SEARCH

Categories

Implications of Changes in DTC Rules and Rates

Preference for Capital Gains

Dividends have until now been the most tax-efficient form of investment income for individual investors. The ongoing reduction in gross-up rate and dividend tax credit rates will increase the effective tax rates on dividends until 2012. As a result, investors paying higher income taxes will prefer to receive capital gains instead of dividends. Vendors of businesses will also favour capital gains over dividends.If a taxpayer is paying the top marginal tax rate, the difference ranges from a low of 1.35% in favour of capital gains in Alberta to a high of 10.29% in favour of capital gains in Newfoundland. Several provinces are expected to make further amendments to their gross-up and dividend tax credit mechanisms. After 2010, it is expected that only Manitoba, Quebec, Nova Scotia, Prince Edward Island and Newfoundland will have eligible dividend tax rates higher than capital gains tax rates.

Bonus down vs. Retain

Prior to the 2008 federal budget, CCPCs preferred retaining business income subject to the general corporate tax rate and paying out dividends in later years as opposed to paying out business income as bonuses to shareholders. This was due to the tax savings earned by CCPCs retaining profits. However, as a result of the 2008 federal budget, general corporate tax rates will decrease to 15% by 2012, thus eliminating the tax savings by 2012 in almost all provinces. Provinces which experienced tax costs prior to the 2008 budget will now have a slightly lower tax cost position by 2012.

Increases in Government benefits applicable to low income individuals

As mentioned above, until 2007, the increase in the gross-up rate inflated the net income applied for calculating various Government benefits. Individuals falling in lower income tax brackets had to forgo certain benefits. Hence, a lower gross-up is good news for seniors that are in low income tax brackets.

Impact on professional corporations

CCPCs are now required to track the income from which they can pay eligible dividends through a new notional account referred to as General Rate Income Pool (GRIP). Dividends not paid from the GRIP will not be considered non-eligible and taxed at the existing higher rate. While the new dividend rules create some additional administrative work for owners of professional corporations, it also provides some interesting planning opportunities. Reduction of corporate taxes will reduce the need for professional corporations to pay out bonuses in order to reduce taxable income to the $500,000 federal small business limit.

Previously, corporations preferred paying bonuses out of their income which was in excess of their small business limit to avoid paying taxes twice on dividends. With the double tax effect being eliminated, corporations will consider retaining profits at the corporate level and paying shareholders dividends.

Amendments to the rules and rates of dividend tax credit rates across provinces over the last few years have improved the integration of Canada’s tax system. While from the perspective of Canadian-controlled private corporations (CCPCs), the 2008 federal budget brought a significant compliance burden and greater complexity that requires them to track the GRIP, it has also created a few planning opportunities. General corporate tax rates which have traditionally been high will be brought down to 15% by 2012 and the disadvantages brought about by the earlier dividend tax system will be eliminated to a certain extent.

These measures will also make Canada’s tax system more competitive and build a tax-neutral business environment. However, the process of integrating the tax system is expected to continue over the next few years. Therefore, it is difficult to predict whether this integration will improve or deteriorate, due to the uncertainty of future provincial income tax rates.