Withdrawing money from a Canadian corporation: What you need to know!

You have worked hard for your business and now planning to take some money out? Maybe you need to finance your personal needs. Whatever the reason is, simply withdrawing cash from the corporation will likely result in an unexpected tax bill. Though tax is unavoidable, with better planning, you can reduce the tax bill and, in most cases, defer it.

In this article, I will discuss efficient ways of withdrawing money as applicable to a small business corporation, commonly known as a Canadian Control Private Corporation (CCPC). But before that let’s discuss a major principle of the Canadian tax system.

Integration

Canadian tax laws are based on the concept of “integration”. This means that no matter how you receive the income, you should be paying the same amount of tax. Accordingly, you should be indifferent as to how you are receiving this income.

For example, it would not have a tax impact whether you receive income through a corporation or proprietorship. Similarly, receiving a dividend or salary from the corporation would not have a tax implication. Since a fully “integrated” tax system shall make you pay the same amount of tax.

To achieve this objective, Income Tax Act (ITA) uses various tools like:-

1. Wages are tax-deductible at the corporate level but are taxed at a higher rate at the personal level.
2. Dividends are not deductible at the corporate level, but because of dividend tax credits, dividends result in less tax at the personal level.
3. Additional Refundable Tax (“ART”) / Refundable Dividend Tax On Hand (“RDTOH”) on investment mechanism imposes the higher tax on passive income earned inside a corporation – discouraging holding investment inside the corporation. The tax is refundable later when income is passed on to the shareholder.

So theoretically, we should not be discussing the “tax-efficient” structure of a business or whether to take salary or dividend. Often, the results of calculations done in isolation of factors discussed later in this article, show minimal tax savings one way or another.

But since nothing is perfect in life, our Canadian tax system is no exception. This makes some options of withdrawing money favorable. To clarify, rather than issues with the tax system, these opportunities arise more because of the specific situation of shareholders, their ages, family structure, tax credits available, cash flow needs, long-term and short-term goals, etc.

However, as the tax laws are complicated, there is no simple answer as to which way is more efficient decisively. Nor is the answer is same for any two businesses. One way may produce better results for you, but may not be appropriate for another business owner.  Each approach has its pros and cons, and Tax on Split Income (TOSI) rules add more complexity to this. While developing a strategy, one needs to consider all factors specific to the situation.  

Let us now discuss various approaches that can be used by business owners and their implications.

1) Paying a salary to yourself and family members:

If family members work for the business, a salary that is “reasonable” (same paid to other employees) can be paid. This is especially highly effective if family members are in lower tax brackets.

As regards salary to owner-managers, it does not have to meet the “reasonable” test. Canada Revenue Agency (CRA) will allow this exception. CRA generally will not question the amount of salary or bonus paid to the Canadian resident owner-manager of CCPC.

Following are the major pros and cons of paying salary:

 

 2) Paying a dividend:

Dividends are paid by the corporation out of after-tax income, hence, are not tax-deductible. However, at the personal level, dividends come with the dividend tax credit, which makes them more efficient than the salary.

You can also pay the dividends to your family members (spouse and children) if they contributed to the business. However, it is very important to keep in mind the impact of the Tax on Split Income (TOSI) rules, making dividend sprinkling exceedingly difficult.  As per TOSI rules, the dividend will be subject to the highest rate of personal tax, with restrictions on tax credits, unless an exception is available from TOSI rules.

Following are major pros and cons to be considered while paying dividends:

3) A mix of a dividend and salary to optimize your personal situation:

Often the business owner would use a mix of a salary and dividend to optimize their personal situation. Often, a salary and bonus are paid out to ensure that CCPC income does not exceed CAD500,000, the limit of the small business deduction, a practice called “bonus down”. Up to this amount, a CCPC pays income tax at a preferred low rate, currently around 12.2%, depending on the province of the CCPC).

In some scenarios, it makes more sense to retain after-tax income inside the corporation and defer higher personal taxes (which can go up to 50%)  by delaying the payment to shareholders and using the tax saving for business expansion.

But keep in mind that if you choose to retain income inside the corporation and invest in passive assets, this passive income not only will be taxed at a higher rate but starting from 2019 will also restrict the small business deduction limit claimed by CCPC after passive income exceeds CAD50,000. The Small business deduction limit becomes nil when passive income reaches CAD150,000, penalizing the generation of investment income inside the corporation.

4) Pay a capital dividend:

Another potential tax-free way to pay to shareholders is paying a dividend out of a corporation’s capital dividend account (CDA). CDA is a notional account (does not appear in corporate financial statements) and represents the non-taxable portion of capital gain (currently 50%) realized by a private corporation when it disposes of its capital assets.

A positive balance in CDA can be distributed to Canadian resident shareholders as tax-free dividends.  CDA balance will be reduced by any capital loss realized by the corporation. However, any loss realized after the distribution, will not impact the dividend already paid. Therefore, it is recommended to pay out any balance in CDA as soon as possible.

However, CDA rules are complex and there can be a negative impact of incorrect distribution. Therefore, it is important to take professional advice.

5) Shareholder loans:

On many occasions, business owners ask what if they simply borrow (withdraw) money from the corporation account and use it for personal purposes. ITA contains very specific rules restricting the ability of a shareholder to withdraw money from the corporation. Otherwise, any amount borrowed/withdrawn from a corporation will be included in the shareholder’s income.

However, there are a few exceptions where income will not be included in the shareholder’s income. Here are those exceptions: –

Exception # 1: Temporary borrowing by shareholder

If a shareholder borrows money from the corporation, it has to be repaid within one year after the year-end in which the shareholder borrowed the money.  Otherwise, the amount will be included in the shareholder’s income.

For example, if a shareholder borrowed money from the corporation in 2020, then it must be repaid before the end of 2021. If unpaid, the amount will be included in the borrower’s income for 2021. However, once paid back, the shareholder can claim a deduction in the year of repayment.

Another thing to remember is that it cannot be a series of loans and repayments.

Exception # 2: Providing a loan to a shareholder owning less than 10% shares

The second exception applies to a loan provided to an employee who owns less than 10% shareholding

Exception # 3: Providing a loan to a shareholder for three specific uses.

Finally, there is another exception for loans provided to a shareholder who is also an employee for three specific purposes, which are the purchase of a:-

• Home,
• Car for use duties of employment and
• Treasury shares of the corporation.

However, two conditions must be met.

• First: a bona fide arrangement must be made for repayment within a reasonable time as per normal commercial practice.
• Secondly, the loan is provided to a person because of employment and not in the capacity of a shareholder (or in other words, other employees of the company would qualify for the loan on the same terms and conditions).

In all three exceptions, an imputed interest benefit (the difference between the interest charged to the shareholder by the corporation and CRA’s prescribed rate) is included in the shareholder’s income for the period the loan remains outstanding

5) Reducing/returning the paid-up capital

The paid-up capital (PUC) is the cash (or other assets) a shareholder invests in the corporation in consideration of receiving shares. The corporation can return the PUC to shareholders as a tax-free payment.

6) Reimbursing shareholders for business expenses paid

If you have personally paid for your corporation expenses (perhaps using your personal credit card), the corporation can reimburse you for these expenses. This reimbursement is not taxable income for you. However, it is imperative to keep track of expenses and receipts.  The corporation will receive a tax deduction for these expenses.

7) Repaying loans to shareholders

If you have loaned money (or other personal assets) to the corporation as a shareholder, the loan repayment by the corporation is not taxable.

Conclusion

To summarize, despite the integration approach of the Canadian taxation system, with careful planning and considering all the specific factors of a case, it is possible to formulate a strategy that optimizes your tax situation and results in tax saving/deferment.

As mentioned in the beginning, the tax laws are complicated, thus much time and energy are required along with professional advice to develop an appropriate tax planning strategy. And, more importantly, this should be an ongoing ritual, rather than looking at books annually and realizing that you have already missed out on some good tax planning opportunities.

 

 

If you find this post helpful, please let us know in your comments. If you have any questions or any tax and accounting issues, please feel free to reach out to Source Accounting. Source Accounting is an accounting firm in Mississauga, dedicated to small and medium-sized businesses, providing tax, accounting, bookkeeping, payroll solutions, etc. And if you find this post helpful, please let us know in your comments.

 

 

 

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.