Although I am quite familiar with the tax-advantaged options of incorporating your business, my interest is looking at ways in which people can reduce corporate tax payable on investments held within a corporation and their relation to the types of income generated from that corporation.
Active Income versus Passive Income
Active business income is income that is generated by actively doing something. In other words, your business provides some type of goods or service, or is involved in manufacturing or sales. The combined Federal and Provincial (Ontario rate) for active income earned by Canadian Controlled Private Corporations (CCPC’s) which is less than $500,000 is 12.2% for 2020. Active business income earned greater than $500,000 is taxed at 26.5%
This can be compared to passive business income which is typically investment income. The combined Federal/Ontario passive investment tax rates for corporations for 2020 are 50.17 % interest income and foreign income, 38.33% dividends and 25.08 % capital gains.
Clearly, money held in your corporation as passive investment is taxed at the highest corporate tax rate compared to active income. As a result of an increase in corporate tax rates on investment income, there is no longer any tax deferral and tax savings advantage to earning investment income inside the corporation, as was the case in the past.
How a Tax-Advantaged Investment Helps Business Owners
Canadian business owners who are shareholders of private corporations and have cash flow in excess of what is required to operate their business will often accumulate wealth within their company as retained earnings. Most prefer not to take extra income or dividends from the company and pay more tax. Their annual income is sufficient enough that doing so does not mean sacrificing their lifestyle. By leaving the money in their company, there can be a significant tax deferral rather than distributing it through dividends or income then paying personal tax on it.
However, these retained profits surplus of cash build passive investment portfolios that typically consist of investment vehicles that return a mix of interest, dividend and capital gains. The high amount of tax paid on passive investments and the loss of wealth due to loss of compounding growth can make this type of investment at times less desirable. An alternative solution would be to invest the profits into a corporate-owned, tax-exempt permanent insurance policy. An exempt insurance policy is defined in regulations 306 and 307 of the Income Tax Act (ITA).The ITA provides that the cash value accumulation is exempt from annual accrual taxation, provided certain conditions within the regulations are met. Significant cash values can accumulate on a tax deferred basis if the maximum deposits permitted by the ITA are deposited into the exempt policy.
The deposits can be designed so that they remain tax-sheltered within the contract. Not only does a corporate-owned exempt policy allow for tax-deferred growth of the cash value of the policy, but there’s also a mechanism that allows the death benefit proceeds to go tax-free to shareholders through the corporations capital dividend account (CDA).
A Capital Dividend Accounts as a Tax-Advantaged Investment
The CDA credit is unique to corporate-owned life insurance. Upon death of the insured, a private corporation receives the death benefit tax-free and that amount less the adjusted cost basis (ACB) of the policy is added to the corporation’s capital dividend account. The policy’s ACB is generally the sum of the cumulative premiums paid minus the cumulative net cost of pure insurance. The CDA balance resulting from receipt of death benefit proceeds from a life insurance death benefit will remain until such time as capital dividends are elected. This allows corporations the ability to elect to pay a capital dividend when it’s most advantageous for shareholders.
Since payment of capital dividend is elective, detailed knowledge of tax legislation is required. I would recommend your accountant be involved in the election process. Tax-advantaged growth and tax-free distribution on death results in corporate-owned permanent life insurance having two significant and unique tax advantages over traditional investments.
Contact us to learn more and discuss tax-advantaged investment options for your Canadian business.