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However, the proposals only changed the federal legislation and to completely eliminate
the double tax effect, amendments to the provincial legislation adopting similar rules
was required. While the provinces have adopted the rules, the rate changes (both federal
and provincial) necessary to eliminate the double tax effect are transitioned over four
years. In 2010, the changes will be fully implemented.
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©2008 Fuller Landau
ALIGNMENT
Should You Bonus Down to the Small
Business Limit?
The traditional wisdom of paying bonuses to the shareholders to reduce corporate
income to the maximum amount that is subject to the small business deduction requires
re-thinking due to the number of provisions introduced by the Department of Finance
over the last few years.
Background
Prior to the recent changes in legislation, dividends paid to a shareholder out of corporate
income that was taxed at full corporate income tax rates resulted in a combined corporate
and personal tax that was greater than the tax an individual shareholder would pay on
a bonus.
The decision to pay a bonus to reduce the corporate income to the amount subject only
to the small business deduction considered other factors including:
a) the length of time the income will be retained by the corporation;
b) whether the company was eligible for the manufacturing and processing tax credit;
c) whether the company was claiming scientific research and experimental development tax credits;
d) the tax rate of the shareholders receiving the dividend; and
e) some non-tax considerations such as banking covenants.
Prior to the changes in the legislation, the analysis revolved around the tax deferral that
resulted. The tax deferral was equal to the difference in personal tax that would have
been paid on the bonus and the corporate tax paid on the income in excess of the small
business limit. The deferral in Ontario was approximately 10%. For corporations that
would not be paying out dividends to the shareholders for many years, the double tax
effect was secondary to the immediate tax deferral.
Changes in Rules
In 2006, the Federal Government introduced the concept of eligible dividends being
dividends paid from corporate earnings that were subject to the high rate of corporate
income tax. The intention of the government was to remove the “double tax” effect.
Ontario legislation includes a surtax that effectively eliminates (claws back) the benefits
of the Ontario small business deduction where the taxable income for corporations (or
associated groups) exceeds the small business limit. While Ontario adopted the eligible
dividend concept, it did not eliminate the surtax. The effects of the surtax must be
considered when deciding whether or not to bonus.
Our Analysis
Our analysis began by preparing tax estimates for various levels of income so as to
determine whether the Ontario surtax would have any impact on the decision to bonus.
The 2006 analysis presented another challenge arising from the fact that the small
business deduction limits were not the same -- the federal limit was $300,000, while the
Ontario limit was $400,000.
Our analysis discovered that the double tax cost was at least 6% and as high as 9% for
companies that had taxable income between $400,000 and $1,000,000. A company
with $3,000,000 of taxable income would subject their shareholders to an additional
tax cost of at least $130,000, depending upon when the retained earnings would be
distributed by way of dividend. We concluded that all other considerations being equal,
companies earning $3,000,000 or less, should continue to bonus down to the small
business limit. Companies earning more than $3,000,000 would have to consider the
length of time the company would retain the income and the rate of return it would earn
on the additional cash it would have as a result of the tax deferred before concluding
whether to bonus or not. What we did discover was that the greater the corporate
income, the less time a company had to retain the income to offset the double tax effect.
There became no hard rule of thumb once corporate income exceeded $3,000,000.
The analysis for 2007 was very similar to 2006 as there were only minor rate changes
effective for 2007 and the increase in the federal small business deduction limit to equal
Ontario’s $400,000. As a result, our conclusions for 2007 remain the same as those for
2006.
On October 30, 2007, the Federal Government announced additional corporate tax
reductions. Along with previously announced reductions, the top corporate tax rate
for 2008 will be 19.5%, down from 22.12% for 2007. The corporate tax rate will be
reduced each year until 2012 when it reaches 15%.
The additional tax reductions might finally change the rule of thumb for corporations
earning less than $3,000,000, and likely not to change the rule for companies earning
greater than the small business deduction limit (currently $400,000), and less than
$1,000,000 as the Ontario surtax is too great to overcome.
For 2008, a company with $3,000,000 of taxable income would only need to earn an
after-tax rate of return of 10% for three years to offset the double tax effect. If it is likely
to earn such a rate of return and the shareholders intend to leave the retained earnings
in the company for 3 years or more, then it would be better off to pay the top corporate
tax and not bonus down.
For 2009 and subsequent years, the required after-tax rate of return is even lower. In
fact, in 2012 the double tax effect will be completely eliminated and there will even be
a small tax savings to having the corporation pay the top corporate tax.
Conclusion
All companies earning less than $1,000,000 should continue to bonus down to the
small business limit. Companies earning up to $3,000,000 may benefit from paying the
higher corporate tax depending upon the length of time the income will be retained by
the corporation and the rate of return earned on those funds. Before making the bonus
down decision, companies should seek advice from their Fuller Landau advisor.
Should You Bonus Down to the Small Business Limit? was authored by Gordon Jessup of the Fuller Landau Tax Group.
To contact Gordon directly, please call (416) 645-6508 or email [email protected].