Welcome changes to the refundable dividend tax rules

I promised in my last post that I would visit the changes proposed in the 2018 federal budget with respect to the account for refundable dividend tax on hand (RDTOH), and here is the result. There are some very provisions coming into effect that will really bring some needed integration and antiabuse provisions in this field for Canadian-controlled private corporations (CCPCs).

The changes will affect certain key forms that need to be filed:

• T2 Schedule 3, which reconciles dividends received, taxable dividends paid, and Part IV tax calculations;
• T2 Schedule 53, which reconciles the flows within the Generate Rate Income Pool (GRIP) that determine what can be paid as eligible dividends reported on the T5 return;
• T2 Schedule 54, which reconciles the flows within the Low Rate Income Pool (LRIP) that determine what can be paid as non-eligible dividends similarly reported; and
• page 7 of the T2 return, concerning the determination of RDTOH and dividend refunds for the year.

This is important, as eligible dividends paid from GRIP, because of the "gross-up and credit" system of reporting taxable dividends, are more or less accounted for on the individual T1 returns with minimal impact on the overall tax collected when you add the effects of personal and corporate taxes together. Non-eligible dividends paid from LRIP will result in being effectively marginally taxed at the personal level. Until now, if there were balances in both pools there was no rule governing which pool had to be drawn upon first for paying dividends to shareholders.

The changes

Beginning with the first taxation year after 2018, the RDTOH will be divided into two accounts:

1. The current account will be designated as "non-eligible RDTOH".
2. A new account, to be known as "eligible RDTOH", will be created.
3. Where a corporation is a CCPC throughout that first year, an opening balance will be created for eligible RDTOH equal to the lesser of a) its RDTOH at the end of the previous year, and b) 38⅓% of its GRIP at the same date. An anti-avoidance provision will be in effect to prevent any manipulation concerning the opening balance.
4. Otherwise, additions to eligible RDTOH will arise from Part IV tax on "eligible portfolio dividends", which are dividends received from a) corporations with which the corporation is not connected under ITA s. 186(4), and b) connected corporations paying dividends from their own eligible RDTOH accounts.

Why is that necessary? It is because of the rules that will also come into force with respect to obtaining dividend refunds relating to Part IV tax and the refundable portion of Part I tax paid in previous years that had already flowed into the RDTOH:

1. If a corporation pays an eligible dividend, it will not be able to obtain a dividend refund unless it has a positive balance for eligible RDTOH.
2. If it pays a non-eligible dividend, it will obtain a dividend refund as long as there is a positive balance in either RDTOH account.
3. The non-eligible RDTOH account must be depleted before a dividend refund can be obtained with respect to its eligible RDTOH account.

 Why does this matter?

This is related to Ottawa's efforts to ensure that passive income within corporations is properly taxed when it flows back to individual shareholders. The current régime which provided for a single RDTOH pool was inconsistent with that goal, so it had to be dividend to ensure that taxation was occurring properly with respect to each source of investment income occurring for the corporation. This change was both necessary and desirable.

Penalties will still exist for eligible dividends paid that are in excess of available GRIP for the year, reported as Part III.1 tax on T2 Schedule 55. Therefore, several different sets of forecast and other calculation scenarios will be necessary before directors decide to declare any relevant dividends. Another reason to have a very good CFO at your side.

None of these changes affect the existing rules concerning the capital dividend account, out of which tax-free capital dividends can be paid, but it is still necessary to maintain up-to-date calculations as to what the eligible balance is. The relevant forms for this exercise are T2 Schedule 89 and T2054, mailed together to the office stated in the instructions, on or before the date the dividend is first paid or payable.. The corporation's auditors should have already compiled the necessary information, if it is not already available internally.

The passive income controversy (cont'd)

Bill Morneau finally brought down his budget last Tuesday. While the flavour du jour is gender-based analysis, you had to dig (as per usual) to find out what Finance is doing to really improve the Income Tax Act, among other laws. They have come up with an interesting resolution to the taxation of passive income in CCPCs that I discussed earlier here and here, as well as doing a needed correction to the handling of refundable dividend taxes on hand. I'll deal with the latter matter in a subsequent post.

The Budget (and the real document)

The public version, which most commentators appear to have focused on, is an interesting PR exercise as usual:




However, to see what is really going on, you always have to read this:

 What they're doing with the Small Business Deduction

Where they start discussing their proposal for limiting the availability of the small business deduction (SBD) to CCPCs (at pp. 17-20 and pp. 53-55), you discover that this is really a multiple-factor calculation. The basic formula is:

 $  ABL = BL - max(A,B)  $

where:

• ABL = adjusted business limit to what can be claimed for the small business deduction
• BL = the business limit otherwise available
• A = limitation with respect to taxable capital employed in Canada (a concept borrowed from the Part I.3 tax on large corporations), which is already in effect as ITA 125(5.1)
• B = limitation with respect to adjusted aggregate investment income (ie, passive income) for the year (being the figure from the T2 Schedule 7 with some adjustments)

The very brief summary of the impact is that:

• if a CCPC's taxable capital is less than CAD 10 million, and its passive income is less than CAD 50,000, it will continue to have full access to its business limit
• if either its taxable capital is greater than CAD 15 million, or its passive income is greater than CAD 150,000, it will have no access to the small business deduction
• there is a transitional phase where the above calculation comes into play; it is effectively a percentage reduction of what the dollar amount would otherwise be

The charts that illustrate the impact (as shown in p. 74 of the Budget and pp. 18-19 of the Tax Measures) are very poorly done, as they fragment the extent of its impact. Some commentators have said that these limitations are straight-line calculations, but they are wrong. Both limitations are curvilinear in nature as shown in the following.

The taxable capital limitation

The limitation with respect to a CCPC's taxable capital employed in Canada is:

$ \left[ \frac{0.00225(C-10,000,000)}{11,250} \right],  10,000,000 \leq C \leq 15,000,000 $

where C is such taxable capital, and the business limit after reduction for this limitation is:

The passive income limitation

The limitation with respect to a CCPC''s passive income for the year is

$ \left[ \frac{BL}{500,000} - 5(E-50,000) \right],  50,000 \leq E \leq 150,000$

where E is the adjusted aggregate investment income for the year.



Further testing proved that these calculations are effectively percentage reductions to what otherwise would be the business limit to which a CCPC would be entitled.

This also begs the question as to what to expect when the two curves intersect - as that could happen - and this is something that the wizards at Finance decided not to try to visualize. I tried to summarize this in a single formula, but that was not a practical solution. Through the tried-and-true "brute force" technique, I compiled a dataset of calculated datapoints and have constructed a chart of my own, which proves to be revealing:


You can see that the curve has a definite peak, either side of which tapers down to eventual ineligibility for the small business deduction. That may be worth investigating further, in order to help out with any necessary tax planning such corporations may need to undertake.

I like this solution, but do object to the way it's being advertised. CPA Canada has described it as being "much simpler than what was originally proposed," but no-one has mentioned its integration with the taxable capital limitation in any detail yet, but it represents a very significant expansion. If this goes through in its proposed form, it will essentially expand this anti-abuse provision, because much of the work that CCPCs and their tax advisers have done over the years in making sure that their taxable income is low enough to fully qualify for the small business deduction will become useless, as it's much more difficult to fudge passive income and capital employed. This is to be welcomed, together with last year's exclusion of personal services business income (as now shown on line 520 of Schedule 7) from the SBD and the new SBD denial rules.

This area is becoming rather exciting now. Let's see what happens next.