Corporate Tax

Kevin Greenard: Refund of corporate taxes beforehand paid

Corporations have a notional account that is referred to as the Refundable Dividend Tax On Hand (RDTOH) — in fact, as of 2019 corporations have two of these notional accounts. The purpose of this article is to provide some context for why CRA created the following two notional accounts: Eligible Refundable Dividend Tax on Hand (ERDTOH) and Non-Eligible Refundable Dividend Tax on Hand (NERDTOH).

We realized that the tax terminology for corporations can be a little confusing for those that are not professional accountants. To complicate things further, many changes have occurred with respect to the taxation of corporations in recent years. Some of these changes impact the tax deferral benefits when investment income is earned in a private corporation.

Two changes that were introduced limited the access to the small business deduction and limited the access to refundable taxes. Perhaps we can start with some background information and a summary of some changes that were part of the reason CRA implemented both the ERDTOH and NERDTOH.

Small business deduction

Up to $500,000 of active business income in British Columbia earned by an associated group of Canadian-controlled private corporations (CCPCs) is subject to a combined federal and B.C. small business tax rate of 11 per cent for 2021. This is significantly lower than the general corporate tax rate of 27 per cent for 2021.

The recent changes introduce a grind to the small business limit of $500,000 in cases where an associated group of CCPCs has earned $50,000 or more of Adjusted Aggregate Investment Income (AAII) in the previous taxation year. For every $1 of AAII earned above the $50,000 threshold, the small business limit will be reduced by $5. When AAII reaches $150,000, the small business limit is effectively eliminated.

Under the recent changes, AAII generally includes the regular categories of investment income, such as dividends from publicly traded securities, interest income, rent, royalties, and taxable capital gains from the disposition of passive investments. AAII excludes taxable capital gains from the disposition of assets used in carrying on the active business. AAII also excluded rent or interest received from an associated corporation that is classified as active business income. Lastly, AAII also excluded dividends from connected corporations.

Illustration:

An example of an associated group of CCPCs could be a client that has an operating company (dental practice), investment holding company (to hold publicly traded securities that generates dividend income), and a real estate holding company (that owns a residential building that generates rental income).

If the investment holding company has $35,000 in dividend income, and the real estate holding company has $60,000 of rental income, combined the AAII is $95,000 of investment income, $45,000 of this income would result in the small business deduction limit being reduced by $225,000 [($95,000-$50,000) x 5].

The small business limit would effectively be reduced to $275,000 ($500,000 – $225,000). Provided the active business income is below this level then the 11 per cent rate would still apply. Any active business income above $275,000 would be subject to the general (higher) corporate tax rate of 27 per cent.

These changes make it more punitive for a CCPC to allocate profits into passive investment holdings if the aggregate amount earned is $50,000 or greater.

Integration

The motivation behind these recent changes is related to the concept of integration within the Canadian income tax system. Integration attempts to achieve equality — essentially the total amount of combined taxes paid by a company and its owner on income earned through the corporation will be equal to the taxes paid on the same income earned directly by an individual.

The mechanism of how this is achieved varies between different forms of income. The forms of income for a CCPC are active business income at the small business tax rate, active business income at the higher general tax rate, and passive investment income.

General Rate

In B.C., active business income earned by a CCPC is subject to either the small business rate of 11 per cent, or the general rate of 27 per cent. If the income is subject to the general tax rate of 27 per cent tax, the corporation will accumulate a General Rate Income Pool (GRIP) account from which eligible dividends can be paid, provided there is enough of a balance. Individual shareholders that receive eligible dividends are subject to a lower tax rate than non-eligible dividends.

Passive Investment Income – Part I Tax

In British Columbia, investment income earned by a CCPC is subject to a higher tax rate than active business income. Interest income and foreign dividends are taxed at a high corporate tax rate and are subject to a 50.67 per cent Part I tax.

However, 30.67 per cent of Part I tax is refundable and is added to the corporation’s non-eligible refundable dividend tax on hand (NERDTOH) account. Only when the corporation pays out a taxable dividend to its shareholders in the future will it receive a tax refund from the NERDTOH account balance.

Example of when the Part I tax is levied:

HoldCo owns shares in some foreign publicly traded blue-chip dividend paying stocks. During the tax year, these stocks generated $39,400 in foreign dividend income that is subject to Part I tax. These foreign dividend paying stocks will also be subject to withholding tax, but for purposes of this example we will just illustrate how Part I tax would be calculated.

The HoldCo would have to pay tax at 50.67 per cent, or $19,963.98 ($39,400 x 50.67 per cent) on the foreign investment income. 30.67 per cent of this Part I tax, or $12,083.98 ($39,400 x 30.67 per cent) is then added to the notional NERDTOH account and will be refunded when a taxable dividend is paid out to its shareholders at a later date.

A second illustration of Part I tax for the HoldCo can be shown with interest income from corporate bonds. The HoldCo also owns some corporate bonds and received $16,800 in interest income during the year from them that is subject to Part I tax.

Similar to the foreign dividend income, the HoldCo will have to pay tax at 50.67 per cent, or $8,512.56 ($16,800 x 50.67 per cent) on the dividend income. 30.67 per cent of this Part I tax, or $5,152.56 ($16,800 x 30.67 per cent) will be added to the notional NERDTOH account, which will then be refunded in the future when a taxable dividend is paid out to the HoldCo’s shareholders.

As noted above, in 2019 CRA introduced two separate Refundable Dividend Tax On Hand (RDTOH) pools: eligible (ERDTOH) and non-eligible (NERDTOH). The ERDTOH pool accumulates when a corporation earns eligible portfolio dividends or eligible dividends paid by connected corporations, such as wholly owned subsidiaries (to the extent that the payor corporation received a refund from its own ERDTOH pool).

The remainder of the refundable taxes generated from regular investment income, such as interest, rent, royalties, and capital gains, will be added to the NERDTOH pool.

Payment of eligible dividends can only result in a refund from the ERDTOH pool. A payment of non-eligible dividends will result in a refund from the NERDTOH pool first, before a refund can be obtained from the ERDTOH pool, if applicable.

Canadian Controlled Private Corporation (CCPC) – Part IV Tax

A CCPC has a 38.33 per cent Part IV tax that is applied to eligible dividends received from a corporation where the CCPC owns 10 per cent or less of the shares of the corporation – these dividends are often referred to as portfolio dividends. This tax can also apply if the CCPC receives dividends from another corporation that are not portfolio dividends (CCPC owns more than 10 per cent of the other corporation) if the other corporation receives a dividend refund on the payment of the dividends to the CCPC. Our corporate clients that have a portfolio of Canadian publicly traded securities paying dividends will be subject to the 38.33 per cent Part IV tax. This extra tax is effectively levied to ensure that there is no advantage for an owner of a business to earn investment income in a CCPC. 100 per cent of Part IV tax gets added to the ERDTOH account and is later refunded when a taxable dividend is paid to the individual shareholder of the corporation.

Example of when the Part IV tax is levied:

HoldCo owns shares in some Canadian publicly traded blue-chip dividend paying stocks. During the tax year, these stocks generated $39,400 in eligible dividend income. The Holdco would have to pay tax at 38.33 per cent, or $15,102 on the dividend income ($39,400 x 38.33 per cent). The full amount of this tax, $15,102, would be added to the notional ERDTOH account and will be refunded when a taxable dividend is paid out to its shareholders at a later date.

Eligible and Non-Eligible Dividends

In our article, Clarifying the confusion around eligible and ineligible dividends, we explained the differences between these two forms of dividends. When a corporation pays an eligible or non-eligible dividend to its shareholder, it triggers a tax refund to the corporation. From a shareholder’s perspective, an eligible dividend is always taxed more favourably.

CRA Information

Below is some information from the CRA website on how dividend refunds are calculated, along with how the ERDTOH and NERDTOH balances are calculated. We realize this information is rather technical.

Dividend Refunds

A dividend refund is currently available to a private corporation that pays taxable dividends in a taxation year. The amount of its dividend refund for the year is equal to the lesser of 38 1/3 per cent of all taxable dividends it paid in the year and its refundable dividend tax on hand (RDTOH) balance at the end of the year.

A dividend refund is available whether a corporation pays eligible dividends or non-eligible dividends in a taxation year. Eligible dividends are generally paid from a corporation’s active business income that was taxed at the general corporate income tax rate, including from eligible portfolio dividends received by the corporation (i.e., eligible dividends received from non-connected corporations). Non-eligible dividends are generally paid from a corporation’s active business income that was taxed at the small business tax rate, including non-eligible dividends received by the corporation, or from its passive investment income (excluding the non-taxable portion of capital gains).

Calculating the Dividend Refund

A private corporation’s dividend refund for a particular taxation year will be equal to the total of the following three amounts:

Amount One: the lesser of

• 38 1/3 per cent of the total of all eligible dividends it paid in the year, and

• its ERDTOH balance at the end of the year;

Amount Two: the lesser of

• 38 1/3 per cent of the total of all non-eligible dividends it paid in the year, and

• its NERDTOH balance at the end of the year; and

Amount Three*: either

• if 38 1/3 per cent of the total of all non-eligible dividends it paid in the year exceeds its NERDTOH balance at the end of the year, the lesser of

– the amount of the excess, and

– the amount by which its ERDTOH balance at the end of the year exceeds Amount One, if any, determined for the year

• in any other case, nil.

*The computation above will effectively require a private corporation to obtain a refund from its NERDTOH balance before it obtains a refund from its ERDTOH balance, when it pays a non-eligible dividend.

Eligible Refundable Dividend Tax on Hand (ERDTOH)

A corporation’s ERDTOH balance at the end of a taxation year is the amount, if any, by which the total of

• its Part IV tax for the year in respect of

– eligible dividends received in the year from non-connected corporations, and

– taxable dividends received in the year from connected corporations, to the extent the dividends caused a dividend refund to those corporations from their eligible RDTOH balance, and

• where it was a private corporation at the end of its preceding taxation year, its eligible RDTOH balance at the end of that preceding year,

exceeds

• the portion, if any, of its dividend refund from its ERTDOH balance (i.e., the total of Amount One and Amount Three as determined above) for its preceding taxation year.

Non-Eligible Refundable Dividend Tax on Hand (NERDTOH)

A corporation’s NERDTOH balance at the end of a taxation year is the amount, if any, by which the total of

• where it was a Canadian-controlled private corporation (CCPC) throughout the year, the refundable portion of the Part I income tax that it paid on investment income in the year (equal to 30 2/3 per cent of its aggregate investment income, subject to certain limits),

• its Part IV tax for the year, excluding the amounts included above in computing its ERDTOH balance at the end of the year, and

• where it was a private corporation at the end of its preceding taxation year, its NERDTOH balance at the end of that preceding year,

exceeds

• the portion, if any, of its dividend refund from its NERTDOH balance (i.e., Amount Two above) for its preceding taxation year.

Understanding these two types of dividends is important when understanding ERDTOH and NERDTOH. Canada Revenue Agency (CRA) rules state that when non-eligible dividends are paid, the refund must come from the NERDTOH account prior to obtaining a refund from the ERDTOH account.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email greenard.group@scotiawealth.com or visit greenardgroup.com/secondopinion

Related Articles