Taxation of Investment Income in a Canadian Corporation: A Comprehensive Guide

Withdrawing funds or dissolving a corporation can be expensive for those with extra cash or investments in their corporation due to high tax costs. To avoid these taxes, individuals often opt to maintain their corporations and focus on maximizing investment returns. Investing in a tax-efficient way can significantly enhance the corporation’s net after-tax return. However, the tax implications of investment income within a corporation are often not well understood, even by many accountants.

A Canadian-controlled private corporation (CCPC) benefits from a lower tax rate on business income compared to public corporations, aiming to support small businesses and foster economic growth. However, the government aims to prevent individuals from exploiting this incentive by using the corporation to earn investment income. Accordingly, the tax rate on investment income is generally very high, though it varies by province. This is a deliberate attempt to discourage people from accumulating investment income within a corporation or a holding corporation and to provide a level playing field for Canadians who hold investments directly instead of through a corporation.

Investment income and its taxation are critical factors in corporate planning, influencing surplus management, income distribution, and long-term financial strategies.

Tax Rates for Different Types of Income

In a Canadian corporation, income is classified into two main groups and treated accordingly.

a) Active Business Income: This is the income generated by a corporation through activities such as trading, services, manufacturing, etc., excluding passive income or income from a personal services business (which refers to an incorporated employee). Active income is subject to two tax rates:

1. Income qualifying for the small business deduction: Canadian-controlled private corporations (CCPCs) enjoy a special tax reduction called the small business deduction (SBD) on their active business income up to $500,000. This deduction reduces the tax rate to 12.2% in Ontario.
2. Income taxed at the general rate: When income exceeds $500,000 or if the corporation does not qualify for the small business deduction, the additional income is subject to the regular tax rate of 26.5% in Ontario.

b) Passive Income or investment income: The second group of income is investment income, which is generated from activities such as income from property, including interest, dividends, rent, and royalty income. This type of income is taxed at a very high rate, typically exceeding 50%, depending on the province.

Types of Investment Income

Within investment income, we can categorize income into three broad categories

Dividends: Dividends received by a Canadian corporation are generally not included in taxable income. However, dividends from non-connected Canadian corporations are subject to a special Part IV tax, which will be discussed in greater detail later.

Capital Gains: Only a portion of gains from the sale of assets, investments, or property is included in taxable income, instead of 100% gain. After recent changes, effective June 25, 2024, 66.66% of the capital gain is included in taxable investment income, up from the previous 50% inclusion rate.

Other Investment Income: This includes interest income, rental income, royalty income, and foreign dividends or investment income. Other investment income is fully included in taxable investment income.

Capital gains and other investment income are taxed at the regular investment income tax rate, i.e. 50.17% in Ontario. This is the case whether the investment income is earned in your operating company or your holding company.

On a side note, if a corporation temporarily has excess cash or office space that is invested while awaiting future use, the income generated may be classified as incidental income and taxed as active business income. However, if the excess cash or space is not incidental or is not considered a temporary surplus, the income will be included in the corporation’s aggregate investment income and taxed at the applicable investment income rate.

Tax rate on capital gains and other investment income:

Investment income within a CCPC or a private corporation is subject to Part I tax at a rate of 50.17% in Ontario, which includes 38.67% federal tax and 11.5% provincial tax. This rate also incorporates an “additional refundable tax” of 10.6% on investment income. This tax rate applies to both capital gains and other types of investment income.

Tax on dividend income from Canadian Corporations:

Dividends received from Canadian sources are treated differently. Dividends from Canadian corporations are not included in taxable income and are not subject to regular income tax (Part I tax). Instead, tax on dividend income depends on the source of the dividend, i.e. dividend income from a connected corporation or non-connected corporation.

Dividend from the connected corporation: Typically, dividends received from a connected corporation are not included in taxable income and are not subject to tax. However, this exemption does not apply if the paying corporation received a refund of its taxes (“a dividend refund”) when it distributed the dividends. A corporation is considered connected if the receiving corporation owns 10% or more of its voting shares, either directly or indirectly.

Dividends from non-connected corporations: Dividends from non-connected Canadian corporations, also known as portfolio dividends, are not included in taxable income and are not subject to regular tax. However, these dividends are subject to a special Part IV tax of 38.33%. This tax is “fully refundable” when the receiving corporation distributes dividends to its shareholders.

Refundable Dividend Tax on Hand (RDTOH) and its objective:

As noted, a corporation’s dividend and investment income are subject to an additional but refundable tax regime. This refundable tax supports a key principle of the Canadian tax system known as “integration.” Integration ensures that individuals are indifferent to earning income through a corporation versus personally, paying the same amount of tax in either case. Without these additional refundable taxes, corporations would pay less tax on investment income, creating an unfair advantage for corporations compared to individuals who earn investment or passive income directly.

Accordingly, when a corporation pays tax on investment income, the refundable tax is added to a notional account with the CRA called Refundable Dividend Tax on Hand (RDTOH). A refund is only issued when the corporation pays dividends to its shareholders. By imposing these additional refundable taxes, the Income Tax Act compels shareholders to distribute dividends to individuals, effectively shifting investment income from the corporation to individual shareholders and countering the goal of accumulating and retaining income within the corporation.

Amount of refund from Refundable Dividend Tax on Hand (RDTOH)

The CRA issues a “dividend refund” from the RDTOH account at a rate of 38.33% of the dividend paid, provided there is a positive balance in the account. In other words, the dividend refund amount is the lesser of 38.33% of the dividend paid or the balance remaining in the RDTOH account at year-end.

To further complicate the matter, in 2019, the federal government separated the RDTOH into two distinct accounts: Eligible RDTOH (ERDTOH) and Non-Eligible RDTOH (NERDTOH).

Before we dive into ERDTOH and NERDTOH, it’s important to understand the types of dividends a Canadian private corporation can issue: Eligible dividends and non-eligible dividends (also referred to as “other than eligible dividends”).

Eligible dividends are distributed by a Canadian corporation from active business income that has been taxed at the general (higher) corporate tax rate, referred to as the General Rate Income Pool (GRIP), or from eligible dividends received from non-connected Canadian corporations. These dividends qualify for an enhanced Dividend Tax Credit (DTC) for shareholders, resulting in lower personal tax for individuals receiving them. This is because the income has already been taxed at a higher rate at the corporate level.

Ineligible dividends, also known as “other than eligible dividends,” are paid from corporate income that has been taxed at lower rates, referred to as the Lower Rate Income Pool (LRIP), typically applicable to Canadian-Controlled Private Corporations (CCPCs). These dividends receive lower dividend tax credits for shareholders because the corporation paid a lower tax rate. As a result, individuals receiving these dividends face higher personal taxes compared to eligible dividends.

This mechanism ensures that investors in both types of corporations end up paying the same or similar amount of tax, whether they earn income through a Canadian-controlled corporation that benefits from lower corporate tax rates or through a public company that does not receive such preferential tax treatment.

Let’s briefly discuss eligible RDTOH (ERDTOH) and non-eligible RDTOH (NERDTOH) and their critical role in corporate tax planning and estate tax planning.

The Non-Eligible RDTOH (NERDTOH) account accumulates refundable tax paid on investment income, such as interest, foreign investment income, capital gain, and rental income. When a corporation pays non-eligible dividends to shareholders, the corporation receives a dividend refund from the NERDTOH account.

The Eligible RDTOH (ERDTOH) account tracks refundable taxes paid on eligible portfolio dividends (i.e., dividends received from the Canadian public corporation). Any taxable dividend (eligible or non-eligible) paid by a corporation entitles it to a refund from its ERDTOH account. However, as per the ordering rule, a private corporation paying a non-eligible dividend must consume its NERDTOH account before claiming a refund from its ERDTOH account.

Other side effects of earning investment income inside a corporation:

Additional Downsides of Accumulating Investment Income Inside a Corporation:

For tax years starting after 2018, passive investment income earned by a corporation, or its associated corporations can impact its eligibility for the Small Business Deduction (SBD) on active business income (ABI). As mentioned earlier, the SBD reduces the income tax rate for a CCPC from 26.5% to 12.2% on active business income up to $500,000, known as the business limit.

Under this rule, if investment income exceeds $50,000, the business limit will be gradually reduced. For each dollar of passive investment income above the $50,000 threshold, the business limit is reduced by $5. Consequently, the business limit is entirely eliminated when investment income reaches $150,000 or more. This means that when investment income surpasses the $50,000 threshold, the corporation will not only face a high investment income tax rate of 50.17% but may also incur an additional federal tax (Part I tax) 6% tax on active business income. This effectively increases the overall tax burden on investment income within a Canadian corporation to 56.17% (in Ontario).

Fortunately, the reduction in the small business tax deduction or business limit applies only to federal taxes and is not mirrored by Ontario. Ontario does not follow the federal measure that phases out the $500,000 small business limit for corporations earning between $50,000 and $150,000 of passive investment income in a taxation year. Otherwise, the negative impact of investment income inside a corporation could have been further aggravated.

Here’s an example of Mississauga General Pharmacy Professional Corporation to illustrate how investment income can adversely impact the tax rate on active business income.

As can be seen from the above (scenario # 3), when business income crosses the threshold, it also results in business income tax at a higher federal tax rate.

To calculate the business limit reduction, a corporation’s investment income from the previous year, known as “adjusted aggregate investment income” (AAII), is measured. AAII generally:

1. Includes: Net taxable capital gains, interest income, portfolio dividends, rental income, and income from non-exempt life insurance policies.
2. Excludes: Certain taxable capital gains or losses from disposing of active business assets and shares of certain connected CCPCs, net capital losses carried over from other years, and incidental investment income related to an active business.

When Investing Through a Corporation is Still Advantageous Despite Higher Taxes

We’ve observed that investment income is taxed at a high rate and that holding investments personally is often more advantageous. However, this isn’t always the case. For example, consider Mark, a physician and highly successful medical professional whose personal income exceeds $250,000, placing him in the highest personal marginal tax bracket of approximately 50%. The table below illustrates the taxes payable and the after-tax income available to Mark.

At first glance, Mark might appear indifferent to holding investments personally or through a corporation since the tax payable would be nearly the same in either scenario. However, let’s delve deeper into the analysis. Please refer to the table below, Table 2: A “360 view” of Mark’s situation.

From Table 2, we observe that although Mark pays $10,000 in taxes in both scenarios, the personal tax is permanent with no refundable component. In contrast, Mark’s Medicine Professional Corporation corporate investment tax includes a significant refundable portion of 30.667% (known as the “dividend refund”). When Mark’s Medicine Professional Corporation issues him a dividend, the corporation will receive a refund of $6,133.40. This refundable tax effectively reduces the corporate tax rate from 50.17% to 19.50%.

This shows clearly that, in some cases, even with a high initial investment tax rate, earning investment income within a corporation is still advisable.

Additional Tax Planning Opportunities with Investment Income Inside a Corporation:

Additionally, Mark can leverage another layer of tax planning by holding the investment inside Mark’s Medicine Professional Corporation, given that he is generating substantial income from his practice as a physician until retirement. Upon retirement, when income from the practice has stopped, the corporation can begin paying dividends to him.

By doing so, not only will the corporation receive a tax refund, but when Mark receives the dividend in a year with significantly reduced taxable income, it will be subject to a much lower personal tax rate compared to his current marginal rate of 50%. This illustrates that tax strategies are not one-size-fits-all; each case must be evaluated individually.

Advanced Tax Planning for Investment Income Held within a corporation:

Another important factor to consider is the personal tax implications if a shareholder decides to withdraw funds from the corporation to make a personal investment. For example, John, who operates a successful IT business through his corporation, IT Solutions Inc., has accumulated a substantial cash surplus in the corporation. Suppose John is in the top personal marginal tax bracket of 50% and wants to purchase an investment property worth one million dollars. To achieve this, he would need to issue a dividend of two million dollars from the corporation to end up with one million dollars in after-tax cash in his personal account.

In this scenario, it might be more advantageous for John to purchase the property through the corporation. By doing so, he would only need one million dollars to acquire the property. The tax on investment income from the property’s rental income would likely be significantly lower than the tax incurred from withdrawing two million dollars in dividends. Alternatively, John could obtain a mortgage from a commercial bank and gradually take dividends from the corporation in a tax year when his business income is lower.

Conclusion: The taxation of investment income within a corporation is complex and is designed to eliminate any tax advantages of earning such income through a corporation rather than personally. Currently, most provinces and territories impose a tax disadvantage on earning investment income inside a corporation. However, there are situations where investing through a corporation may still be advantageous. It is crucial to thoroughly understand the implications of withdrawing excess cash from the corporation and to utilize tax deferrals and other tools provided by tax laws when investing through a corporation. As illustrated in the example above, paying higher taxes now might ultimately lead to better tax savings in the future.

If you need advice regarding your investments through your corporation and how it impacts your overall tax bill, please book an initial consultation call with our CPA expert at 647-930-8130. We are trusted by hundreds of business owners, as reflected by over 168 five-star Google reviews.

Source Accounting Professional Corporation (CPA) is a full-service accounting firm in Mississauga, dedicated businesses, providing tax preparation, corporate tax filing, accounting, bookkeeping services, payroll solutions, etc. If you are a professional such as a physician, pharmacist, nurse, realtor, immigration consultant, dentist, IT consultant, or a business owner like a franchise restaurant owner, medical clinic operator, retail store owner, or any other business, and you’re looking for guidance on how to handle your investments tax-efficiently, please book a consultation call with our tax specialist by calling 647-930-8130.

Disclaimer: The above contents are provided for general guidance only, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. It does not provide legal advice, nor can it or should it be relied upon. Please contact/consult a qualified tax professional specific to your case.