There is integration in the Canadian tax system which does not put a corporate taxpayer at an advantage as compared to an individual taxpayer. This integration is not perfect but still, it works. Whenever an individual shareholder receives dividends from a corporation, there is an income inclusion, grossed up based on whether the dividends are eligible or non-eligible. This income is taxed at the individual’s marginal tax rates. A dividend tax credit is available to mimick the taxes paid on that income at the corporate level. Even if the individual withdraws the bonuses or salaries from the corporation, still there is an income inclusion. of employment income.
Many individual taxpayers tend to avoid withdrawing cash from their corporations to avoid paying more in personal taxes. This does not solve the problem, however, it keeps on deferring the tax in long run.
Important Disclaimer: This post is not tax advice and the readers must consult their professional tax accountants to get tailored advice. Further, this post may not be updated in the future and the author assumes no responsibility for the intended or unintended outcomes of any decisions on the mere reading of this post.
Extracting surplus cash from a corporation without the use of holding corporation
Having surplus cash in the corporation causes many other issues. One of these major issues is unable to meet the eligibility requirement for the Qualified small business corporation (QSBC) status for Lifetime capital gain exemption purposes. Another downside of pooling too much cash in the corporation is the risk associated with creditors.
A widespread strategy is to use a holding corporation. Intercorporate dividends are tax-free in Canada due to the availability of a deduction of the same amount. The holding corporation can then use this cash to make further investments.
If you do not have a holding corporation, you can set one up and transfer the shares held by an individual to the holding corporation using sec 85(1) rollover.
The downside of extracting cash from OpCo and pooling it in a HoldCo is that Opco still may not be a QSBC.
The below-outlined strategy comes in handy when the goal is a purification for LCGE purposes. However, you can still use it to extract surplus cash or assets from a corporation.
The shareholder of OpCo must be an individual, not another corporation. The nominal amount serves as the dividend amount for an individual shareholder as opposed to the Fair market value. However, in the case of the corporate shareholder’s section, 55 and subsection 52(3) come into play as well, which will cause a dividend amount equal to the FMV of the preferred shares issued by OpCo.
This strategy works fine with simple tax situations. Section 55 implications must be closely determined before taking up this strategy especially if the assets being removed from the OpCo have inherent gains, or if the corporation has multiple shareholders. Further, the tax planning may not work if either the OpCo or NCo are subsequently sold. Alternate tax planning strategies can help with other complex situations. You must work closely with your corporate tax accountant for tax advice and a corporate lawyer to ensure that corporations can issue those shares.
There are many other provisions of the Income Tax Act that can create unintended tax consequences if some errors or mistakes are made during the planning process.
Maroof HS CPA Professional Corporation is a Toronto-based boutique accounting firm providing tax and accounting services in Ontario and Alberta. It helps many small and medium businesses to take advantage of advanced income tax planning and other complex corporate tax issues. Get in touch with us today.