Clients often come to me with the desire to reduce tax. I am more than happy to help them in that regard – I particularly enjoy helping families keep their wealth rather than giving it to the government unnecessarily. Just as often though, I realize that not only do I have the opportunity to preserve their wealth, but also their family relationships. Unfortunately, big estates often come with big fights (or with the potential for big fights). With proper planning during their lifetime, families can preserve their wealth and their relationships. Having said that, I have noticed that, although many of my clients come to me with a good general understanding of how their businesses, companies and estates are taxed, there are a number of misconceptions and unknowns as well. Here are some big ones:
Contrary to what many people think, there is no such thing as an “inheritance tax” in Canada. So what tax does apply on death?
Canadian tax law provides for what is called a “deemed disposition” on death. This means that the law “pretends” that the deceased sold all of his or her capital assets immediately prior to death at fair market value. This would give rise to tax where the deceased owned capital assets consisting of an inherent (not yet taxed) capital gain. (Note that RRIFS and RRSPs would also be fully included in income in the year of death, and tax will be applicable at the deceased’s regular marginal tax rate.) In other words, cash in the bank (other than in RRIFs, etc.) would not be subject to any tax on the deceased’s death. Interestingly then, imagine the following two scenarios:
In scenario one, the deceased had no capital assets, but had $100 million of cash sitting in a bank account.
In scenario two, the deceased had no cash in the bank at all, but had a building that had appreciated in value by $1 million since the time it was purchased for $1 million.
Who pays more tax – the person with $100 million of assets, or the person with $2 million of assets? You guessed it – the person with $2 million of assets will pay about a quarter of a million dollars of tax on death (he will have realized a $1 million capital gain, half of which is taxable), while the $100 millionaire won’t pay a dollar of income tax directly in connection with this $100 million!
This seems unintuitive, but it makes sense conceptually (at least in my mind). The $100 million of cash in the bank is after-tax money (presumably). The building has appreciated in value by $1 million, but no one has paid any tax on that increase in value. If not for the deemed disposition, that $1 million of accrued gain (and future growth) could remain untaxed indefinitely for generations.
So, bottom line – the biggest potential tax consequence on death is often as a result of accrued and untaxed capital gains in respect of capital property owned by the deceased on his or her death. Many strategies exist to minimize this tax. My goal is always to do whatever I can to preserve hard-earned wealth of my clients and their families and, even more importantly (at least according to some), preserve family relationships that could be affected by improper (or lack of) estate/tax planning.
Probate tax is a Provincial tax that is officially called “Estate Administration Tax”. The tax is about $15,000 on the first $1 million of assets. Technically, not all assets of a deceased have to be “probated” and be subjected to the tax. A common strategy to reduce probate tax involves setting up “multiple wills”. One will to govern the assets that are required to be “probated”, and one will to govern the assets that are not required to be “probated” (such as shares of a private company).
Tax on a Corporation’s Income
This is a large topic, but some basics are as follows:
Corporate Tax on Active Income
A Canadian corporation (that is controlled by one or more Canadian taxpayers) (also called a “Canadian Controlled Private Corporation” (a “CCPC”)) that earns “active business income”, is taxed (in respect of that income) at a very low corporate tax rate – approximately 15.5% (currently) in Ontario on the first $500,000 of income. This is referred to as the “small business deduction”. On income above the small business deduction threshold, the income is taxed at the general corporate tax rate of 26.5% (currently). Corporate income that is taxed at the general corporate tax rate also forms a tax account called “GRIP” – or, “General Rate Income Pool”. When a corporation has a GRIP account, it can declare “eligible dividends” to the shareholders, which are taxed at a lower rate than non-eligible dividends.
Corporate Tax on Passive Income
The corporate taxation of “passive” income is different than that of active income. Generally speaking, “passive” income (e.g., rental income from a passive real estate investment) is taxed at investment tax rates. The investment tax rate in Ontario for a CCPC is currently over 50% (part of which generates another tax account called “RDTOH”, which is a pre-paid tax that is refundable once the corporation declares a taxable dividend to the shareholders). Conceptually, the government decided that it made sense to establish an “anti-deferral” regime which prevents a person from simply placing his/her passive investments into a corporation, allowing the investments to be taxed at 26.5%, rather than the individual’s marginal rate, which would, in most cases, be higher (more than double in the case of a top-marginal rate individual).
Interestingly, passive investment income earned by a non-CCPC is not subject to the investment tax rates and RDTOH mechanism described above. Rather, such income is taxed in a non-CCPC at the general corporate tax rate (26.5% currently). This can give rise to some very interesting tax planning opportunities. However, any plan that seeks to take advantage of this rule should carefully consider the fact that eligible dividends cannot be declared/paid to non-residents of Canada. Furthermore, there are certain very significant implications to converting an existing company from CCPC status to non-CCPC status, and vice versa.
Corporate Capital Gains
When a corporation realizes a capital gain, only half of the gain is taxable (as is the case when an individual realizes a capital gain). This is sometimes described as a “50% inclusion rate”. This does not mean that the tax rate is 50%. It just means that if you sell something for $1 million more than what you bought it for, only $500,000 of the $1 million is subject to tax at whatever tax rate applies. In the case of a corporation, the half portion of the gain that is taxable is subject to the investment tax rates (the same rate that applies to passive rental income, for example). This means that, once again, a corporation will pay over 50% tax (on only the taxable half of the gain), and will generate RDTOH (the refundable tax described above). The non-taxable half of the capital gain forms another tax account called the “capital dividend account”, or “CDA”. Where a company has a CDA balance, it can declare a “capital dividend”, which is a tax-free dividend.
In summary, a corporation will pay tax up-front of about 25% (approximately 50% of the 50% of the gain that is taxable). That is $250,000 of tax up front on a $1 million capital gain. Half of the capital gain can be extracted tax-free via capital dividends to the shareholders. The other half is taxable, but part of the tax is ultimately refundable on the declaration of taxable dividends by the corporation.
Note again, that the non-CCPC discussion above also applies for capital gains. As you can imagine, there could be significant planning opportunities available in this context as well.
Generally, when a company pays a dividend to a “holding company”, it goes up tax-free. In order for the inter-corporate dividend to be tax-free, the payor company and the payee company must be “connected” within the meaning of subsection 186(4) of the Income Tax Act (Canada). Essentially, the holding/payee company must own shares of the payor company representing more than 10% of the votes and value of the payor company. There are numerous tax and estate planning opportunities that exist as a result of this system.
Tax on the Shareholders
The corporate income tax is not really the end of the story. Now we have to get the money out of the company (sometimes), and into the hands of the shareholders. Generally speaking, when funds are extracted by the shareholders from a company, the shareholders must pay tax. Typically, money is extracted as a dividend, a salary or a fee of some sort. The shareholder then must pay tax on amounts extracted at the shareholder’s marginal tax rate. Although there are, therefore, two levels of tax, this does not generally give rise to “double taxation” in the sense that the same money is being taxed twice. The corporate tax system is designed to achieve (ideally) “integration”, so that the end tax result after withdrawing the money from the company is the same as it would have been if the shareholder had earned the money directly (i.e., not through a corporation) and paid tax thereon.
In some cases, there may be opportunities to extract money from a corporation tax-free (such as through an “84.1 pipeline”). These circumstances are somewhat limited, but one should take advantage of doing so when possible.
My general rule is that there is usually a way to pay less tax. You just have to know the rules and use them to your advantage. That’s why they are there (at least from my perspective.)