Corporations And Their Shareholders

Corporate structures in Canada may be generally classified into two categories: public and private. Because most of your contact will be with private corporations, this chapter will focus on them. We will deal with the following areas:

1. why companies incorporate
2. how a private corporation is taxed on the various types of income it earns
3. how incorporation can be used for estate planning purposes
4. sale of a business
5. unwinding a corporation

There are many reasons for incorporating a business, some of the more common being:

1. Limited Liability

- A corporate shareholder can only stand to lose the amounts paid for his shares and will not be personally liable beyond this amount.

2. Continued Corporate Existence

- A corporation continues to exist indefinitely unless terminated by a wind-up, amalgamation or bankruptcy. This feature of continued existence is very significant since there will be no deemed disposition of a business on the death of a shareholder whereas a business carried on by a proprietor or partner will be deemed to have been disposed of upon the death of the proprietor/partner. This is also one of the reasons why corporations are often used for estate planning purposes.

3. Anticipated Earnings

- Tax law states that losses incurred by a corporation are only deductible against corporate profits. A carryover system is in place such that a corporate non-capital loss in a year may be carried back 3 years and forward 7 years to offset profits in any of those years. It is not, however, possible for the shareholder to claim a corporate loss against personal income from other sources. For this reason, if losses are anticipated, it is best to delay incorporation and run the business as a proprietorship in order to allow losses to be offset against other sources of personal income. Personal non-capital losses which cannot be claimed in a year may be carried back 3 years and forward 7 years to offset income from other sources.

4. Tax Deferral and Savings

- The next area to be considered in the decision as to whether to incorporate is tax deferral and tax savings. Presently, the combined federal and provincial corporate tax rate for Canadian Controlled private corporations is 18 - 23% on the first $200,000 of active business income. Essentially, active business income includes just about any activity other than earning investment income. This 18 - 23% rate is further reduced for the initial years of incorporation of businesses located in provinces which provide a corporate tax holiday. Those provinces are Quebec, Nova Scotia, Newfoundland, Manitoba and B.C. The rate reduction due to provincial corporate tax holiday will vary depending on the province of residency. Corporations eligible for a tax holiday on income will be subject to a tax rate of only 13%. Comparing a tax rate of 18 - 23% versus 46 - 54% if the income is earned personally is obviously a motivating factor to incorporate. The additional cash made available through the lower corporate tax rate can either be reinvested in the corporate business, used for investment purposes in the corporation or distributed as a dividend to the shareholders. To the extent income is distributed to shareholders immediately, no advantage is achieved by incorporation since the personal tax on the dividend received when combined with the corporate tax already paid will be the same as if the income were earned personally via a proprietorship in the first place. In this sense, the low corporate tax rate provides a deferral rather than a true tax saving. The tax deferral achieved through incorporation normally saves taxes then for as long as profits are reinvested in the corporation.

The tax deferral achieved through incorporation can be made a permanent tax saving if the shares of the business are eventually sold and are eligible for the $500,000 capital gains exemption. To be considered qualified shares they must meet the following criteria:

• they must be shares of a Canadian-controlled private corporation.
• throughout a period of 24 months immediately preceding the disposition, the shares must have been owned by the individual or a person related to the individual,
• throughout that 24 month period, more than 50% of the fair market value of the company assets must have been used in an active business carried on in Canada. Also, at the time of disposition of the shares, atleast 90% of the fair market value of the assets of the company must have been used in an active business carried on in Canada.

In order to take advantage of the tax deferral and possible tax savings we have seen that result from low corporate tax rates on the first $200,000 of active business income, it is important that the business not be deemed by Revenue Canada to be a personal services business. A personal services business is a corporation created to carry on employment duties previously performed by the shareholder of the corporation. The result is negative from a tax standpoint in that the combined corporate and personal taxes would be higher than if income were earned personally. For this reason it is important for anyone considering incorporation to ensure that the personal services business rules will not apply.

Among the benefits of incorporation is the annual income deferral which may be achieved through the use of bonuses. Remuneration in the form of bonuses accrued in the taxation year is deductible to the corporation in that year provided they are actually paid in the following 180 days. As the individual will only be taxed when he or she receives the bonus, a one-year deferral of tax is achieved. To illustrate, a company whose year end is December 31, 1996 may accrue a bonus and deduct the amount on its 1996 tax return provided the amount is paid within 180 days. When the amount is paid it will be reported as income on the shareholder's 1997 personal tax return - hence the 1 year deferral. Note that this strategy of accruing bonuses only works for companies having a year end after July 4 as a result of the 180 day rule. If the corporate year end were before July 4, the accrual of the bonus would only be deductible if paid within 180 days which means that the shareholder would be required to receive and report the bonus in the same calendar year.

We noted earlier that the corporate tax rate is only about 13% for newly incorporated companies eligible for a provincial tax holiday. This is due to the fact that these provinces waive provincial corporate taxes for the first few years the company is in business in order to stimulate new business development. Where this low corporate tax exists, there is again the opportunity for absolute tax savings from incorporation rather than tax deferral.

This is because the combined corporate tax at a 13% rate plus personal taxes on the dividend paid out to the shareholder are less than the personal taxes the shareholder would pay if the business were operated as a proprietorship. Remember, as noted earlier, the shareholder receives the same amount after tax as a proprietor or if incorporated where the corporate tax rate is 18 - 23%.

Where the corporate tax rate is 13%, remuneration should be taken in the form of a salary/dividend mix with a heavy emphasis on dividends. The reason for the emphasis on dividends is that they are paid by the company on an after tax basis which is tax efficient where the corporate tax rate is so low. We won't go into detail on how to calculate the optimum salary/dividend mix for an owner/manager whose corporation is taxed at the 13% rate but you should be aware that later in the chapter there is a formula for determination of the optimum mix depending on the owner's cash requirements.

5. Choice of Year End

- In the year of incorporation a business may choose any year end that does not result in a fiscal period in excess of 53 weeks. The proper structuring of the corporation's year end can result in a one year deferral of tax. For example, a business incorporated in September may choose a year end of January 15. This would result in no 1996 corporate tax liability and a low 1997 tax bill due to the fact that the first fiscal year is only 3 months long.

One point to consider in the structuring of a corporation's year end is the ability to also achieve a one year deferral of tax on part of the owner/manager's salary. This is using the 180 day accrual period on payment of bonuses as we discussed earlier. Remember that to achieve this tax deferral the corporate year end would have to be after July 4. Ideally then, a business incorporated today should choose a year end of July 5 in order to maximize tax deferral possibilities. This is because a July 5 year end would result in no 1996 tax liability. Second, the owner/manager could declare a bonus at the end of the fiscal year which would be deductible on the company's 1997 tax return but which can be paid January 2,1998. The company would be required to make the necessary source deduction withholdings on the payment of this salary.

Clients should always be careful to consider non-tax factors as well when choosing a corporate year end. A year end which is desirable for tax purposes may well be undesirable for other reasons such as the fact that it falls in a particularly busy period for the business when it is not convenient to close the books and prepare financial statements. Note that it is not possible to change a year end without the approval of Revenue Canada and such approval will not be granted where the sole purpose is tax planning.

6. Scientific Research Incentives

- If the business is incorporated and has certain activities that may be considered research and development activities, various tax incentives are available to it which would not be available to an unincorporated business. For example, the investment tax credit for qualifying Canadian-controlled private corporations incurring scientific research expenditures is 35%, versus 20 - 30% for individuals. In addition to a higher rate of credit for corporations, credits earned by a corporation may be refunded in cash at a higher rate than to individuals. A Canadian controlled private corporation whose income did not exceed $200,000 in the previous year can claim a 100% cash refund of investment tax credits earned at a rate of 35% for up to $2 million of scientific research expenditures made in the year. Individuals are limited to cash refunds of only 40% of the 20 - 30% rate of tax credits.

7. Income Splitting and Estate Planning

- In order to show how a corporate structure aids an income split, let's look at an example where the client is currently operating a profitable business on a proprietorship level. The client is a resident of a province which levies tax at a 56% rate and does not have a provincial corporate tax holiday.

Facts:

1. Annual income of business is $130,000.
2. Client's wife earns a reasonable salary of $20,000 from the business.
3. Client and wife maximize RRSP contributions.
4. 1996 tax rates are in effect.

Before illustrating the tax effects if the client's business were incorporated, note that the process of incorporating the business is not too complex but will require the services of a lawyer to obtain the corporate charter and an accountant to properly transfer the business assets into the corporation. The assets can be transferred to the corporation on a tax-free basis under Section 85(l) of the Income Tax Act provided the values established for the assets fall at some point between cost and fair market value. In exchange for the net assets (the corporation will also assume the liabilities of the proprietorship), the client will take back preferred shares of the corporation. Client and his wife are issued common shares at a nominal price in the desired proportion (we'll use 50-50 in the example). Now let's look at the tax treatment using the same facts as the previous example.

Further assumptions:

1. Corporate tax rate is 23.12% (includes 4% surtax) on income which qualifies for the Small Business Deduction.
2. Client and spouse will maximize RRSP contributions on their own behalf (assuming 1995 earned income is the same as 1996).

Now let's compare client's after-tax position prior to and after incorporation:

As you can see, clients are "better off" by over $2,500 each year as a result of incorporation of the business which allowed a better income split between spouses. Also, clients will enjoy all of the previously mentioned benefits of incorporation. Before moving on, a couple of notes regarding the choice of salary/dividend mix in the example above. Because clients are not resident in a province with a corporate tax holiday there is no tax benefit of taking a mix of salary and dividends. Why do it then? The reason is that Revenue Canada may attack the spouse's salary as being unreasonable. Therefore, a reasonable salary of $20,000 is paid which allows reasonable contributions to RRSP and CPP. Why not pay the husband a large salary and small or no dividend then? This is due to the fact that husband and wife both own 50% of the shares and therefore must receive an equal amount of dividends. The mix chosen in the example was based on these factors plus the clients' cash requirements. Of course, clients could also structure the company with disproportionate shareholdings or issue different classes of common and preferred shares in order to minimize dividend payouts. The purpose of this section is only to demonstrate the process of splitting business income through incorporation.

Also, it is not uncommon that problems arise where shareholders of a CCPC have different cash requirements from the company. Suppose two brothers A and B are equal shareholders of X Ltd. A requires $50,000 cash annually but B only requires $25,000. There is a very simple way of keeping both shareholders satisfied. Both shareholders can form holding companies by transferring their shares of X Ltd. into holding companies under Section 85(l) of the Income Tax Act as discussed earlier. Now A Ltd. and B Ltd. each own 50% of the shares of X Ltd. with A and B each owning 100% of their respective holding companies. X Ltd. will pay an annual dividend of $100,000 to its shareholders, A Ltd. and B Ltd. Note that no Part IV tax applies on dividend payments to companies which control the payor corporation unless the dividend payment triggers a repayment of refundable tax to the payor. Therefore A Ltd. and B Ltd. will each receive $50,000. A can then declare a dividend of the full amount to himself and pay the appropriate tax. B will declare a dividend of $25,000 to himself from B Ltd. and the balance of the cash can be invested by the holding company, or loaned back to X Ltd.

The income splitting example between spouses shown above was based on the fact that both spouses were active in the business. Incorporation, however, offers other income splitting and estate planning opportunities - particularly where family members are not employed in the business.

A common technique employed in estate planning is the "estate freeze". The objective is to rearrange your asset holdings so that future increases in their value will accrue to the benefit of your heirs and thus eliminate or reduce taxation on your death. This technique can more readily be applied to an incorporated business than to a proprietorship or partnership interest.

Let's have a look at two methods of effecting an estate freeze for shares of a company. The first and simplest method of effecting a freeze is a share reorganization under Section 86 of the Tax Act.

In this example, Mr. A owns 100% of the common shares of A Co. Under Section 86, Mr. A will exchange his common shares for preferred shares of the company. In order to ensure that future growth in the value of the company is passed on to family members, it is important to ensure that the value of the preferred shares are fixed at an amount equal to the old common shares. Revenue Canada has taken the position that if the preferred shares are redeemable at the option of the corporation and retractable at the option of the shareholder, then they will have a value equal to their redemption price, regardless of the fact that the shares may not carry the right to vote or be paid dividends.

There are no tax consequences of this share exchange as the preferreds will have a redemption value fixed at the current fair market value of the old common shares. The ACB of the preferreds will also be equal to the ACB of the old common shares. Thus, if the common shares had an ACB of $100,000 and a FMV of $1 million, the new preferreds would have the same ACB of $100,000 and a redemption value of $1 million. If Mr. A's common shares were considered to be qualified shares for purposes of the $500,000 capital gains exemption, he could elect an ACB higher than the ACB of the old common shares thereby triggering a capital gain equal to the difference between the elected ACB of the preferreds and the ACB of the common shares.

Once Mr. A has exchanged his common shares for preferreds, the company now issues new common shares at nominal value (of say, $1 each) to Mr. A, his spouse and/or children. Mr. A would only purchase new common shares if he wished to effect only a partial estate freeze. If he wished to effect a complete freeze, the new common shares would only be issued to Mr. A's spouse and/or children. Since the redemption value of Mr. A's preferreds is equal to the fair market value of his old common shares, the fact that the new common shares are issued at a nominal price is of no tax consequence since they also have nominal value. The new common shares will, however, soak up any future increases in the value of A Co. since the preferreds remain fixed in value.

Estate Freeze

Section 86

Before:

Mr. A

After:

Preferred shares must be equal in value to former common;

If greater: taxable benefit > Use price adjustment clause

If less: capital gain > Use price adjustment clause

If Mr. A wished to effect a complete estate freeze by not subscribing to any of the new common shares but also wished to maintain some influence over the future growth of the value of the shares, he may instead create a family trust to purchase the shares. The family trust could be drafted in such a manner that no beneficiary has a fixed entitlement to any income or capital of the trust during Mr A's lifetime, so that the trustees of the trust could determine in each year which of the beneficiaries would receive income in that year and to what extent. Note also that if any of the subscribers of the new common shares are minors, creation of a family trust should be considered to retain control of the shares.

Once the Section 86 reorganization is complete, Mr. A holds preferred shares which are fixed in value and his family holds the common shares to which future increases in the value of the company will accrue. This provides 2 major benefits:

First, dividends may be "sprinkled" among family members in order to income split, and

Second, future increases in the value of the company may be exempt from tax via the $500,000 capital gains exemption available to each family member. With regard to the first benefit of dividend sprinkling, note that the attribution rules will not apply provided the company meets the definition of a "small business corporation". Essentially, this means that 90% or more of the assets of the company must be used in an active business carried on in Canada.

A couple of final points regarding the Section 86 share reorganization.

• the shareholder must convert all, not just some of his common shares into preferred shares
• the shareholder must be careful that the redemption value of the preferred shares does not exceed the fair market value of the common shares he is exchanging. If this happens, the excess will be taxed to him as a taxable benefit. Similarly, if the preferreds have a lower value than the commons, a capital gain will result. As stated earlier, a capital gain may be triggered intentionally in order to utilize the individual's $500,000 capital gains exemption. In any event, it is often difficult to accurately place a value on the common shares of a private corporation which means that Revenue Canada may later challenge the elected value. It is important to avoid this since a change in the value could trigger an unwanted capital gain or taxable benefit. In order to deal with this problem, it is recommended that a price adjustment clause be inserted into the articles of amendment. A price adjustment clause simply allows for a retroactive change to the elected values of the common and preferred shares if Revenue Canada challenges the values arrived at by the shareholder.

Next let's look at an estate freeze effected under Section 85 of the Tax Act. A Section 85 freeze is a little more complicated than a Section 86 freeze since it involves the creation of a separate holding company.

Once again, we have the situation where Mr. A owns 100% of the common shares of A Co. Mr. A then creates B Co. and common shares are issued to Mr. A, his spouse, children and/or a family trust. The shares of B Co. are issued at a nominal value since the company has no assets.

In the second step of the freeze, Mr. A sells his common shares of A Co. to B Co. in exchange for fixed value preferred shares. As with the Section 86 reorganization, Mr. A can exchange his common shares in A Co. for preferred shares of B Co. at the ACB of the common shares, thereby resulting in no immediate capital gain. Alternatively, he may trigger a gain by electing an exchange value which is higher than the ACB of the common shares. Also, as with a Section 86 reorganization, it is important to insert a price adjustment clause into the articles of amendment in case Revenue Canada later challenges the elected values of the shares.

After the holding company has been set up we see that is only asset is the shares of A Co. The preferred shares of the holding company are held by Mr. A while his family hold the common shares. Income earned by A Co. may be flowed to B Co. via a tax free intercorporate dividend and then paid out to the common shareholders (or to the preferred shares if Mr. A wants income). Once again, the attribution rules do not apply to the dividends paid to family members provided A Co. meets the definition of a small business corporation.

Again, any increases in the value of A Co. will be reflected in increased value of the common shares of B Co., thereby allowing each family member to utilize his/her capital gains exemption on a future disposition of the shares of B Co.

Estate Freeze

Section 85

Mr. A. sells his common shares in A. Company to B. Company in exchange for fixed-value preferred shares in B Company.

Taxation Of Corporate Investment Income

The federal corporate tax rate for income earned in Canada is 38% and is called Part I tax. An additional 6^2/3% tax is added if the income is earned on investments. From this, a federal tax abatement of 10% is deducted on income earned in a province. While provincial corporate tax rates vary from province to province, the idea of the federal abatement is to offset provincial taxes payable. Thus, the federal corporate tax rate is 34^2/3% and about 50% combined federal/provincial depending on the province in question. It should be noted that a provincial tax rate of 15% is necessary to achieve a combined federal/provincial corporate tax rate of 50%. Currently, provincial tax rates on investment income under Part I vary between 14 and 17% depending on the province.

Corporate investment income is normally confined to three forms: interest, dividends and capital gains. Because the tax treatment for all three forms of investment income is somewhat different, we'll look at each separately.

1. Interest

- taxed under Part I at approximately 50%. There is, however, a mechanism built into the corporate tax system which provides for a partial refund of federal tax paid when the interest income is passed on to shareholders by way of dividends from the corporation. This is called Refundable Portion of Part I tax and amounts to 26^2/3% of taxable investment income. To illustrate, assume that a corporation which pays 15% provincial tax for a combined rate of 50%, earns $10,000 interest income.

The $2,667 of refundable Part I tax is recorded in an account called Refundable Dividend Tax on Hand (RDTOH). The account is an ongoing record of refundable taxes on hand with Revenue Canada. Whenever the corporation pays a taxable dividend to its shareholders it is entitled to a refund from Revenue Canada of a portion of its RDTOH. For every $1 in RDTOH, it takes a taxable dividend of $3 to shareholders to have the $1 refunded.

Thus, in order to get a full refund of the refundable tax in this example, a dividend of $8,000 would be required to be paid to shareholders. Let's follow through with the tax treatment of the $8,000 dividend after the shareholder receives it. Assume that the shareholder is also in about a 50% marginal tax bracket. This would be the top marginal rate in most provinces when federal and provincial surtaxes are accounted for.

This brings us to a very important point - it doesn't make any difference in terms of taxes payable, whether investment income is earned by a corporation or by the corporate shareholder personally. The corporation is simply a conduit through which the investment income flows. Some tax is paid at the corporate level because interest income is being converted to dividends as the shareholder receives the income. The tax paid by the corporation compensates for the fact that the dividends received by the shareholder qualify for preferential tax treatment due to the application of the Dividend Tax Credit. To illustrate using the figures from above:

It is not significant that a 50% marginal tax bracket is used for the shareholder in any of the examples used in this section. Try working through the example using any marginal rate you wish and you will find that the result is the same. That is, it does not matter whether income is earned by the corporation or by the shareholder personally.

2. Capital Gains

- taxed in the same manner as interest except that only three-quarters of the capital gain is taxable. The other quarter is included in what is termed the Capital Dividend Account and can be passed on to shareholders as a tax-free dividend. Using the same figures as above, here is an illustration of the tax on a $10,000 capital gain earned by a corporation.

Dividend to shareholder will be $8,250 of which $2,500, representing the non-taxable portion of the capital gain, is not taxable. Tax at the personal level will be:

To illustrate the conduit effect of the corporation with regard to capital gains:

In addition to demonstrating that a person is indifferent as to whether he earns interest and/or capital gains through a corporation or personally, note that the after-tax returns show that an equal amount of capital gain allows a 25% higher after-tax return than interest ($6,250 vs. $5,000). It follows that a person must earn a rate of interest 1.25 times higher than his anticipated capital gain in order to receive an equal after-tax return. Note that this 1.25 - 1 ratio only applies at the top federal tax bracket of 29%. At the 17% and 26% federal rates, the ratio is less than 1.25 - 1.

3. Dividends

- are not subject to Part I tax, but instead are taxed in the corporation under Part IV at a rate of 33 ^1/3% of the amount of the dividend. The amount of Part IV tax paid is recorded in the Refundable Dividend Tax on Hand account along with the amount of Refundable Portion of Part I tax arising from taxes on interest or taxable capital gains.

In order to encourage corporations to distribute dividends received to shareholders, the full amount of Part IV tax is refundable as soon as the dividend income is distributed in full. This effectively means that if a corporation receives dividends in a year and distributes them to shareholders in the same fiscal period, the income is flowed through at no cost to the corporation. It is obvious that the conduit principle applies to dividends as the only tax cost on such income is the tax paid personally by the shareholder. Here is an example to illustrate this point.

Shareholder would receive the $10,000 dividend whether from the corporation or if he had invested personally.

A person must earn a rate of interest 1.25 times higher than anticipated dividend return in order to receive an equal after-tax return ($6,250 vs. $5,000). This ratio applies at any tax rate. One final note with regard to the taxation of dividends earned at the corporate level. As noted earlier, dividends received from controlled corporations are not subject to Part IV tax in most cases. Therefore, if Mr. A owned shares in a holding company, which in turn held shares in an operating company, any dividends paid by Opco to Holdco would not be subject to tax in Holdco. Mr. A would simply pay tax at the personal level when he receives a dividend from Holdco. This tax treatment is very important in estate planning as we will see later.

While this section of the chapter is intended to demonstrate how investment income is taxed at the corporate level, the integration of corporate and personal tax on such income is of vital importance. Often you will encounter a client who is investing through a holding company or has cash balances in an operating company which are available for investment. The above illustrations of the conduit effect of the corporate entity should emphasize that the tax effect of investing at the corporate level is not different from the tax effect of investing personally. Therefore, when a client tells you that he wants to purchase an investment in the name of his company and flow the income to himself, your recommendations as to choice of portfolio should be exactly the same as if the client were giving you the funds as an individual. The intent of the corporate tax rules relating to investment income is to make the taxpayer indifferent as to whether the investment is in his name or his company's.

Before going on to briefly look at how other forms of corporate income are taxed, recall that the examples of the tax on each form of corporate investment income used an assumed income of $10,000 on capital invested. As you are well aware, the real world rarely presents a situation where rates of return on capital gains, interest and dividends are all the same. We saw that interest returns must be 1.25 times higher than capital gain returns and 1.25 times higher than dividend returns in order to provide an equal after-tax return. To conclude the section, here is a summary chart of the material just covered, showing that, as with individuals, corporations must earn 1.25 times interest to provide the same after tax return as dividends or capital gains.

This completes our review of the taxation of corporate investment income. We will now shift the focus to the taxation of various other types of business income. The following section may seem somewhat complex and not overly important to the success of your franchise, but it can be of great benefit in dealing with clients who are involved with their own corporations if you have at least a general knowledge as to how corporate earnings are taxed. If you are comfortable in dealing with corporate clientele, you possess a key to a vast potential source of further sales.

Let's proceed.

Taxation Of Corporate Earnings Of A Canadian Controlled Private Corporation (CCPC)

In the section dealing with the taxation of corporate investment income you will recall that the combined federal/provincial corporate tax rate is about 50% depending upon the province in which the corporation resides. This rate includes a 6^2/3% tax if income is earned from investments so the corporate tax rate on non-investment income is about 44% assuming a provincial corporate tax rate of 15% plus corporate surtax. Remember - the federal corporate tax rate after the 10% abatement is 28%. A significant deduction from this rate is available, subject to certain limitations, against federal tax otherwise payable on active business income. This deduction is called the Small Business Deduction (S.B.D.), and is currently set at 16%. Active business carried on by a corporation means the business of manufacturing or processing property for sale or lease, mining, operating an oil or gas well, prospecting, exploring or drilling for natural resources, construction, logging, farming, fishing, selling property as a principal, transportation or any other business carried on by the corporation other than a specified investment business, or a personal services business. We'll get back to these shortly. For now, be aware that active business income will qualify for the S.B.D. which is 16% of the least of:

1. Canadian active business income net of losses from Canadian active businesses;
2. Taxable income less 10/4 of the foreign tax credit on foreign investment income and two times the foreign tax credit claimed on foreign business income;
3. The corporation's annual business limit (currently $200,000).

An explanatory note before proceeding. The annual business limit available to corporations must be allocated among associated corporations. Corporations are considered to be associated if they are controlled by the same person or related group of persons.

The SBD is also reduced for certain large private corporations. A large corporation is one whose capital exceeds $10.0 million. Consequently, where taxable capital employed in Canada by a private corporation (or a group of associated corporations) during the preceding taxation year is above $10.0 million, the SBD is gradually reduced and completely eliminated when taxable capital reaches $15.0 million. The calculation of the reduction is complex and is tied into the calculation of the large corporation capital tax of the corporation. We will not be discussing the reduction in the SBD on the large corporation capital tax in this chapter.

We can now see that a CCPC which earns income qualifying for the SBD will have a federal tax rate of 12% and a combined rate of about 23% depending upon which province or provinces are applicable. Let's go through a simple example of a CCPC which has $250,000 taxable income in a year, all of which is considered active business income. The applicable rate of provincial tax is 11% on income which qualifies for the SBD and 17% on income which does not qualify for the SBD.

The least amount is $200,000, so 16% x $200,000 = $32,000

Note that this example has ignored corporate surtax.

So far, it's easy!!

I noted above that an exclusion from active business income is provided for a specified investment business and personal services business. This effectively means that although a business may be carried on by a corporation, the 16% S.B.D. on active business income will not apply to the above-mentioned two types of businesses. Thus, it is important to be able to determine whether income is derived from either of the two types of business and how such income will be taxed.

1. A specified shareholder is any person who owns 10% or more of shares of any class of a personal services corporation.
2. Specified investment business means a business the principal purpose of which is to derive income from property (including interest, dividends, rents or royalties), unless:
   1. the corporation employs in the business throughout the year more than five full-time employees, or
   2. in the course of carrying on an active business, any other corporation associated with it provides managerial, administrative, financial, maintenance or other similar services to the corporation could reasonably be expected to require more than five full-time employees if those services had not been provided.

A specified investment business is not entitled to claim the S.B.D.

3. A personal services business is, by definition, a corporation created to carry on employment duties previously performed by a specified shareholder of such corporation, or by a person related to such specified shareholder.

Where a personal services business exists, no Small Business Deduction is allowed. However, if the corporation employs in the business through the year at least six full-time employees, the business will not be characterized as a personal services business. The idea of the personal services business concept is to prevent incorporated employees from qualifying for the S.B.D. as was possible prior to November 12, 1981. The income from a personal services business will be subject to the full corporate tax rate of approximately 45% and it will be disadvantageous to earn such income through a corporation since the after-tax income of the corporation when distributed as dividends will be subject to additional tax to the shareholder.

Here is a comparative illustration where a person earns $60,000 through a personal services corporation as opposed to earning the income as an individual.

It is important to note that the carrying on of a personal services business by a corporation does not taint any income derived by the corporation from carrying on active business. The only result is that the income from the personal services business does not qualify for any S.B.D.

That essentially covers the Small Business Deduction, however, this discussion would not be complete without a brief reference to the manufacturing and processing profits deduction (M & P). This is a deduction available to corporations that carry on an active business in Canada and derive 10% or more of their gross revenue from the sale or lease of goods manufactured or processed in Canada. The calculation of M & P profits can be very complex and we won't bother with it. After the amount eligible has been determined, the M & P profits deduction is equal to 7% of the profits not qualifying for the S.B.D. and nothing on profits which do qualify for the S.B.D. The credit effectively reduces the combined corporate rate to approximately 38% for corporations whose M & P profits do not qualify for the S.B.D.

There are further deductions available to corporations in Canada such as the foreign tax deduction and the logging tax deduction, but since these are not commonly encountered, I will not discuss them further. Better you don't fall asleep before we get to more relevant material.

Let's now go through an example of calculating corporate tax where the corporation has both business income and investment income.

Assume the following:

1. Corporation X has income in 1996 of $277,000 comprised of

2. Applicable rate of provincial tax is 11% on income which qualifies for the small business deduction and 17% on income which does not qualify.

3. No dividends paid to shareholders during the year.

The first step is to determine X Ltd.'s taxable income. Income is $277,000 less the $6,000 non-taxable portion of capital gains less dividends of $18,000 (which you will recall, are not subject to tax under Part I).

Taxable income is therefore $253,000 on which tax would be:

If dividends were paid to shareholders, the amount of the dividend refund is the lesser of 33^1/3% of the dividends paid or the balance of the Refundable Dividend Tax on Hand Account at the end of the fiscal year. Thus, if in our example above, a dividend of $24,000 were paid to shareholders during the fiscal year, the dividend refund would be $8,000 which is the lesser of the payment from the two pools and the year end balance in the RDTOH account of $14,268.

In the example above, we arrived at tax payable of $79,212. There is a fairly simple way to check whether the calculation is correct. We know that the first $200,000 of active business income was taxed at a rate of 23%, calculated as follows:

We know that active income in excess of $200,00 is $22,000. This income does not qualify for the 16% small business deduction and is taxed at a 16% provincial rate. Because the income qualifies as from manufacturing and processing, the 7% M & P credit may be claimed. Thus, the $22,000 is taxed at a rate of 38% calculated as follows:

Next we have $31,000 of investment income ($13,000 of interest and $18,000 taxable capital gain) which is taxed at a 51^2/3% rate calculated as follows:

Next, we add federal surtax which is 4% of federal tax calculated after the provincial tax abatement, but before any other credits and deductions. Therefore ($96,140-$25,300) x 4% = $2,834.

Finally, we have $18,000 of dividend income which is taxed under Part IV at a rate of 33^1/3%. There is no provincial tax applied to dividend income. Part IV tax is then calculated as 33^1/3% x $18,000 = $6,000.

Total tax is $79,212 and we know that our calculation is correct. The key to the calculation of corporate tax liability is to separate each type of income earned and then apply the appropriate rate of tax. Practice with a few examples and you'll find that it's pretty simple.

One final note before we move on. In the example of Corporation X, we started the calculation of tax liability with a couple of adjustments in order to determine taxable income. We had to deduct from income the non-taxable portion of capital gains and the dividends received by the company as both of these items are not subject to tax under Part I. Dividends are taxed under Part IV and the non-taxable portion of the capital gain is recorded in an account called the Capital Dividend Account. Any balance in this account may be distributed to shareholders as a non-taxable dividend under Sec. 83 (2) of the Act. Other adjustments may often be necessary to adjust net income of a corporation in order to arrive at income for tax purposes. A common example is that depreciation is a deduction for accounting purposes but is not allowed as a deduction for tax purposes. Corporations are entitled to claim capital cost allowance (CCA) at prescribed rates. Thus, if net income of a company includes a charge for depreciation, this amount must be added back to net income and the appropriate CCA claim deducted. The key is to remember that some items which are income or deductions for accounting purposes may not be income or deductions for tax purposes.

Income To Shareholders

Now that you understand how corporate income is taxed, let's now shift our attention to how the after-tax income is flowed out of the corporation to its shareholders.

Since a corporation is legally a separate "person", you must follow one of the methods shown below to remove funds from a corporation:

• dividends
• salary
• repayment of shareholder loans
• capital dividends
• repayment of capital
• loan to shareholder
• deemed dividends

Let's look at each method in turn.

1 Dividends

Dividends are the repayment of a corporation's profit to its shareholders. They are not deductible to the company. When dividends are received by shareholders of the company they are grossed up by 25% and eligible for the dividend tax credit just the same as dividends earned from investments. If the corporation earns income, pays tax on it and pays out the after tax proceeds as a dividend, the combined corporate and personal tax will be the same as if you had earned the income directly. This is the concept of the integration of the personal and corporate tax systems. As we noted earlier, where there is a situation where a provincial corporate tax holiday exists, integration will not be present since the corporate tax rate will be below 20%. In this case, the optimum tax position will be a blend of salary and dividend remuneration with an emphasis on dividends. For example, we'll look at a shareholder/manager resident in Nova Scotia who requires $45,000 of after tax income in 1996 in order to meet his living expenses. We'll assume that client's corporation qualifies for the provincial corporate tax holiday and that the company's income qualifies for the small business deduction. Therefore corporate tax will be levied at a rate of 13.12% (includes surtax) federal and 0% provincial. Client is entitled to claim the full married credit.

To retain $45,000 on an after tax basis, the client would have to draw a salary of $65,000. To illustrate:

Note that I have ignored CPP contributions in the calculations.

The $65,000 salary less $20,148 leaves client with $44,852 after tax.

If client were to receive his remuneration as a dividend rather than salary, he would require a cash dividend of only $50,500 in order to retain about $45,000 after tax. To illustrate:

The $50,500 dividend less $5,587 leaves client with about $45,000 after- tax and also has allowed the corporation to retain more money than if it had paid $65,000 in salary. Because the payment of salary is tax deductible to a corporation whereas the payment of dividends is not, the company will incur an increase in taxes of $65,000 x 13.12% or $8,528 as a result of paying dividends versus salary. After paying $50,500 as dividends and $8,528 in extra taxes, the corporation has still saved $5,972 as opposed to paying a salary of $65,000. On the downside, the dividend received by the shareholder is not considered earned income for purposes of contributing to RRSP nor is it eligible for CPP contributions. These factors may not be of concern, however, as provincial corporate tax holidays normally apply only to the first 2 or 3 years of incorporation. This being the case, the shareholder could choose to receive his/her remuneration in the form of dividends while the tax holiday is in effect and then switch to salary. For details on provincial corporate tax holidays refer to the tax section of your Information Manual.

A couple final notes regarding the payment of dividends.

First, dividends are not considered non-preference income for purposes of calculating tax liability under the Alternative Minimum Tax System. We won't go into detail on this since the subject is well covered in Chapter 2 of the Tax Library. Be aware, however, that where an owner/manager is facing an AMT liability in the year as a result of a large exempt capital gain for example, that taking remuneration in the form of salary is preferred versus dividends.

Second, for purposes of the Cumulative Net Investment Loss or CNIL rules, dividends are credited to the individual's CNIL account whereas salary is not. Thus, where the owner is about to realize a capital gain on the disposition of qualified small business corporation shares or qualified farm property and some or all of his exemption will be precluded because he has a CNIL balance, remuneration via dividends should be considered to reduce the CNIL account and thereby allow some or all of the capital gain to be sheltered by the exemption.

2. Salary

Where the corporation pays a salary, the amount paid is deductible to the company and taxable to the owner/manager as employment income. In order for a salary to be deductible to the company, it must be reasonable given the activities of the employee in the business. Thus, a salary could not be paid to the owner of a holding company whose only assets were investments such as mutual funds or term deposits. In this case there is no activity on the part of the shareholder which could justify a salary. In the case of an owner/manager of a company which generates active business income, it is the general position of Revenue Canada that a high salary is not unreasonable, even to the extent that the salary paid exceeds the net profit of the company in the year. A corporation may have low income or even a loss year but this does not mean that the activities of the owner/manager did not justify a high salary. Besides, Revenue Canada will collect personal taxes on the amount of salary taken.

As mentioned earlier, the owner/manager may take a base salary supplemented by a year-end bonus. If the corporate year end is between July 4 and December 31, a one year tax deferral can be achieved by accruing the bonus in the current year and paying it to the owner/manager in the following calendar year.

Generally, an owner/manager is motivated to take his remuneration in the form of a salary rather than a dividend. As we saw above, the exception to this rule of thumb is where the marginal tax rate of the corporation is below 20% - a situation that occurs where there is a provincial corporate tax holiday for the first 2 or 3 years of operation of a company located in Quebec, Nova Scotia and Manitoba. Also, dividends may be considered where the owner/manager wishes to reduce his CNIL balance. In all other cases salary alone is preferable - remembering that to be paid a salary, the employee must be actively involved in the company. There are 4 major reasons why salary is preferred over dividends:

First, salary is earned income for purposes of making RRSP or pension plan contributions.

Second, salary is earned income for purposes of qualifying for CPP/QPP retirement benefits.

Third, salary is necessary in order to receive a retiring allowance when the owner/manager ceases to be actively involved with the company. Remember the Revenue Canada criteria that a retiring allowance must be reasonable in amount and that "reasonable" is defined as an amount not to exceed 2 1/2 times salary in the 5 years previous to retirement.

Fourth, as we discussed earlier, salary is preferred over dividends in reducing the impact of Alternative Minimum Tax if AMT is going to be a factor in a given year.

Finally, salaries and bonuses also have an important impact on the calculation of the corporation's Small Business Deduction.

To illustrate, consider a corporation with active business income of $230,000 and a provincial tax rate of 10% on income which qualifies for the S.B.D. and 14% on income which does not qualify.

The decision to pay a $30,000 bonus allowed $12,600 more to be distributed to shareholders.

3. Repayment of Shareholder Loans

If you lend funds to the of capital is neither deductible to the corporation nor taxable to the owner/manager. The reason the repayment is not taxable is because the owner/manager has loaned money on which he corporation, the company can repay any amount of the loan at any time without tax consequences. Such a repayment has already paid personal tax at the time of receipt.

As an alternative, the owner/manager may arrange to have the company pay interest on the loan. There is no requirement that interest be charged but there will be a tax advantage if the corporation is taxed at a higher rate than the owner/manager. This is because the payment of interest on the loan will be tax deductible to the company. If interest is paid by the company, ensure that a formal loan document is drawn as there is a danger that Revenue Canada will disallow the deduction to the company on the basis that the interest was not paid pursuant to a legal obligation to do so.

While charging interest is obvious where the corporation is taxed at a higher rate than the owner/manager, there is another situation where the owner/manager may charge interest on a loan to his company even where the company is not taxed at a higher rate. This is where the owner/manager has a Cumulative Net Investment Loss (CNIL) balance which will reduce or eliminate his $500,000 capital gains exemption on a future disposition of qualified property. As you are aware, interest income will reduce the CNIL balance and help to alleviate the problem. Once again, even though the owner/manager must pay tax on the interest charged, his company will be entitled to a deduction for the amount paid.

4. Capital Dividends

As noted earlier, every company has what is called the Capital Dividend Account. This is a notional account in which is recorded the amount of the non-taxable quarter of capital gains realized by the company plus any proceeds received where a shareholder or employee who is covered by corporate owned insurance dies. Both of these items are amounts which if received by an individual would not be taxable. To ensure integration exists between the personal and corporate tax systems, dividends paid from the Capital Dividend Account are not taxable. To illustrate, if a corporation sells a property and realizes a capital gain of $120,000, the company is taxed on 3/4 of the gain or $90,000. The remaining non-taxable gain of $30,000 is recorded in the Capital Dividend Account and may be paid out as a tax free dividend to the owner/manager at any time. This tax treatment is the same as if the owner/manager had earned a $120,000 capital gain personally. He would report 3/4 of the gain or $90,000 on his personal tax return and the other $30,000 would not be taxed. Note that like all dividends paid by a corporation, a capital dividend is not tax deductible to the company.

5. Repayment of Capital

Any amount which is less than the corporation's "paid-up capital" may be paid out to the shareholders as a repayment of capital with no tax consequences. Paid-up capital for tax purposes means essentially the amount of capital contributed to the corporation in exchange for its shares.

For example, ABC Corp. was originally capitalized with $50,000 by the owner/manager in exchange for 1,000 common shares of the company. The owner/manager can, at any point in the future, withdraw up to $50,000 with no tax consequence as long as the paid-up capital amount is reduced by the amount withdrawn. If the owner/manager withdrew $30,000 from the company, ABC would simply be in a position where the 1,000 shares now have a paid-up capital of $20,000. The repayment of capital to the owner/manager is of course not tax deductible to the company.

All of the mechanisms we have looked at so far - dividend, salary, repayment of a loan, capital dividend and repayment of capital - are legitimate ways for the owner/manager to extract funds from the company. We'll now turn to some of the rules designed to prevent the extraction of funds without following the normal routes.

6. Loan To Shareholders

Suppose that company simply makes a loan to the owner/manager? If certain conditions are not met, the entire amount of the loan will be included in the owner/manager's income. This is a very serious penalty, because the company received no deduction for the amount of the loan even though the owner/manager has paid tax on the amount. (However, where a loan has been included in income and is subsequently repaid, a deduction is permitted for the amount of the repayment). To avoid this negative tax treatment, the loan must fall into one of the following two exceptions:

a) the loan involves bona fide arrangement for re-payment within a reasonable time and is for the purpose of one of the following:

• the purchase of a home as principal residence
• the purchase of company stock
• the purchase of a car for business use

OR

b) the loan is repaid within one year of the end of the company's fiscal year in which the loan was made. Note that this exception will not apply where the loan is part of a series of loans and repayments.

If the loan falls into one of the 2 exceptions but is made at no interest or a low rate of interest, the owner/manager will be considered to be receiving a taxable benefit from the company based on the difference between Revenue Canada's prescribed interest rate and the rate actually being paid. For example, if the owner/manager took a loan for $100,000 from his company at no interest and repaid the loan within one year of the end of the company's fiscal year, he would have a taxable benefit of $9,000 (assuming that the prescribed rate at the time the loan was taken is 9%). Note that if the loan is used to generate income from business or property (for example, to invest in stocks or mutual funds), the amount included in income as a taxable benefit is considered loan interest and is therefore tax deductible. Thus, the loan would effectively be tax free since the notional interest deducted offsets the taxable benefit.

One final point in this area. We noted that the taxable benefit is based on the difference between the interest rate charged on the loan and the Revenue Canada prescribed rate. The prescribed rate is adjusted by Revenue Canada every quarter so if the rate goes up in future so does the amount of the taxable benefit. Similarly, if the prescribed rate goes down, so does the amount of the benefit. There is, however, preferential tax treatment regarding the taxable benefit where the purpose of the loan is to acquire a home. In this case, the prescribed rate at the time the loan is taken becomes a ceiling for purposes of calculating the benefit. Thus, if the prescribed rate rises during the term of the loan, the taxable benefit will remain the same but if the prescribed rate falls, so will the amount of the benefit.

7. Deemed Dividends

Certain types of actions that involve changes to a corporation's capital structure will cause the owner/manager to be deemed to have received a dividend from the company. Generally, this is done when the corporation takes actions which would otherwise allow you to extract funds as a repayment of capital.

For example, if the corporation redeems shares held by the owner/manager, any amount paid by the company in excess of the paid-up capital of the shares is deemed to be a dividend - not a sale which would result in a capital gain.

We have covered all of the normal methods of extracting funds from a corporation. Suppose the owner/manager doesn't follow any of the legalities and simply takes money out of the company's bank account and places it in his own without declaring a dividend? In such cases, the Income Tax Act deems that any benefit the corporation confers on a shareholder will be added to his income with no deduction to the company and no dividend tax credit to the shareholder.

Clearly, it is to the advantage of the owner/manager to follow the more conventional methods we have covered in order to extract funds from the company.

Now that we have covered the methods used to remove money from the company, let's turn our attention to the subject of shareholders' agreements.

Shareholders' Agreements

Where you share ownership of a private corporation, it is usually wise to have a shareholders' agreement. Such an agreement can set out rights and obligations of the shareholders that go beyond the basic ownership of shares.

Typically, a shareholders' agreement will provide for the orderly termination of the relationship between the shareholders if there is a future disagreement, or death or disability of one of the key shareholders.

For example:

Bob and Al start a small manufacturing business together. Each owns 50% of the shares of the corporation. Over the years the business becomes very successful but Bob and Al cannot get along and agree that one of them must leave.

Bob and Al signed a shareholders' agreement which contained a "shotgun" clause. Bob now offers Al $500,000 for Al's shares of the company. The shotgun clause means that if Al refuses to sell, the agreement provides that Al must buy Bob's shares for the price Bob offered - $500,000.

The shotgun clause is just one example of a provision which can resolve major disputes between key shareholders. Typical provisions in a shareholders' agreement deal with:

• the desire of a shareholder to sell his or her shares
• possible dissension among shareholders
• death or disability of a shareholder
• agreement as to who the directors and/or officers of the corporation will be
• agreement to vote the shares in a particular way on certain issues
• what will happen if the company's shares are awarded to a shareholder's spouse on separation or divorce

Typically, shareholders' agreements are funded with insurance in order to ensure that cash is available if one of the provisions in the agreement arises. If the provision relates to death, normal life insurance will be used. Because of the large amounts which are commonly involved and the fact that death may occur after the expiration of a term policy, permanent insurance such as whole life or term to 100 is normally utilized. If the provision of the agreement relates to an event such as retirement, an endowment policy will be used. In any event, the fact that permanent or endowment policies are usually required to fund shareholders' agreements means that the area should be of great interest to you as financial planners. The financial reward to you for properly funding a shareholders' agreement can be significant.

Tax considerations play a major part of planning for shareholder agreements. The tax treatment of life insurance receipts, the availability of the $500,000 capital gains exemption, the valuation of the shares, and many other issues must be considered. Your job is to recognize when an agreement is desirable, explain the features and benefits and then direct your client to a competent lawyer to draft the actual provisions. Once the agreement is drawn you will be in a position to fund it with the appropriate insurance.

Let's move on to a very important planning area for owner/managers - that being the crystallization of the $500,000 capital gains exemption which is available on the disposition of qualified small business corporation shares.

As we outlined earlier in the chapter, to be considered qualified, shares must be of a Canadian-controlled private corporation all or substantially all of whose assets were used principally in an active business carried on primarily in Canada. The shares must also satisfy 2 additional requirements in order to qualify for the exemption.

First, they must have been held by the shareholder or a person related to the shareholder for the 24 month period immediately preceding disposition, and

Second, throughout that 24 month period, more than 50% of the fair market value of the company's assets must have been used in an active business carried on in Canada. At that time of disposition of the shares, more than 90% of the fair market value of the assets have been used in an active business carried on in Canada.

Note that shares in a holding company which holds all or substantially all of its assets in the form of qualified small business corporation shares will also be considered qualified shares.

Because of the large tax savings available via the $500,000 exemption, owner/managers will want to ensure that they use the exemption before either it is taken away in a future federal budget or the company's shares lose their qualified status. It is not likely that the government will eliminate the exemption but there is a good possibility that a company whose shares are qualified now may find the shares no longer qualify in the future. This is because as a company matures, it is common that some portion of annual profits are not paid out to shareholders but are reinvested in the name of the company. Remember, as we discussed earlier, it is sound financial planning to reinvest excess profits in the name of the company since this avoids personal tax if the monies are paid out as salaries or dividends. The problem is that as reinvested profits grow in terms of percentage value of the entire company, the shares will lose their qualified status. Remember that at the time of disposition, 90% of the fair market value of the company's assets must be used to generate active business income. Further, in 24 months preceding disposition, passive assets such as investments cannot exceed 50% of the value of the company's assets.

Where a company's shares do not qualify because passive assets exceed the percentage limits, the first step the owner/manager should take is the purification of the company. This is a relatively simple procedure as it merely involves removing excess passive assets - usually cash or investment capital - from the company. This can be done by paying out the balance of the Capital Dividend Account and/or repaying loans from shareholders. If the company is actually being sold, retiring allowances may also be paid out in order to lower cash balances. Where these methods are not available, the alternative is to establish a holding company. Investment capital is then shifted to the holding company via a tax free intercorporate dividend and the operating company now holds only assets that generate active income.

Once a company has been purified, there are 3 methods of crystallizing accrued capital gains inherent in the company's shares without actually selling the business to a third party.

The first is to transfer shares to one or more family members. If the transfer is to a spouse, future capital gains on the shares will be subject to the attribution rules and therefore taxed back to the owner/manager. If, however, the sale is made on a commercial basis whereby the spouse agrees to pay market value for the shares via a promissory note at commercial rates, attribution will not apply. This means that future growth on the shares will be taxed to the spouse, enabling the use of his/her $500,000 capital gains exemption. The promissory note would be repaid using dividends earned on the stocks transferred to the spouse. If the transfer is not made on a commercial basis, the capital gain will still be crystallized but the attribution rules will eliminate the possibility of using a second capital gains exemption on future growth of the share value. This problem does not arise with transfers to children regardless of whether or not they are minors since future capital gains are not subject to attribution. Note, however, that if shares are being transferred to minor children, creation of a family trust should be considered to retain control of the shares.

The second method of crystallization involves the creation of a holding company and transferring common shares of the operating company in exchange for shares of the holding company. This action can also serve to freeze the owner/manager's estate as we discussed earlier. If crystallization without a freeze is desired, the owner/manager would simply take back common rather than preferred shares of the holding company.

The third and final method of crystallization is an internal transfer of shares. The owner/manager would simply sell his existing shares back to the company and, in exchange, receive new shares in the company. This procedure is under Section 85(l) of the Act as discussed earlier with respect to estate freezing. Once again, if the owner/manager wishes to combine the crystallization of his capital gains exemption with an estate freeze, he would take back preferred shares in exchange for his commons. If he only wished to crystallize, he would take back new common shares in exchange for his old ones.

Whatever method of crystallization is chosen, there are two potential problems to consider:

First, crystallizing the $500,000 exemption can trigger Alternative Minimum Tax depending on the owner/manager's other income amounts in the year of disposition. Chapter 2 in the Tax Library discusses the use of the capital gains reserve provisions to avoid the problem in most cases but even if AMT does apply, the AMT excess will almost always be recovered during the 7 year AMT carryforward period. What has to be considered is ensuring the owner/manager has the cash available to pay his taxes if AMT applies when crystallization occurs.

The Second potential problem is that the CNIL rules could come into play when the capital gain is triggered via crystallization. If the owner/manager has a large CNIL balance, crystallization will be of little or no benefit as the capital gain will be taxable to the extent that CNIL precludes the claiming of the capital gains exemption.

Sale Of A Business

There are two ways to dispose of an incorporated company - sell the assets or the shares of the business. While there appears to be little difference in which method is selected, the tax consequences of each could be significant. To illustrate, consider ABC Ltd. which has the following assets:

To keep the illustration simple, we'll assume that ABC Ltd. has no other assets, no liabilities and the shares are fully owned by Mr. A. The shares have an adjusted cost base of $100.

If the assets of the company are sold for their market value of $500,000, the tax implications would be as follows:

The taxable gain to ABC Ltd. would be $340,000 x 3/4, or $255,000. This gain would result in tax to ABC of about $102,000 of which one-half or $51,000 would be refunded when the after-tax gain is flowed to Mr. A via dividends.

Tax to ABC Ltd. on recaptured depreciation of $95,000 would be about $20,000.

After paying the taxes of $102,000 on taxable capital gains and $20,000 on recaptured depreciation, ABC Ltd. is left with $378,000 plus $51,000 of refundable tax which will be refunded to the company when dividends of about $204,000 are paid to Mr. A from the company. Mr. A will pay tax of about $105,000 on monies paid to himself from the company leaving him with about $324,000.

As an alternative to selling the assets of the company for their market value of $500,000, suppose Mr. A simply sold his common shares to the purchaser for $500,000. Assuming ABC Ltd. is qualified small business corporation (a Canadian-controlled private corporation of which at least 90% of the assets are used in active business carried on primarily in Canada), the capital gain of $499,900 on the sale would be exempt from tax given the $500,000 lifetime capital gains exemption. Mr. A has over $175,000 more in his pocket from selling shares versus assets. Why then, does anyone ever sell the assets of a company rather than the shares? One answer is the tax position of the purchaser when he compares buying assets versus shares. If the purchaser, Mr. B were to buy the shares of ABC Ltd. for $500,000, he takes over the assets at their original cost to the company. For depreciable property such as the building and equipment, Mr. B assumes the undepreciated capital cost. Mr. B can only claim a total of $25,000 of future capital cost allowance on the building and equipment even though the real value of these assets is $400,000. Further, if ABC sells any of the assets in future, the capital gain will be based on original cost. On the other hand, if Mr. B bought the assets, his adjusted cost base would be bumped to $500,000 rather than $160,000 and he would be able to claim $400,000 of future CCA on depreciable assets rather than $25,000.

In most cases then, the vendor is motivated to sell shares and the purchaser is motivated to buy assets. It is not uncommon on the sale of a business to see the vendor offer the business for two separate prices - one price for the shares and a higher price for the assets in order to compensate for the higher tax cost to the vendor.

Unwinding A Corporation

Let's go back to Mr. A and assume that he has sold the assets of ABC Ltd. for $500,000. The company has $378,000 in cash after tax (plus entitlement to a tax refund from Revenue Canada of $51,000 when dividends of $204,000 are paid to Mr. A) and Mr. A wants to get the money into his hands. He could pay himself a cash dividend of $429,000 based on the cash in the company plus the refundable tax but he would pay about $105,000 in personal tax by doing so. (Note that $85,000 of the dividend would be tax free, leaving a taxable dividend of $344,000. We'll discuss why a portion of the dividend was tax free in a moment). Of the sale price of $500,000, Mr. A is left with only about $324,000 after taxes. As a financial planner, you can show him several ways to improve his after tax retention on the sale, in addition to selling shares versus assets. The following areas should be considered:

1. Retiring Allowance

It is not necessary for an arm's length employer/employee relationship to exist in order for a retiring allowance to be paid. Thus, when a company is sold (either assets or shares) a retiring allowance should be considered. The amount of the payment is tax deductible to the company but will not be taxable to the recipient to the extent that the payment may be sheltered in a RRSP. Under Sec. 60(j.1) of the Income Tax Act, the maximum amount of retiring allowance which may be transferred to RRSP is $2,000 for each year or part year of service with the company prior to 1996 plus an additional $1,500 for each year or part year of service prior to 1989 the employee was not covered by vested benefits from a pension plan or DPSP. Going back to an example of Mr. A who sold his corporate assets for $500,000 in 1996, suppose he had worked for ABC Ltd. for 30 years and did not have a pension plan or DPSP in the company. ABC Ltd. could pay a retiring allowance of $94,500 (23 x $3,500 + 7 {1989 - 1995 inclusive} x $2,000) to Mr. A which would not cause any immediate tax consequences (Alternative Minimum Tax may apply) as the full amount may be transferred to his RRSP. ABC Ltd. will claim a tax deduction for the $94,500 which would offset income from recaptured depreciation and taxable capital gains arising from the sale of the corporate assets. Instead of a tax bill of $122,000 resulting from the sale of assets, the taxes owing by ABC Ltd. would be reduced to about $100,000. Further, $94,500 of corporate surplus has been moved from the company to Mr. A although it will of course be taxable to him when received from his RRSP.

Note that where assets of the corporation are sold, Mr. A will still be an officer (likely president) of ABC Ltd. The payment of a retiring allowance to Mr. A is valid, but Revenue Canada requires that Mr. A must first resign his position as an officer of ABC Ltd. prior to payment of the allowance.

If Mr. A had sold shares of ABC Ltd. versus assets he would still be allowed to pay himself the $94,500 of retiring allowance prior to the sale of the shares. If the $94,500 tax deduction to ABC Ltd. exceeds corporate income for the fiscal year, the loss may be carried back to be applied to previous tax years to recover taxes already paid by the company in respect of those years.

Note that if Mr. A, as a condition of the sale of the company, had agreed to stay on with ABC as a consultant for a period of time, a retiring allowance could not be paid in the year the company is sold. This is because he would continue to be an employee of the company even though he no longer owned it. In this case, Mr. A should negotiate the payment of a retiring allowance when his employment actually terminates. The retiring allowance could be paid in the year of sale if Mr. A were only to stay with the company in the capacity of a director at nominal compensation.

2. Loans From Shareholders

It is not uncommon that a shareholder may at some point loan money to a corporation. Because the shareholder is loaning after tax dollars, the repayment of the loan by the corporation is not taxable to the shareholder. Thus, when unwinding a corporation, review the company's balance sheet to see if loans from shareholders are present so that repayment may be effected. Such loans will be recorded in the liabilities section of the corporate balance sheet. If an account shown as "shareholder loan" is listed as an asset of the company, this means that the shareholder has borrowed money from the company rather than lending to it. It is only loans from shareholders that we are looking for.

3. Capital Dividend Account

The corporate Capital Dividend Account (CDA) is a notional account used to record amounts which may be paid as tax free dividends to shareholders. One of the most common items recorded in the CDA is the non-taxable portion of capital gains realized by the corporation. If you recall my previous example where Mr. A sold assets of ABC Ltd. rather than shares, the capital gain to the company on the sale was $340,000. The non-taxable quarter of the capital gain of $85,000 would be recorded in the CDA of ABC Ltd. Mr. A would therefore be entitled to pay himself a non-taxable dividend of $85,000 out of the company's surplus. The balance of the CDA of the company may in fact be much larger than $85,000 as the account is recorded on a cumulative basis. To determine the balance of the Capital Dividend Account you will have to contact the company's accountant. Because the account is notional (neither an asset or a liability) it is not shown on the corporate financial statements. Only the accountant's working papers will show the current balance at any point.

To summarize, the 3 areas to consider when unwinding a corporation are:

1. Retiring Allowance - tax deductible to the company but not immediately taxable to the shareholder if transferred to RRSP.
2. Repayment of loans from shareholder - not deductible to the corporation but not taxable to the shareholder.
3. Payment of dividends from Capital Dividend Account - not deductible to corporation but not taxable to the shareholder.

If any surplus still remains in the company after the 3 steps listed above have been effected, further distributions to the shareholder will be taxed to him/her as taxable dividends. Now the question is to determine the marginal tax rate of the shareholder to see if it is worthwhile to pay out the surplus or let it remain in the company for investment by the corporation. As you are aware, an individual with no other source of income may receive about $24,000 of dividends without paying any income tax. Therefore, if the corporate surplus is $50,000, it could be paid out over a 2 year period with only minimum tax cost to the shareholder. If, on the other hand, the surplus is significant, (say $200,000) it will be better to invest the capital in the name of the company rather than paying it out to the shareholder. This is because a $200,000 cash dividend to the shareholder would result in about $53,000 of taxes payable leaving him/her with only $147,000 to invest personally rather than the full $200,000 available to invest in the name of the company. Remember that interest and dividends earned by a company and flowed to the shareholder of the company will result in the same after tax return to the shareholder as if he had earned the income directly from investment personally. Capital gains are also taxed in the same manner in that three-quarters of the gain is taxable whether realized by an individual or a corporation. If corporate surplus is invested in the name of the company rather than distributed to the shareholders, that investment can carry on indefinitely. For example, suppose the $200,000 surplus noted above is used to provide an annual income to the shareholder of the company, Mr. B. When Mr. B dies, there is a deemed disposition of his shares of the company but not a disposition of the $200,000 investment. Mr. B's shares will pass to his beneficiaries who may choose to continue to hold the shares or pay out the capital to themselves depending on their personal tax position. If the company remains intact, its shares will continue to pass to the beneficiaries of the existing shareholders at their death. The point is that while shareholders die, companies do not. Each shareholder must decide whether the corporate surplus should remain invested in the name of the company or be distributed. The key factor is the tax cost to the shareholder to get the money out of the company.

Conclusion

It is very important to keep in mind that this chapter is far from being an all-inclusive study of corporate taxation. Your job is not that of accountant or lawyer but you must be able to understand some of the basic features of corporate taxation and its implications if you are to be effective in dealing with applicable clientele. Hopefully, an understanding of the concepts dealt with here will allow you to deal comfortably in a marketplace which controls a vast amount of investment capital. Owners of private corporations need your help also.