400,000 business limit has no effect on the
  total active business income of the group.
• Thus, any active business income in excess of
  400,000 within the associated group will be
  taxed at full corporate rates as it would have
  been without the new corporation.

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• These deeming rules are summarized in the chart
  below

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• As indicated previously, the incentive to
  re-characterize business income, that would be
  taxed at the high corporate rate, as investment
  income is greatly reduced with the higher 45
  gross-up and tax credit on eligible dividends.

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• PART IV TAX
• Part IV tax is levied on taxable dividends that
  have been excluded from taxable income under
  sections 112 and 113.
• Without this Part IV tax, there would be
  inequality in the tax system, as individuals
  could incorporate a company to receive dividends
  they would otherwise receive personally, and
  avoid paying taxes (at least on a current basis).
• Part IV tax is levied at the rate of 1/3,
  applies to all private corporations, not just
  CCPCs.

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• Any Part IV tax paid is also added to the RDTOH
  account and is refundable on paying a taxable
  dividend to shareholders.
• The 1/3 rate is used, because it is approximately
  the tax rate that applies to taxable dividends
  received by individuals.
• (Remember that Manitoba has a higher top dividend
  tax rate - 37.40).
• Subsection 186(1) uses the term "assessable
  dividends" to describe the dividends subject to
  Part IV tax.

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• These are defined at subsection 186(3) as
  dividends that have been deducted in determining
  taxable income.
• An assessable dividend, as defined under
  subsection 186(3), is an amount received by a
  private corporation on account of a taxable
  dividend, which is deductible under section 112
  and 113 in computing the recipient's taxable
  income.

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• There are two types of assessable dividends
• (1) those received from non-connected
  corporations (generally these are from corporate
  shares held as part of an investment portfolio,
  and are generally referred to as portfolio
  dividends) and
• (2) those received from connected corporations.
• The first type are always subject to the 1/3 Part
  IV tax.
• The second type are only subject to the Part IV
  tax in limited circumstances, and in a different
  manner.

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• First, we'll define a connected corporation.
• Corporations are connected if
• the dividend-paying corporation is controlled by
  the dividend-receiving corporation or
• the dividend-receiving corporation owns more than
  10 of the voting shares of the dividend-paying
  corporation and
• those shares represent more than 10 of the fair
  market value of all the issued share capital.

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• For the purposes of Part IV tax, subsection
  186(2) contains a definition of controlled
  corporation.
• A corporation is controlled by another
  corporation if more than 50 of its voting shares
  belongs to
• the other corporation
• persons related to the other corporation
• or
• the other corporation and persons related to it.

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• Consider the following situation.
• Is Benson Ltd. connected with Indy Ltd.?

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• Solution
• Benson Ltd. is connected with Indy Ltd. because
  Benson Ltd. is controlled by Indy Ltd. under
  paragraph 186(4)(a).

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• Consider the following situation.
• Is Xavier Ltd. connected with Callus Ltd.?

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• Solution
• Under paragraph 186(4)(b), Xavier Ltd. is
  connected with Callus Ltd. because Callus Ltd.
  holds more than 10 of the voting shares and more
  than 10 of the FMV of all the outstanding shares.

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• Dividends are allowed to pass freely (i.e.,
  without Part IV tax) between connected
  corporations because the money is not really
  leaving the "economic entity".
• The only time there is Part IV tax on dividends
  between connected corporations is when the payer
  receives a dividend refund from its RDTOH.
• The Part IV tax payable by the recipient
  corporation should be viewed as simply a
  replacement of that refundable tax.

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• Connected Corporations Dividend
• ABC Inc. owns 100 of the shares of XYZ Inc.
• XYZ Inc. paid a dividend of 40,000 up to its
  parent company (ABC Inc.).
• XYZ Inc had 10,000 of refundable Part I taxes in
  its RDTOH account.
• On paying the taxable dividend, these taxes were
  refunded to XYZ.
• What is ABC Inc.'s position vis-à-vis Part IV
  taxes and RDTOH?

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• Solution
• Dividend refund to XYZ from its RDTOH 10,000
• ABC Inc.
• Part IV tax payable on 40,000 dividend 10,000
• Addition to RDTOH 10,000
• Change in the economic position
• of both companies
• considered together NIL

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• In the preceding example, the Part IV tax
  liability of ABC Inc. was equal to the dividend
  refund realized by its subsidiary, and not 1/3 of
  the dividend received.
• This is because ABC is only required to replace
  the dividend refund paid to XYZ.
• This "matching" is accomplished by the formula
  given at paragraph 186(1)(b).

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• Payer's dividend refund X Dividend received
  from a connected company
• Total dividend paid by the payer
• As you can see from the formula, the recipient's
  Part IV tax on dividends from a connected
  corporation is related to the dividend refund
  realized by the dividend-paying corporation and
  not 1/3 of the dividends.
• If the payer corporation does not receive a
  dividend refund, then no Part IV tax is payable
  by the connected recipient corporation.

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• APPLICATION OF NON-CAPITAL LOSSES TO PART IV
  TAXES
• It is possible for a private corporation to
  reduce dividend income subject to Part IV tax by
  applying otherwise available non-capital losses.
• The corporation may either apply the non-capital
  losses to reduce taxable income or apply the
  non-capital losses against dividend income
  subject to Part IV tax.

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• From a tax-planning perspective, it is generally
  unwise to utilize losses to reduce Part IV, since
  Part IV tax is a refundable tax.
• The only time losses should be used to reduce
  Part IV tax is where those losses are expiring
  due to the seven- or ten- or twenty-year carry
  forward limitation.

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