Eligible Dividends - Another New Landscape[1]

By Florence Marino, LLB, Manulife Financial

Introduction

The preferential tax treatment for "eligible dividends" was originally introduced to "level the playing field" between income trusts and traditional corporations.[2] Other measures that specifically targeted income trusts were also introduced.[3] The goal of the eligible dividend measures was to lower tax on corporate distributions of active business income which was subject to the general corporate tax rate. The mechanism to accomplish this was to increase the gross-up and dividend tax credit applicable to eligible dividends. From the perspective of Canadian controlled private corporations (CCPCs), the advent of eligible dividends came with a significant compliance burden and greater complexity which requires tracking of the "general rate income pool" (GRIP).

Since these measures were put in place,[4] further federal tax changes have been made which once again change the tax landscape for CCPCs and their shareholders. This article will address the changes brought about by the Federal Economic Statement dated Oct. 30, 2007[5] (the "Statement") and the further changes to the gross-up and dividend tax credit announced in the 2008 federal budget[6] including subsequent consequential changes to the GRIP calculation announced on July 14, 2008 (referred to herein as the "July 2008 Proposals").[7] It will also reflect the movement of the provinces in relation to these changes in their 2008 provincial budgets. The impact on planning generally and in respect of corporate-owned life insurance specifically will be discussed in light of these changes.[8]

The Statement

The Statement delivered significant corporate tax rate reductions over a four year period of time. The following chart shows the general corporate rate by province[9] in 2007 and 2012. Income taxed and retained at the corporate level at this rate generally is what enables the payment of eligible dividends from CCPCs.

The combined effect of the original eligible dividend measures and the significant decreases in corporate tax resulted in the following general planning considerations: in most provinces shareholders in CCPCs would shift their preference from receiving capital gains to receiving eligible dividends,[10] and the propensity to keep profits at the corporate level and not to "bonus down" would likely become the norm for CCPCs.[11]

The federal government did suggest that there may be some further adjustments to the gross-up and dividend tax credit for eligible dividends in light of these significant decreases in corporate tax rates when the Statement was released.[12] Notwithstanding the warning, it is still significant to see just how much changed largely as a result of the "adjustments" announced in the 2008 federal budget.

2008 Federal Budget
The 2008 federal budget changed the gross-up and dividend tax credits applicable to eligible dividends. The effect of these changes increased the rate of tax on eligible dividends from their previous levels. The following chart illustrates where eligible dividend tax rates were expected to be by province in 2012 before the 2008 federal budget measures and afterwards:

General implications:

a) Capital gains vs. Eligible dividends

As a result of the 2008 federal budget changes, in 2012 it will be more favourable to receive capital gains than eligible dividends in all provinces for taxpayers in the top tax bracket. Where the taxpayer is paying tax at the top marginal rate, the difference ranges from a low of 1.35% in favour of capital gains in Alberta, to a high of 10.29% in favour of capital gains in Newfoundland and Labrador. This has implications for structuring the sale of a business (preference for share sale by the vendor as capital gains are preferred); for post-mortem planning capital gains producing transactions (e.g. pipeline and 88(1)(d) bump strategies) preferred over dividend producing transactions (e.g. redemption and 164(6) loss carry back strategies) in circumstances where no capital dividends are available.

In looking at buy-sell agreements it may be wise to keep options flexible so that the most appropriate, tax effective method of buy-out can be determined at the operative time. It is possible that the provinces may make further adjustments to their gross-up and dividend tax credit mechanisms provincially which could further change the landscape.[15]

b) Bonus down vs. retain and later pay out eligible dividend

Prior to the 2008 federal budget, in most provinces (by 2012) there would be a tax savings (or minor tax cost) to a CCPC retaining active business income subject to the general corporate tax rate and later paying out such income as eligible dividends (vs. paying out such income as a bonus to the shareholder/employees). As a result of the 2008 federal budget, no provinces are in a tax savings position by 2012 and those that had a tax cost prior to the 2008 federal budget changes, are in a higher tax cost position. And as a result of the July 2008 Proposals, the tax cost positions in 2012 will be slightly lower, but still higher than what would have been the case before the 2008 federal budget measures.

Even with provinces all being in a tax cost position, given the significant tax deferral (with general corporate tax rates ranging from 25% in British Columbia and Alberta to 31% in Prince Edward Island and Nova Scotia), the question will be: how long is the retained surplus expected to remain at the corporate level before distribution from the CCPC? By 2012, the deferral (i.e. the difference between the general corporate tax rate and the highest marginal tax rate personally) ranges from 14% in Alberta to 21.32% in Quebec. The tax cost associated with retention may be minor compared to this significant deferral. The following chart shows tax cost or savings for 2012 based on expected tax rates as they were pre-2008 federal budget, post-2008 federal budget and post-July 2008 Proposals[16]:

The general conclusion is that despite the tax changes in the 2008 federal budget, CCPCs may still be more likely to retain corporate surplus than bonus down to shareholder/employees in most provinces.

Implications for Corporate-owned Insurance Planning
The changes brought about by the 2008 federal budget have not changed the basic conclusions relating to corporate-owned insurance planning. Some of the more notable conclusions in specific contexts are explored below.

Buy-Sell/Business succession/em>

Life insurance is an effective vehicle to fund buy-sell obligations and business succession plans. This has not changed. Shifting preferences between capital gains and eligible dividends will not as dramatically impact the choice of buy-sell method where life insurance funding is in place. This is due to the tax benefits created by the payment of capital dividends made possible by life insurance proceeds. However, agreements may wish to provide the flexibility for the parties to elect varying structures depending on the tax effects of each method for the parties taking into consideration such things as: desire/ability to use a spousal roll and redeem strategy; availability of the capital gains exemption; the ability to pay capital dividends, eligible dividends, ineligible dividends or some combination of these.

The structure for a buy-out where insurance is not in place may shift more closely with changing preferences for capital gains vs. eligible dividends. As a result, flexibility to consider the approach to the buy-out at the operative time would make sense. Funding with insurance would only improve the tax position of the parties since this would give rise to the ability to pay capital dividends to the extent of any capital dividend account balance.

Insurance Funded Owner-Manager Retirement Options

As time goes on, retirement compensation arrangements (RCAs) keep making less and less sense for the owner-manager. With corporate tax rates decreasing, the general propensity to simply retain funds at the corporate level and pay tax at 25%-31% vs. bonusing down (and pay tax at 39%-48% in a shareholder´s hands depending on the province) applies equally to refundable tax (50% paid in respect of RCA contributions by the corporation). Just because it´s refundable, doesn´t mean it can be ignored. It is only refundable when income is paid out of the RCA (and tax is paid by the owner-manager at 39%-48% assuming he or she remains in Canada). Either way you slice it there is a significant tax deferral opportunity with lower general corporate tax rates.

Life insurance strategies can capitalize on the fact that there will be more trapped surplus in CCPCs to provide for an owner-manager´s retirement planning. Corporate-owned insurance leveraged to pay eligible (or even ineligible) dividends to an owner-manager in retirement years can provide higher levels of after-tax income to an owner-manager than insurance-funded RCAs.

Insurance for Remaining Capital Gains Tax Liabilities

More retained corporate earnings may result in higher share values on the death of an individual owning shares in a CCPC. Life insurance to fund remaining tax liabilities can be held individually or corporately. Cash-flow producing insurance strategies (like corporate-owned life insurance leveraged to pay eligible dividends) can provide the funding for serial redemptions (for "wasting freezes") and cover remaining tax liabilities on death for shares that remain.

Conclusions

Some commentators question if the eligible dividend rules will survive. But at least for the foreseeable future these rules cannot be ignored. As is evident from the foregoing discussion, these rules significantly complicate the estate and business succession planning for shareholders of CCPCs. Careful planning is required to ensure that shareholders of CCPCs retain the flexibility to optimize the benefits of these rules, now and in the future.

Endnotes

[1] Substantial portions of this article are reprinted with permission of Federated Press. These first appeared in (2008) 14 Insurance Planning 907. This article updates and modifies the original article.

[2] Department of Finance News Release 2005-082, Nov. 23, 2005.

[3] On Oct. 31, 2006, Minister Flaherty announced measures imposing a distribution tax on income trusts. Draft legislation was released on Dec. 21, 2006, followed by a period of consultation. Income trust distribution tax was implemented in Bill C-52, Budget Implementation Act, 2007 which received Royal Assent June 22, 2007. Technical amendments were announced by the Department of Finance in news release 2007-106 Dec. 20, 2007.

[4] Bill C-28, Budget Implementation Act, 2006, No. 2, received Royal Assent, Feb. 21, 2007.

[5] Bill C-28, Budget and Economic Statement Implementation Act, 2007 received Royal Assent on Dec. 14, 2007.

[6] Bill C-50, Budget Implementation Act, 2008, received Royal Assent, June 18, 2008.

[7] Legislative Proposals and Explanatory Notes relating to the Income Tax Act, the Excise Act, 2001 and the Excise Tax Act released by the Department of Finance, July 14, 2008.

[8] For a discussion of the impact of the original legislation on eligible dividends refer to Florence Marino, (2006) 12 Insurance Planning 790.

[9] Provincial rates are current as of May 20, 2008, and include the 2008 Provincial budget information for all provinces.

[10] By 2010, it was expected that only Manitoba, Quebec, Nova Scotia, Prince Edward Island, and Newfoundland and Labrador would have had eligible dividend tax rates higher than capital gains tax rates.

[11] In most provinces there would have been a small tax savings by 2012 for retaining income at the corporate level and later distributing as an eligible dividend. Only Quebec, Nova Scotia, Prince Edward Island, and Newfoundland and Labrador would have a tax cost, and even in those provinces the tax cost was to be minor (highest was 5.09% in Newfoundland and Labrador). In addition, special considerations also applied in Ontario because of the provincial small business deduction "claw back" which would increase corporate tax rates in respect of income above the small business limit up to a certain threshold. For companies within this income range, there would be higher corporate tax rates that would reduce the tax deferral and increase the tax cost for retaining income within those thresholds. This would likely have lead Ontario companies to continue to bonus down to the small business limit as opposed to retaining income at the corporate level.

[12] Explanatory notes to the Notice of Ways and Means Motion for the Economic Statement released Oct. 30, 2007 stated as follows: "Budget 2006 legislated an enhanced dividend tax credit (DTC) to ensure that the combined corporate and personal income tax rates on dividends from large corporations is comparable to that on other forms of income. The enhanced DTC measure was established with reference to the total average 2010 federal-provincial corporate tax expected at the time. As a consequence of the corporate income tax rate reductions announced in this Economic Statement, consideration will be given to adjustments to the enhanced DTC to ensure the appropriate tax treatment of dividend income, as well as adjustments to other rules in the Income Tax Act that assume a specific underlying corporate income tax rate."

[13] This rate reflects 2008 British Columbia provincial budget dated Feb. 19, 2008.

[14] Based on the current Ontario legislation, Taxation Act, 2007, S.O., c. 11, s.13, the Ontario dividend tax credit is calculated as a percentage of the federal dividend tax credit. Due to the change in the federal dividend tax credit from the 2008 federal budget, the Ontario rate changes. This is reflected in the chart. However, Ontario Finance has indicated (2008 Budget Papers, Chapter III: Tax Support for Families and Business) that it "proposes to maintain its plan to increase the tax credit on grossed up eligible dividend from 7% in 2008 to 7.4% in 2009 and 7.7% in 2010 and subsequent years." If this comes to pass, then the rate for 2012 would be 26.74%. At the time of writing this intention has not yet been implemented. It should be noted that the current legislation of all provinces except Manitoba and Quebec also calculate the dividend tax credit for provincial purposes as a percentage of the federal dividend tax credit or gross-up. The rates in the above table reflect this. It is possible that these provinces may also implement changes like what was expressed as the intention in Ontario.

[15] At the time of writing, all 2008 provincial budgets have been reflected. British Columbia´s was the only provincial budget which came down before the federal budget so it obviously did not contemplate the 2008 federal budget. Also, there is some indication in Ontario that further changes to the calculation of the dividend tax credit will be made. See note 14.

[16] This chart assumes all available after-tax income taxed at the general corporate rate is distributed to the extent possible as an eligible dividend using the GRIP generated and then the rest of the available after-tax income is distributed as an ineligible dividend. It also assumes that there is no GRIP balance additions other than that generated by active business income taxed at the general corporate rate. Since this addition was to be calculated using 68% of the corporation´s full rate taxable income it inherently assumed a corporate tax rate at the provincial level of 32%. (This assumption is reflected in the "Pre-2008 Federal Budget" and "Post-2008 Federal Budget" columns of this chart. The extent to which a province´s tax rate varies from that assumption affected the tax cost or savings calculated. As discussed, all provinces are expected to be below 32% by 2012. The lower the corporate rate was below 32% the larger the ineligible dividend component of the total dividend will be when corporate profits, net of income tax, are distributed from the corporation, thereby increasing the personal tax payable and the "tax cost" as calculated above. Given that the corporate tax rate reductions will steadily reduce corporate tax rates over time, it was plausible that this (68%) percentage was going to be revisited so as to address this. This is precisely what happened with the July 2008 Proposals, the column indicated reflects a 72% rate which implies an inherent general corporate rate of 28% in 2012.

[17] This chart assumes the eligible dividend tax rate in accordance with current Ontario legislation. See note 14 for more details. For the intended Ontario tax rates, the tax savings would have been 1.25% for 2012 reflecting the pre-2008 federal budget rates and there would be a tax cost of (1.71%) for 2012 reflecting the post-2008 federal budget rates. Also, this ignores "claw back". If within "claw back" range the tax costs would increase to (1.78%) and (7%) respectively under current Ontario legislation, and (1.78%) and (4.7%) respectively under intended Ontario legislation.

[18] Subsection 89(1) definition of "capital dividend account" of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supplement), as amended.

[19] See David, Louis, "Eligible Dividends - A Prediction", Tax Planning for Small Business, May 2008 Number 30 pp. 5-7.

Copyright the Conference for Advanced Life Underwriting, September 2008