Should your client incorporate?

Using an investment corporation to hold a portfolio can have tax advantages. But those advantages vary, depending on where clients live and what they invest in.

There can be a tax cost to earning portfolio income inside a corporation, especially if it earns mostly interest. If your client’s in the highest tax bracket, however, a corporation may let her defer some of that tax.

How’s this possible? Our tax system is built on the theory that people should pay the same amount of tax whether they earn income personally or through a corporation. To achieve this, Canadian-controlled private corporations (CCPCs) pay a refundable investment tax, tracked in an account called the RDTOH (Refundable Dividend Tax On Hand).

The company recovers $1 of RDTOH for every $3 of dividends paid to shareholders. A shareholder then receives a dividend tax credit to help reduce her taxes payable. The net of the refundable tax and the dividend tax credit should put her in the same position as if she’d earned the income directly.

But due to differences in tax rates and credits between provinces, this doesn’t work perfectly. The result: total personal and corporate tax owing may differ. Also, depending on the shareholder’s personal tax rate, she may have a lower corporate tax rate initially, allowing her to postpone tax by leaving profits in a corporation.

Here are four questions to ask when deciding whether your client should incorporate.

• What personal tax bracket is your client in?

  If it’s higher than an investment corporation’s tax rate, earning funds through such a corporation can allow your client to defer taxes (see “Corporate tax rates,” below).

  Corporate tax rates

  Type of income	Ontario CPCC tax rate, 2014
  Interest	46.17%
  Dividends from Canadian public corporations	33.33%
  Dividends from Canadian private corporations	If connected, no tax*
  Dividends from non-Canadian corporations	46.17%
  Capital gains	23.085%

  * “Connected” is a defined term as per the Income Tax Act. No tax is applicable unless the paying corporation received a refund from its RDTOH account on the payment of the dividend.

• Does your client’s income primarily come from a private Canadian company she controls?

  If yes, she may be able to avoid triggering additional personal taxes by leaving those earnings in the company. In structures that use holding companies, funds can be moved from one Canadian corporation to another on a tax-free basis.

• Is a significant portion of her portfolio in U.S. investments, and does she have an estate greater than $5.34 million?

  If the answer’s yes to both questions, your client likely has exposure to U.S. estate taxes (even if she’s not classified as a U.S. person). Holding American investments inside an investment corporation can avoid triggering U.S. estate tax at death. Although U.S. estate tax is creditable against Canadian tax triggered on the same assets, there may not be much Canadian tax if the portfolio has a high cost base. The corporation may have to file a T1135, and FATCA reporting should be similar to what would be required if the investments were held personally.

Warning

This type of incorporation planning doesn’t apply to U.S. persons, who will need to consider both Canadian and U.S. tax implications.

• Does the client have significant probate tax exposure?

  Holding investments inside a private corporation, coupled with dual wills (one for assets subject to probate and a second for assets not subject to probate), can help reduce that exposure in Ontario. But there may be more efficient ways to avoid probate on an investment portfolio, such as a joint investment account, so only use incorporation if it also meets another planning goal.

Stella Gasparro, CPA, CA, is a partner at MNP in Toronto.