One of the primary tasks that we assist our corporate clients and their shareholders with is that of determining the best alternatives to extracting profits from the corporation.

The most important consideration in deciding the optimum mix of salaries and dividends for shareholders is their cash-flow requirements.  To achieve this, the objective is to meet this after-tax cash flow requirement yet retain as much as possible within the corporation for reinvestment.  We consider, among other things, the annual small business limit, which is presently $400,000 of active business income that is taxed at approximately 19%, as well as RRSP limits, CPP limits and other issues such as child-care expenses and moving expenses, which are limited to the extent of employment income.

25% Gross-Up and Tax Credit

The current system requires that for every $100 in dividends that are received, $125 must be included in taxable income.  When the tax is calculated on the taxable income, a dividend tax credit of 16 2/3% of the amount of the dividends that are received is allowed against the Federal tax, which is a determining factor in the calculation of Provincial tax.  This procedure essentially puts shareholders in the same position as if they earned the same business income personally.

This framework works well when the corporate tax rate is below 20%.  There would be a significant penalty if a higher corporate tax rate were to apply as a dividend gross-up and the tax credit system assumed only a 20% rate of tax.  In Ontario, a corporation that is earning active business income will face a tax rate of 19% on income up to $400,000 and 44% thereafter.  That is the reason why we almost, without question, will bonus corporate income below the annual business limit.

Beginning in 2006, a second type of dividend gross-up and tax credit system was introduced, which applies to income that is taxed at the general rate of what would otherwise apply to corporate income beyond the $400,000 annual business limit.  The gross-up portion is 45% and the tax credit portion against federal tax is 27.5% of the dividend received.

This new system assumes an underlying corporate tax rate of 31% instead of the 20% that is assumed in the 25% gross-up and tax-credit system.  Thereby allowing us to now consider retaining more surplus that is taxed at corporate rates and foregoing a bonus accrual.

However, there is still a tax cost to relying on the new gross-up and tax-credit system, but it is significantly reduced from the previous system that would otherwise apply.  On a per $1,000 of corporate income analysis, the absolute tax cost has been reduced from about $110 to about $39.  Our analysis is that if you were to deploy surplus that is created by this regime, you would break even after about eight years.

Specifically, if you generate a reasonable return on the corporate funds that are available, in excess of a reinvested bonus, the sufficient after-tax surplus would be generated in eight years to offset the previously mentioned $39 tax cost.  This is an improvement over the previous system that required 22 years.

Other Issues

Large bonuses attract Employers’ Health Tax (EHT) in Ontario, whereas dividends do not.  A large bonus could also alter the frequency of your withholding time requirement as the average monthly remittance could now exceed thresholds that could cause a corporation to pay withholding taxes twice monthly and even as much as four times monthly.  Also, the due date for corporations’ taxes would be pushed forward one month as the three-month allowance is only available to corporations with income below the annual business limit.