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TAXATION OF DIVIDENDS - THE NEW RULES

July 2006 Release No: 06-04

Introduction
Last fall, the former Liberal government announced changes to the rules for the taxation of dividends, intended to level the playing field between corporations carrying on business and the use of income trusts. The new Conservative government confirmed in the May 2006 federal budget that they would implement the Liberal government's proposals, and on June 29, 2006, the federal government released draft legislation. Prior to the announcement of these rules, the taxation of business income in a corporation that was not eligible for the small business deduction was not "integrated". What this means is that earning business income in a corporation and then paying out the after-tax income as a dividend to the shareholders resulted in more tax than if the income was earned by an individual directly. A tax system is said to be integrated if the same amount of overall tax is paid if the income is earned indirectly through a corporation or directly by the individual. In recent years, income trusts have been used as a solution to this integration problem. The income trust structure effectively allows investors to be taxed directly on business income earned by the trust and this gave these trusts a tax advantage over businesses carried on in a corporation, such as a public or large private company, where the tax system was not integrated as the corporation was not eligible for the small business deduction. Rather than attacking the income trust structure, the Government has decided to deal with this issue by eliminating the integration problem for all companies. Under the new rules "eligible dividends" will be subject to lower personal tax rates that effectively eliminate this integration problem.

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How Will Eligible Dividends be Taxed?

In recognition of the fact that a corporation pays dividends out of after-tax income, the personal income tax system, when computing personal income tax on a dividend, provides relief for the corporate tax using a dividend gross-up and dividend tax credit (DTC). The idea is to gross income back up to what the corporation received and to provide a credit for the tax it paid. Currently, the grossup and credit is based on the assumption that the combined federal and provincial tax is 20 per cent. However, this is only the case for small business income - regular corporate income is taxed at a much higher combined rate, and therefore, the combined personal and corporate tax is much higher than what the personal tax would be if the income was earned directly by an individual. To eliminate this problem, the Government proposes to introduce an enhanced gross-up and DTC for eligible dividends received by individuals and trusts. An eligible dividend will be grossed-up by 45 per cent, meaning that the shareholder includes 145 per cent of the dividend amount in income. The DTC in respect of eligible dividends will be 27.5 per cent of the actual dividend. This new system is based on an assumed 32 per cent corporate tax rate. The existing gross-up (25 per cent) and tax credit (16 2/3 per cent of actual dividends) will continue to apply to ineligible dividends. These changes will mean that eligible dividends will be taxed at a reduced federal rate.

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How are Eligible Dividends Determined?

In the original announcement last fall, the government basically stated that where after-tax income is taxed at the general corporate rate, the after-tax income will qualify as an eligible dividend when paid and other dividends, such as dividends paid from after-tax small business income or after-tax investment income will be ineligible. Although this was straight forward conceptually, many corporations have different types of income, and in the case of business income specifically, some corporations earn income that is subject to both the small business rate and the general rate in any given year.

One of the options the government could have used was a full tracking of different income types and then reduce these amounts by the actual tax paid on each type of income, to determine what makes up a corporations after-tax surplus. This would have been a time consuming process for both taxpayers and the government (in terms of monitoring). Instead of this, the government announced rules that will determine a proxy for these surplus amounts. One set of rules will apply for Canadian-Controlled Private Corporations (CCPCs) and a second set of rules will apply for other corporations. Well review the CCPC rules first. Note that all of the rules discussed are generally effective on January 1, 2006.

Eligible Dividend Rules for CCPCs

As the first $300,000 of active business income (increasing to $400,000 for 2007) is subject to the federal small business tax rate, the draft rules will assume, as a starting point, that all CCPC income will give rise to ineligible dividends. However, a new tax account called the General Rate Income Pool or GRIP was also introduced for those CCPCs with active income in excess of the limit for the small business tax rate. This pool will be an accumulation of after-tax income that was taxed at the general rate. Since the rate of taxation is based on both federal and provincial rates, the government has decided to simply assume that the combined general tax rate is 32 per cent rather than trying to determine the actual rate that applied. Therefore, each year, an amount equal to 68 per cent of taxable income excluding small business income and investment income will be added to the GRIP balance. In addition, to recognize that a corporation may have had general rate business income in the past, CCPCs will be allowed to add an additional amount to the GRIP in respect of taxation years ending after 2000 and before 2006 for its 2006 taxation year. This addition will again be based on taxable income excluding small business income and investment income. In this case, given tax rates were higher in the past, the rules will assume that this income was taxed at 37 per cent meaning that the pool addition will be 63 per cent of general rate income for those years. Where a CCPC pays a dividend, and it has a GRIP balance at least as large as the dividend paid, the corporation can choose to designate the full amount of the dividend as an eligible dividend, meaning that shareholders who are individuals and trusts will be eligible for the new dividend gross-up and tax credit. As partial elections on a portion of a dividend cant be made, it will become more common to have multiple dividend declarations. Where a non-CCPC becomes a CCPC, special rules apply to estimate the after-tax income tax that was taxed at general tax rates, so that this after-tax income can be added to the corporations GRIP balance.

Eligible Dividends for Non-CCPCs

There are separate rules for non-CCPCs, and these rules are based on the assumption that the corporation would not have any income on hand that was originally taxed at small business rates. However, this may not always be true, and therefore, another new tax account, called the Low Rate Income Pool or LRIP, was introduced. This account will track the after-tax small business income that is on hand. Even though most non-CCPCs arent eligible for the small business deduction, it is still possible for these corporations to have small business income on hand, and the LRIP will include the following amounts: Ineligible dividends received from other corporations. After-tax income of a credit union that qualified for the small business deduction (basically 80% of the business limit). Where the corporation loses its status as a CCPC, an estimate of the amount of income earned prior to the change in status that was investment income or business income taxed at the small business rate. Unlike the rules for CCPCs, non-CCPCs must clear out a LRIP balance before an eligible dividend can be declared. Therefore, ensuring the LRIP balance is correct will be crucial.

What Happens if an Eligible Dividend Designation is too High?

Given that shareholders will have no way of knowing whether or not a corporation was allowed to pay an eligible dividend in the amount received, the consequences of paying too large of an eligible dividend will fall on the corporation. In the case of

of paying too large of an eligible dividend will fall on the corporation. In the case of a CCPC, if the full amount of the dividend designated as an eligible dividend exceeds the GRIP balance, the corporation will be subject to a penalty tax equal to 20 per cent of the difference between the dividend and the GRIP balance at yearend. However, if the corporation and the shareholders jointly elect and other conditions are met, the excess amount will be deemed to be a separate ineligible dividend and the penalty tax will be waived. In the case of a non-CCPC, this penalty tax will apply if the corporation designates an eligible dividend at a time that the corporation had a positive balance in its LRIP. The tax in this case will be 20 per cent of the LRIP. Again, if the parties elect jointly and other conditions are met, the LRIP balance will be considered a separate ineligible dividend and the penalty tax will be waived. Where there are many shareholders, the ability to make such an election may be problematic, so these corporations will need to take more care. Note that if a corporation enters into transactions to artificially manipulate the corporations GRIP or LRIP, the penalty tax may apply on the entire dividend at 30% and there will be no ability to use an excess dividend election.

Are There any Other Rules That Apply?

In addition to the main rules just discussed, there are some other rules that must be kept in mind: Deemed year-ends Where there is a change to or from CCPC status that does not involve an acquisition of control, the corporation will be deemed to have a taxation year end immediately before the corporations status changes (a deemed year-end rule already applies where control is acquired). Election not to be a CCPC A corporation can elect not to be a CCPC for the purpose of these rules. This may be advantageous where the corporation does not otherwise qualify for small business income treatment (i.e. not being a CCPC may make tracking eligible dividends easier) or to defer a deemed year end on a change in status until the corporations usual year-end. Note that this decision is complicated, and advice should be sought from your BDO advisor Special rules for reorganizations Rules have been proposed that will transfer GRIP and LRIP balances to another corporation on an amalgamation of two or more corporations or on the wind-up of a subsidiary where 90 per cent or more of the shares of the subsidiary are held by the parent corporation.

Are There More Changes to Come?

Although these rules may be altered or adjusted to address issues that arise before they are enacted, they should provide most of the detail needed for federal tax purposes. However, with the exception of Qubec and Manitoba (which will harmonize their provincial taxes), provinces and territories have not announced specific rules and dividend tax credit amounts. Nova Scotia has said that it will introduce a dividend tax credit that will maintain the same effective rate on eligible dividends that applied before the original federal government announcement. Ontario and Alberta specifically have not announced new dividend tax credit rates and these provinces (along with Quebec) also have an independent corporate tax system. Consequently, there are more decisions to be made in these provinces since provincial corporate taxable income can differ from the federal amount. For more information on tax rates, and to monitor tax rate changes, keep an eye on our website at www.bdo.ca. Please note: this material is general in nature and should not be relied upon to replace the requirement for specific professional advice. July 2006, BDO Dunwoody LLP

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