The Income Tax Act doesn’t just deal with income tax. Part I of the Act is the income tax proper. However, the Act contains other parts that impose specific taxes in particular circumstances. These special taxes are meant to supplement the income tax and make sure that its intent and goals are not avoided or delayed, or that unintended tax benefits are not had by some. Corporations generally pay a lower tax rate than individuals do on income and, the Canadian Government, has implemented a number of measures in the Income Tax Act to limit the application of the lower rate of tax to active business income earned by corporations and not to passive income.
Part IV of the Income Tax Act is one such special tax that is meant to limit access to a corporation’s lower tax rate on income. This Part deals with “Tax on Taxable Dividends Received by Private Corporations”. The heading, by itself, gives you an idea of where the tax applies and where it doesn’t. We will get back to this later. If Part IV tax applies to your circumstances, then a tax equal to 38 1/3 % is payable on the amount of “assessable dividends” received in the year. This provision is complex and there are a number of definitions and carve-outs that can affect whether the Refundable Dividends Tax on Hand system applies or not.
Let’s start with the basics of the Part IV Tax. Part IV tax is only a concern if you are dealing with a private corporation. This means that you don’t have to worry about Part IV tax if you are dealing with a public corporation, a trust, an individual, or a partnership. Additionally, Part IV tax only applies where the corporation receives “taxable dividends”. This means that tax-free dividends, such as capital dividends, are not subject to Part IV tax.
There is an important exception to the above basic application criteria. Not all taxable dividends received by private corporations are subject to Part IV tax. Only dividends received from corporations that are not connected to the private corporation that receives the dividend are subject to the Refundable Dividend Tax On Hand. Connected corporations are corporations that are either controlled by the recipient corporation or are corporations where the recipient corporation owns shares carrying more than 10% of the votes and value of that corporation. In short, the connected corporation concept is meant to separate dividends earned from a family of corporations engaged in business together from dividends from corporations where share ownership is an investment. Only dividends received on shares held as investments are subject to the Refundable Dividend Tax on Hand.
Another exception is that not all taxable dividends are “assessable dividends”. Assessable dividends are amounts that are paid as dividends or are meant to represent the payment of dividends, where those dividends are eligible for deduction under either section 112, 113(1)(a), 113(1)(b), 113(1)(d), or 113(2) of the Income Tax Act. Therefore only dividends that can be received tax free in certain circumstances are targeted.
If Part IV tax applies, then the corporation has to pay the tax and produces and RDTOH account. This is a notional account that is meant to keep track of the amount of RDTOH paid on dividends received by a corporation. You want to keep track of RDTOH because you can get a refund from the government for the tax paid when the corporation pays a dividend to individuals. The refund is equal to $1 for every $3 of dividends paid. The refund is paid to the extent that there is RDTOH in the account and must be applied for by the corporation. If the corporation forgets to apply for the refund, the refund can be permanently lost.
You may wonder why you have to pay the tax and then are eligible to get a refund for the tax paid. The reasoning is that the Refundable Dividend Tax On Hand is a pre-payment of tax on investment dividends. The purpose is to remove the deferral advantage one could have if a person earned investment income, in the form of dividends, through a private corporation. It is an estimate that is equal to or higher than the highest marginal tax rate applicable to individuals, and is meant to act as a disincentive to earning investment income through a corporation.
Part IV tax is meant to complement the tax on Aggregate Investment Income earned by private corporations. Aggregate Investment Income earned by a Canadian Controlled Private Corporation is taxed at over 49%. This is meant to discourage people from earning investment income through a corporation and encourage earning investment income personally. What is Aggregate Investment Income?
Aggregate Investment Income is made up of a few things. The first is the amount by which the taxable capital gains earned by a corporation exceed the allowable capital losses incurred in a year. Other items that make up Aggregate Investment Income are items that fall under the heading “Income from Property”. Income from property includes rent, interest, and royalties, but does not include dividend income. Income from property also doesn’t include income that is incidental to active business carried on by the corporation. What is incidental is a question of fact that depends on the corporation’s particular circumstances. You also get to deduct business investment losses from investment income when calculating Aggregate Investment Income. Property income doesn’t include dividends, and therefore Aggregate Investment Income does not consider dividends, because dividends are dealt with by Part IV tax.
The extra tax on Aggregate Investment Income and that imposed by Part IV tax is meant to deter shareholders from using corporations for a purpose other than earning active business income. When planning an overall investment and wealth strategy, the analysis is not complete unless you have considered the effect of the tax on Aggregate Investment Income and Part IV tax.