Lecture Notes - Canada’s Premier Tax Law Firm
Chapter 1 Lecture Notes
Basic Legal Principles and Base Tax Rates
David Christian Spring Term 2013
Thorsteinssons LLP UBC Faculty of Law
______________________________________________________________________________
Notes
Income tax law is not a matter of pure reason. It is … interpretation of changing statutory provisions.
Frank J. (1942)
Basic Corporate Law Principles
1. As you will recall from corporate law, the “corporation” is an artificial legal person, possessing the legal capacity of a natural person. It follows that:
a) a shareholder can lend money to the corporation, and thus be a creditor of the corporation as well as its shareholder; and
b) a shareholder can be an employee of the corporation, and thus be both a shareholder and an employee of the corporation.
2. A corporation must have a directing mind, and this must by definition be a natural person or persons – being the directors, officers and other employees. The corporation in effect acts through the agency of these persons when they are acting in their capacity as directors, officers and other employees.
3. The following symbols and acronyms are sometimes used in this course:
4. In corporate tax law, the corporation’s separate legal existence is usually respected – even if a shareholder wants to ignore it for tax purposes. A corporation is treated as a separate “taxpayer” (see subsection 248(1) and the definitions of “taxpayer” and “person”). As a legal person the corporation owns assets, earns income, has expenses, and pays an income tax on its “taxable income” just as any other taxpayer. Recall Tax I – “taxable income from a source”. The shareholder of a corporation is also a separate legal person and is thus a “taxpayer”. The rate of tax that applies to the corporation’s taxable income, and to amounts paid out to the shareholder, is the subject matter of Part A of this Course.
5. As you know from constitutional law, Canada is a federation. The federal, each provincial, and each territorial government imposes an income tax. In British Columbia’s case (as with all of the other provinces and territories except Alberta and Quebec), the provincial income tax is administered and collected by the federal government, and thereafter remitted to the provincial or territorial government.
“Base Case” Corporate Tax Rate
6. Consider, for now, a public corporation (definitions will be examined in Chapter 2) earning income from carrying on a business in British Columbia. I use this example because such a corporation is subject to the “base case” tax rate applicable to corporations in Canada. In Chapters 3 and 4 important special cases are examined that deviate from this base case. The base case is the starting point, because each special case in the later chapters can only be understood with reference to the “base case”.
|“Base case” tax rate to be applied to the |% |Section references and notes |
|corporation’s taxable income to arrive at | | |
|the tax owing by the corporation | | |
|start with (historical) federal tax rate |38 |123(1)(a) - most recent, but still historical, base |
| | |federal rate |
|subtract the federal “general rate |13 |123.4(2) - this gives us the current base federal rate |
|reduction percentage” | |of 25% before making “room” for the provincial and |
| | |territorial taxes - assume here the corporation’s |
| | |income is basic “full rate taxable” income |
|subtract the “provincial abatement” |10 |124(1) – makes “room” for the provinces and territories|
| | |to impose their own tax rate on the corporation’s |
| | |“taxable income earned in a province” – this gives us |
| | |the net current federal rate of 15% where the |
| | |corporation’s income is subject to provincial or |
| | |territorial tax |
| | | |
|add the base case provincial tax rate on | |the provincial rate here is the base rate of 10% in |
|the corporation’s income earned in the | |subsection 14(2) Income Tax Act (British Columbia) or |
|province |10 |the “BC Act” for short[1] |
|thus, the total tax “base case” tax rate | |the base corporate tax will vary across Canada as |
|on the corporation’s taxable income in | |provinces and territories impose tax a rates different |
|Canada is |25 |from British Columbia |
Notice, the base case corporate tax rate is a combined “federal-provincial rate”, and it is “built” by applying the various sections. This is the result of many years of preferences and amendments by both levels of government, and is a fact of life in determining corporate tax in Canada (i.e., arriving at net results by applying, in some cases, many sections at one time).
“Base Case” Individual Tax Rate
7. An individual who resides in British Columbia on the last day of a taxation year is taxed at the top tax bracket (which is often used as the reference point for policy and planning) at the following combined federal-provincial tax rate on the individual’s taxable income from a source:
|start with the federal rate |29 |the top rate in 117(2)(d) – the low rate is 15% (up to |
| | |$44,561) |
|add the provincial rate |14.7 |the top rate in 4.1(1)(e) of the BC Act - again, top |
| | |individual tax rates vary from province to province – |
| | |the low rate is 5.06% (up to $37,568) |
|combined federal-provincial rate |43.7 | |
The “Gross-up & Dividend Tax Credit” System for Individual Shareholders
8. What do you see thus far about the “corporate tax system”? Assume a corporation carries on a profitable business and earns in a year business income of say $100. This is its “taxable income” from a business for the year. Also assume the corporation pays income tax on the $100 of this taxable income, and declares and pays a dividend to its individual shareholder(s) who is at the top individual tax bracket.
9. The dividend received by the individual shareholder(s) must be included in the shareholder’s income by reason of paragraph 12(1)(j) and paragraphs 82(1)(a) and (a.i). It has long ago been held that a dividend declared and paid by a corporation is not a deductible expense to the corporation in earning income from its business. The dividend is not incurred for the purpose of earning profits (and thus, no section 9 deduction is available), but rather the dividend is simply a non-deductible application of the corporation’s profits once earned.
10. What is the total tax on the $100?
|the corporation’s tax, at the “base case” federal-provincial corporate tax rate | |
|of 25%, on the $100 of business income is |$25.00 |
|the individual shareholder’s tax on the available $75.00 dividend received, at | |
|the top individual federal-provincial tax rate of 43.7%, is | |
| |$32.76 |
|thus the total tax paid is $57.76 |$57.76 |
|the total effective tax rate on the $100 of business income is computed as the | |
|total $57.76 of tax paid by the corporation and the shareholder as a percentage | |
|of the $100 of business income earned, or approximately … | |
| |58% |
11. Why would shareholders, who have the choice, carry on business through a corporation? Incorporating a business can make commercial sense – i.e., limited liability. What about the total taxes paid? If the $100 of taxable income could be earned directly by the individual as a sole proprietorship, and taxed at only the top individual rate of 43.7%, why incorporate the business and pay a total tax of approximately 58% - some 15% more?
12. This question was addressed in part during the 1972 tax reform process in Canada. The (i) “gross-up” and (ii) “dividend tax credit” system was invented for all dividends received by individual shareholders from corporations resident in Canada. This is largely the system we have today. In short, the individual shareholder is “given some credit” for corporate tax that is assumed to have been paid. When the system was invented the assumed corporate tax rate was approximately 20%.
13. It is important to understand the original tax policy behind the gross-up and the dividend tax credit:
|[pic] |assume the corporation’s income is |$100 |
| |assume the corporation’s tax at 20% is | |
| | |$20 |
| |assume the actual dividend paid to the shareholder is | |
| | |$80 |
| |the “gross-up” (or add-back) to the actual $80 dividend | |
| |paid was fixed at an amount equal to “¼ of the dividend | |
| |paid” - i.e., $20 here … |$20 |
| |… both the actual dividend and this “gross-up” go into the | |
| |shareholder’s taxable income |$100 |
| |now compute the shareholder’s tax on this “gross-up | |
| |dividend amount” at the top tax rate of say 43.7% | |
| | |$43.7 |
| |deduct from this tax a “dividend tax credit”, which is | |
| |equal in theory to the to the gross-up amount (i.e., the | |
| |tax paid at the corporate level |$20 |
| |the shareholder’s net tax is |$23.7 |
| |the total tax is ($20 plus $23.7) |$43.7 |
| |the total “effective tax rate” is the $43.7 as a percentage| |
| |of the $100 |43.7% |
The theory of the “gross-up” and “dividend tax credit” is to the effect that if the actual corporate tax rate was 20%, there would be no advantage or disadvantage to “incorporating” the source of income - from the tax perspective. The same tax is paid if the $100 of taxable income is earned “through a corporation” (i.e., 43.7% in the above example) or directly by the individual (43.7%). This concept is sometimes described as “integration” if you are focusing on the net all-in tax rate; and “neutrality” if you are focusing on the incentive or disincentive to incorporate.
14. Before 2006 the integration system had one glaring hole: corporate income taxed at the general corporate rate did not integrate with shareholder income (because the dividend tax credit did not compensate the shareholder for the full amount of corporate tax paid). This was fixed for 2006 and subsequent years. The “fix” was the creation of different gross-up and dividend tax credit rates for corporate income taxed at the general “base case” rate. Taxable dividends paid from corporate income taxed at the “base case” rate are called “eligible dividends” (because they are eligible for the higher dividend tax credit).[2] Taxable dividends that are not eligible dividends are called “ordinary dividends”.
15. Now move from policy to law. The “gross-up” for “ordinary” dividends is 1/4 (or 25%) of the actual dividend received (by reason of paragraph 82(1)(b)) (eligible dividends are discussed in more detail in paragraphs 21 – 25). This grossed-up income applies for federal and provincial income tax purposes because individual provincial income is largely the same as federal income. The gross-up is fixed, and is based on the theoretical 20% corporate tax rate in the chart above. Moreover, the gross-up applies regardless of the actual corporate tax rate or amount of corporate tax paid by the corporation.
16. The “dividend tax credit”, in policy terms, should equal the gross-up. The idea is that the shareholder is given a credit (federally and provincially) against the shareholder tax for the assumed corporate tax already paid. Under the existing law, the dividend tax credit is indeed granted in part by the federal government and in part by the provincial government. Two-thirds (2/3rds) of the dividend tax credit is granted by the federal government as credit against the individual’s federal income tax (see section 121). Historically, one-third (1/3rd) has been granted by provincial governments as a credit against provincial individual income tax. This split has reflected the historical fact that provincial individual tax has been roughly half of the federal tax (or 1/3rd of the total individual tax).
17. In British Columbia the matter is further refined (or complicated, depending on your perspective). The current provincial portion of the dividend tax credit for ordinary dividends is only 17% of the gross-up, not 1/3rd (see section 4.69 of the BC Act).[3] The reason for the reduction was a policy choice made by the government of the day; it reduced the dividend tax credit to ensure that the top provincial tax rate was equal to the top provincial tax rate, plus surtaxes, under the prior system.[4]
18. In any event, it is clear the total dividend tax credit available to an individual resident in British Columbia on an ordinary taxable dividend is not equal to the full amount of the gross-up, but rather equals the federal portion under section 121 (2/3rds or 66.67% of the gross-up) plus the British Columbia portion under the BC Act (17% of the gross-up). Thus, rather than the individual shareholder being entitled to a dividend tax credit equal to 100% of the gross-up amount, the individual is entitled to 83.67% of the gross-up amount as a tax credit.
19. We now know, of course, that the “base case” corporate tax rate is not 20% but rather 25%. (We will see different rates in Chapters 3 and 4). And we now know that there is less than 100% tax credit for the gross-up through the dividend tax credit mechanism. Using the 25% base case rate, and the dividend tax credit at 83.67% rather than 100% of the gross-up, a distinct lack of integration arises:
| |the corporation’s tax on the $100 at the base rate of | |
| |25% is |$25.00 |
| | | |
| |the actual dividend paid to the shareholder, being the| |
| |$100 less the $25.00 is |$75.00 |
| |“gross-up” the dividend by ¼ of the actual dividend, | |
| |or $18.75,[5] for a total amount included in the | |
| |shareholder’s income of |$93.75[6] |
| |shareholder tax at the top federal-provincial tax rate| |
| |of 43.7% |$40.97 |
| |deduct the “dividend tax credit”, being the 83.67% of | |
| |the $18.75 gross-up, or |$15.69 |
| |net shareholder tax |$25.28 |
| |the total $50.28 of tax on $100 of income translates | |
| |to an effective tax rate of 50.2%, or rounded to | |
| | |50% |
20. Thus, where the “base rate” of corporate tax applies to the corporation’s income (i.e., 25%), the individual shareholder pays an additional tax of approximately 6.3% by earning the $100 of taxable income “through the corporation” as opposed to earning the $100 directly and being subject only to the personal tax rate at 43.7%. However, there is, while the profits are retained by the corporation and not paid out as a dividend, a “deferral” of tax of 18.7% - being the difference between the 43.7% personal tax that would be paid if the source of income was held personally and the base case corporate tax rate of 25%.
21. The “disintegration” or “non-neutrality” of earning income taxed at the full corporate rate caused, in part, the trend towards the conversion of public corporations to income trusts. By establishing the business in a trust format, corporate tax was, until the announcement of proposed changes on October 31, 2006, eliminated entirely. Income earned by an income trust is passed through the trust to its unitholders, who pay tax on the income at their tax rates. If the unitholder is tax-exempt – such as a pension fund or RRSP – no tax is paid. If the unitholder is not resident in Canada, only withholding tax of 15 – 25% is paid. In order to counter the trend of corporations converting to trusts – ostensibly, to preserve the corporate tax base – the federal government announced in November 2005 that it would provide an enhanced dividend tax credit to offset corporate income taxed at the base rate. The enhanced dividend tax credit for eligible dividends became law starting with the 2006 taxation year. Most provinces – including British Columbia, Alberta and Ontario – have matched the enhanced federal dividend tax credit.
22. The enhanced dividend tax credit relies on a 38% gross up.[7] The dividend tax credit is a percentage of the gross up. For 2013 (and thereafter, until it is changed if the corporate tax rate changes) the federal percentage is 54.55 (6/11). The provincial rate is 354/9, resulting in an aggregate dividend tax credit for eligible dividends that is 89.99% of the gross up.
23. The enhanced dividend tax credit applies only to “eligible dividends” paid by corporations from their “general rate income pool” or “GRIP”. The computation of the GRIP is complicated, but it essentially describes corporate income that is taxed at the base case corporate rate.
24. So, does the enhanced dividend tax credit work? Apply the same analysis as in paragraph 19 but with the increased dividend tax credit.
| |the corporation’s tax on the $100 at the base rate of | |
| |25% is |$25.00 |
| | | |
| |the actual dividend paid to the shareholder, being the| |
| |$100 less the $25.00 is |$75.00 |
| |“gross-up” the dividend by 38% of the actual dividend,| |
| |or $28.50,[8] for a total amount included in the | |
| |shareholder’s income of |$103.50[9] |
| |shareholder tax at the top federal-provincial tax rate| |
| |of 43.7% |$45.23 |
| |deduct the “enhanced dividend tax credit”, which is | |
| |equal to 89.99% of the gross-up, or |$25.65 |
| |net shareholder tax |$19.58 |
| |the total $44.58 of tax on $100 of income translates | |
| |to an effective tax rate of 44.58%, or rounded to | |
| | |45% |
25. Therefore, in 2013, where the “base rate” of corporate tax applies to the corporation’s income (25%), the individual shareholder pays slightly more tax (0.88%) by earning the $100 of taxable income “through the corporation”, rather than directly. Contrast this with the 6.3% disadvantage that would have applied absent the enhanced dividend tax credit, and you can see how the creation of the enhanced dividend tax credit has increased integration, and the neutrality of the corporate tax system.
26. The foregoing assumes the shareholder receiving the dividend is an individual at the top rate. What is the “base case” where the shareholder is another corporation? The “base case” rule is that dividends can be paid tax-free between corporations. A corporation that is a shareholder must include the dividend into income (subsection 82(1)(a)) but is entitled to a deduction equal to that amount (subsection 112(1)). The gross-up and dividend tax credit rules do not apply to a corporate shareholder. Why should the dividends be tax free? The theory is the taxable income has already been taxed once, or is assumed to have been taxed once, at the first-tier corporate level. To tax the income again, at the second-tier corporate shareholder level, would be corporate “double taxation”. However, as we will see in later chapters, there are many important exceptions to this base case inter-corporate dividend rule.
[pic]
27. Also, what if the individual shareholder has no other source of income – i.e., is otherwise at the low rate of income tax. Who might this be? Family members. Such an individual can receive up to approximately $30,000 of dividends and pay almost no tax. Why?
Tax credits.
An individual with no other source of income benefits fully from the basic personal tax credit available to all individuals (Tax I) and the federal and provincial dividend tax credit. Approximately:
|Dividends |30,000 |
|Gross-up (¼) |7,500 |
|Taxable Income |37,500 |
|Federal Tax (15%) |5,625 |
|Personal credit |1,623 |
|DTC (2/3 gross-up) |5,003 |
|Federal Tax |0 |
|Provincial Tax (5.06%) |1,898 |
|Personal Credit |561 |
|DTC (17% gross-up) |1,275 |
|Provincial Tax |62.00 |
The foregoing concept has for years been a staple of tax planning. In 2000 the federal government introduced an “income splitting tax” (commonly known as the “kiddie tax”), in section 120.4 of the Act. The kiddie tax is beyond the scope of this course. I note, however, that other family members may still benefit from this low rate on dividend income. Of course, the corporate tax remains the same.
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[1] The determination of the corporation’s taxable income earned in a province is set out in Regulations 402(1) and (3). The allocation of the corporation’s taxable income to a province turns first on whether the corporation has “permanent establishment” in a province. The taxable income is then allocated to those provinces based on an average of the corporation’s gross revenues and salaries attributable to a permanent establishment in a province. The provinces and territories adopt the same allocation rules when imposing their provincial and territorial income tax on corporations. Our example here assumes only one permanent establishment which is located in British Columbia.
[2] Discussed further in Chapter 5.
[3] The provincial dividend tax credit on ordinary dividends was reduced from 25.5% to 21% in 2009 and further reduced to 17% in 2010. These reductions were made to take account of falling corporate tax rates. However, the initial reduction in the historical dividend tax credit rate (from 33% to 25.5%) has never been rectified.
[4] Until 2000, provincial individual tax was computed as a percentage of federal tax, rather than on net income. This system was advantageous for provincial governments in an era of rising tax rates – the provincial government received increasing revenue without political cost whenever the federal government increased the personal income tax rate. When federal personal income tax rates began to decline in the late 1990s, this advantage disappeared. At that time provincial governments across Canada moved away from the “tax on tax” system to tax net income – so that federal tax cuts would not reduce provincial revenue, and so that provincial governments could take credit for provincial income tax reductions.
[5] Conceptually, this represents assumed corporate tax paid at 20%. This is why the actual dividend (assumed to be 80% of the corporate profit, after deduction of 20% tax) is multiplied by 25%: 25% of 80% is 20%, the amount of the corporate profit available for distribution by dividend that is assumed to have been consumed by corporate tax. Thus, the assumed corporate income is $90.00, on which the assumed 20% tax ($18.00) has been paid, leaving a dividend of $72.00.
[6] As noted, this is the assumed corporate income that is, in theory, the amount on which the corporation is assumed to have paid 20% tax. This amount is in tax policy supposed to be fully “creditable” in the form of the “dividend tax credit”.
[7] The initial rate of the gross-up for eligible dividends was 45%, which represented an assumed corporate tax rate of 32%. As corporate tax rates have fallen, the gross-up for eligible dividends fell with them.
[8] Conceptually, this represents assumed corporate tax paid at 28%. When the actual dividend (assumed to be 71% of the corporate profit, after deduction of 29% tax) is multiplied by 38% and the product added to the dividend, the result is approximately $100, on which the assumed 28% tax has been paid. Of course, the corporate tax is actually 25%, so the dividend tax credit “over integrates” the personal and corporate tax. This effect is countered by reducing the dividend tax credit on eligible dividends.
[9] As noted, this is the assumed corporate income that is, in theory, the amount on which the corporation is assumed to have paid 28% tax.
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Ltd
SH
A
shareholder(s)
shares
corporation
The
corporation’s asset(s)
The
Ltd
Shareholder
$100 of Taxable Income Earned
Ltd
Shareholder
$100 of Taxable Income Earned
Ltd
Shareholder
$100 of Taxable Income Earned
Holdings Ltd.
Ltd.
Individual
taxable income
dividend is tax-free
corporate tax on the income
gross-up & dividend tax credit system
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