Tax Integration Explained

In the Canadian context, tax integration refers to the concept of ensuring that the combined tax burden on corporations and their shareholders is roughly equivalent to the tax burden that would be paid if the corporation’s income was earned directly by the shareholders.

The goal of tax integration is to eliminate or minimize the “double taxation” that can occur when a corporation pays tax on its income and then distributes that income to its shareholders, who are then taxed again on the same income as dividend income. Tax integration seeks to ensure that the total tax paid on corporate income is roughly equivalent to the tax that would be paid if the income was earned directly by the shareholders.

To achieve tax integration, the Canadian tax system includes many measures, most notably including:

The Dividend Tax Credit: This credit provides a reduction in the tax payable by an individual on eligible dividends received from Canadian corporations. The credit effectively lowers the tax rate on dividends to bring it closer to the tax rate on other types of income.

The Small Business Deduction: This deduction allows Canadian-controlled private corporations (CCPCs) to pay lower corporate tax rates on their first $500,000 of active business income. This helps to reduce the tax burden on small business owners, who often earn their income through dividends.

The Refundable Dividend Tax On Hand (RDTOH) Account: This account ensures that corporations do not benefit from lower tax rates on investment income earned through the corporation compared to investment income earned directly by shareholders. The RDTOH account ensures that the tax paid by the corporation on its investment income is refunded to the corporation when it pays dividends, effectively equalizing the tax paid on investment income by the corporation and the shareholder.

The Capital Dividend Account (CDA): This account is used by Canadian corporations to track the tax-free portion of capital gains, foreign accrual property income, and life insurance proceeds that are paid to the corporation. The CDA is an important tool in achieving tax integration in the Canadian tax system because it helps to ensure that the tax burden on corporations and their shareholders is roughly equivalent to the tax burden that would be paid if the income was earned directly by the shareholders.

Dividend Tax Credits

Dividend tax credits are an important component of tax integration in the Canadian tax system. They are designed to ensure that the combined tax burden on Canadian corporations and their shareholders is roughly equivalent to the tax burden that would be paid if the income was earned directly by the shareholders.

When a Canadian corporation pays a dividend to its shareholders, the dividend is taxed at the individual’s marginal tax rate. However, the Canadian tax system provides a dividend tax credit to eligible shareholders, which reduces the amount of tax payable on the dividend. The dividend tax credit effectively lowers the tax rate on dividends to bring it closer to the tax rate on other types of income, such as employment income.

The dividend tax credit is intended to offset the tax paid by the corporation on its income, and ensure that the total tax paid on the income is roughly equivalent to the tax that would be paid if the income was earned directly by the shareholders. This helps to achieve tax integration by eliminating or minimizing the “double taxation” that can occur when a corporation pays tax on its income and then distributes that income to its shareholders, who are then taxed again on the same income as dividend income.

The amount of the dividend tax credit depends on the type of dividend paid and the individual’s marginal tax rate. Eligible dividends, which are paid by Canadian corporations that have paid tax at the general corporate tax rate, qualify for a higher dividend tax credit than non-eligible dividends, which are paid by Canadian corporations that have paid tax at a lower rate. This difference in the dividend tax credit helps to ensure that the tax burden on Canadian corporations and their shareholders is roughly equivalent to the tax burden that would be paid if the income was earned directly by the shareholders.

Refundable Dividend Tax On Hand (“RDTOH”)

The Refundable Dividend Tax On Hand (RDTOH) account is an important component of the Canadian tax system that helps to achieve tax integration between Canadian corporations and their shareholders. The RDTOH account ensures that the tax paid by a Canadian corporation on investment income is refunded to the corporation when it pays dividends, effectively equalizing the tax paid on investment income by the corporation and the shareholder.

When a Canadian corporation earns investment income, such as interest, rental income, or capital gains, the income is subject to tax at the general corporate tax rate. However, when the corporation distributes the income to its shareholders in the form of dividends, the dividend income is taxed again in the hands of the shareholder.

To avoid this double taxation, the Canadian tax system provides a mechanism for refunding the tax paid by the corporation on investment income. The corporation can claim a refund of the tax paid on investment income through its RDTOH account when it pays dividends to its shareholders. The refund is equal to the lesser of the tax paid by the corporation on the investment income and the refundable dividend tax on hand balance in the corporation’s RDTOH account.

The RDTOH account helps to ensure that the combined tax burden on Canadian corporations and their shareholders is roughly equivalent to the tax burden that would be paid if the investment income was earned directly by the shareholders. The refund of the tax paid by the corporation on investment income reduces the effective tax rate on investment income earned by the corporation, making it similar to the tax rate that would be paid by the shareholders on the same income if it was earned directly.

Capital Dividend Account (“CDA”)

The CDA is used to track tax-free amounts that can be paid to shareholders in the form of tax-free capital dividends. These capital dividends can be paid to shareholders tax-free, which helps to ensure that the tax paid by the corporation on its income is roughly equivalent to the tax that would be paid if the income was earned directly by the shareholders.

For example, when a Canadian corporation realizes a capital gain on the sale of an asset, 50% of the gain is included in the corporation’s taxable income, and the other 50% is added to the CDA. The amount added to the CDA is tax-free and can be distributed to the corporation’s shareholders as a tax-free capital dividend.

Similarly, when a Canadian corporation earns foreign accrual property income or receives life insurance proceeds, these amounts are added to the CDA and can be distributed to the corporation’s shareholders as tax-free capital dividends.

By allowing corporations to distribute tax-free capital dividends to their shareholders, the CDA helps to ensure that the combined tax burden on the corporation and its shareholders is roughly equivalent to the tax that would be paid if the income was earned directly by the shareholders.

Tax Planning

Overall, tax considerations should be an important part of your investing strategy. This is because as a wealthy investor, taxes are probably the biggest cost to your economic returns.

Our family office has deep experience co-ordinating the advice of professional advisors on behalf of our clients. We provide extra value by coming to our clients with new ideas that can be brought to qualified advisors and by digesting the advice received. Please contact us for more information.