We previously did a basic overview of the 2018 Federal Budget tax changes for professional corporations and other Canadian small businesses when it was released. The effect on income splitting was explained in Keeping the Sprinkler Running and a series of strategies to continue income splitting as part of your financial plan is in the Financial Physiology section with application details in The Sim Lab.
We did a more detailed review of the main aspect of the new rules – what constitutes passive investment income in my last post. Today, we will explore the second piece of the proposed passive income tax changes. The restriction of Refundable Dividend Tax On Hand (RDTOH when translated into accountant Klingon). We will explore how it works and the new changes. The new changes will result in yet another layer of complexity by creating an Eligible-RDTOH (eRDTOH) and a non-eligible-RDTOH (nRDTOH) account.
It’s like walking in on a Klingon mating ritual… Awkward. Possibly dangerous.
What Is a RDTOH Account & Why Do We Have It?
A RDTOH account is a notional account. This means that it really only exists on paper, as part of tracking your business taxes. It is designed to preserve the concept of tax integration which is that if you get a dividend or income from an investment, that it should be taxed the same by the time it is paid to you as an individual – whether you were paid it directly or via your small business.
To deter using a Canadian Controlled Private Company (CCPC), like a professional corporation, as a tax saving vehicle for passive investment, the passive investment income in a CCPC is taxed at a very high rate. It is supposed to be approximately the average top marginal personal rate. As you can see below, it is an imperfect match up, but close overall.
While that high rate of tax is charged to a CCPC, part of that tax is put into the RDTOH account. The amount put into the RDTOH is 38.33% of eligible dividends and 30.67% of the other investment income types. When the CCPC eventually pays out a dividend to a shareholder, that triggers release of that refundable portion of the tax back to the CCPC. The idea behind this process is to charge tax up front, so that the CCPC isn’t resulting in a tax deferral. To get the refund, for every dollar in the RDTOH you need to give a dividend of $2.61.
The best way to understand it is to see it. It took me a while to wrap my head around this, so I have made diagrams tracing how investment income flows below to illustrate.
Let’s start with eligible dividend refundable tax.
An eligible dividend is a dividend distributed by a Canadian company that earns more than the small business threshold, and therefore pays taxes at the higher general corporate tax rate. That higher taxed portion of income over the threshold is noted in the company’s General Rate Income Pool (GRIP).
A CCPC can give eligible dividends up to the amount of their GRIP, while a publicly traded company can give eligible dividends at any time. The other way that a CCPC can give an eligible dividend, is by receiving an eligible dividend from a publicly traded or non-connected company.
Eligible dividends, when paid out to an individual, are taxed at a lower rate using the enhanced dividend tax credit. This is to recognize that the income earned by the company has already been taxed at a higher rate.
As seen above, using the top Ontario marginal tax rates, an eligible dividend from a passive investment paid to a CCPC puts 38.33% of the dividend into the eRDTOH. That rate is lower than the personal rate of 39.4%, so there is a small tax deferral advantage of 1.01%. When the CCPC pays out an eligible dividend, the final eRDTOH money is refunded and the after-tax value is the same whether the passive income was paid via the corp or directly to the individual. Tax integration works pretty well here.
Now, let’s look at other passive investment income and the RDTOH.
Tax integration is less smooth for other investment income. This could be interest, rent, foreign dividends, or the taxable half of a realized capital gain. This type of income is normally paid out of the CCPC to the individual as a ineligible dividend which is taxed at a higher rate than eligible dividends.
As a side note, the non-taxable half of a capital gain in a CCPC goes into its capital dividend account (CDA) which is another notional account. The money in the CDA can be paid out as a tax-free capital dividend.
Since the RDTOH refund is triggered by the CCPC giving any dividend, whether the money comes from active income or passive income, there was also an opportunity to game the system. This made the taxman very angry as seen on the right and this eye bulging tax reduction process is highlighted in red in the flow chart below.
When a CCPC gets GRIP by earning active business income over the small business threshold and can pay an eligible dividend (taxed at lower rate). Yet, it also triggers a RDOTH refund and that results in lower taxes compared to an individual earning that income and much lower taxes compared to a business that does not have GRIP room.
This “tax loophole” is going to be shut down with the splitting of the RDTOH into an eRDTOH and nRDTOH account. With this new legislation, only a ineligible dividend from a CCPC can now trigger a refund from tax paid into the nRDTOH account.
As you can see above, integration is not perfect.
- Investment income paid via a CCPC is taxed at a 3.68% higher rate than if it were paid directly to the individual.
- Counterbalancing that is the benefit from some tax deferral if the passive income is collected and refund triggered by ineligible dividends disbursed to the owner(s) from active corporate revenue.
Time Sensitive Actionable Advice (Make Their Eyes Bulge While You Still Can)
Timing: The new splitting of RDTOH into eRDTOH and nRDTOH will apply to the fiscal year of a corporation that begins before 2019 and ends after 2018. For example, my CCPC fiscal year ends Aug 31, 2018. So, the rules will apply to my CCPC after Aug 31, 2018 for me. There will be general anti-avoidance rules to prevent people from manipulating their fiscal years.
Action: If you have a CCPC that has a balance in its GRIP, then you may want to pay eligible dividends prior to the new rules if you also have an RDTOH balance. This would likley be high income businesses that haven’t paid out high salaries.
If you do not have investment income that has generated RDTOH to take advantage of that technique, then you may even want to consider if it is worthwhile to realize some capital gains to get it. That has the downside of paying some tax now, but the upside of paying less tax now. It also has the advantage of taking those gains off the table now rather than down the road where they will generate passive income that is counted towards your small business threshold reduction or may even be subjected to a higher tax inclusion rate. That is possible, if governments continue to aggressively seek revenue from those who are “rich” enough to invest.
If this sounds like it could be you, then you should talk to your accountant. You don’t want to be like these guys, who just realized that they missed that opportunity…