As a business owner, you know that good tax management can help you retain more business income but may feel overwhelmed by all the tax regulations. You don’t need to be a tax expert. Just knowing a few basics can help guide conversations with your advisor (so they can do the heavy lifting!) and lead to better financial outcomes for your business.
Here are four things that should be on your radar.
1. How much your company earns will impact its tax rate
This may seem obvious, but small businesses in Canada aren’t subject to graduated tax rates the way individuals are. The general (federal + provincial) tax rate for active business income ranges from 23% (Alberta) to 31% (PEI). However, businesses get a reduced tax rate on the first $500,000 of taxable income ($600,000 in Saskatchewan) thanks to the Small Business Deduction (SBD).
This is important because the tax rate applied to business income will impact the tax rate applied to you personally, as you pay yourself either eligible or non-eligible dividends from the company. Figure 1 shows a simplified example of how $10,000 of business income in Alberta is taxed depending on whether it received the SBD or not.
Figure 1: Tax rate applied to business with vs. without SBD
Source: Alberta, 2023 Tax Facts and Tables, Tax Templates Inc.
2. Your investments can affect your corporate tax rate
The first $500,000 of active business income taxed at the lower rate is known as the business limit. That limit is reduced by $5 for every $1 of adjusted aggregate investment income (AAii) earned over $50,000 within your company or associated companies (See Figure 2). AAii is the net sum income from property, taxable capital gains (passive assets), taxable dividends, interest and foreign investment income.
So, an investment portfolio of $2.5M in your holding company with stocks, bonds and GICs generating 5% taxable income would reduce your business limit by $375,000. The Small Business Deduction mentioned above would only apply to the first $125,000 of active business income. Fortunately, certain investments, such as those held within insurance solutions, do not claw back your access to generous tax rates applied via the small business deduction. Figure 2 outlines the relationship between AAii and the business limit. We’ve done the math to accompany the example above as well.
Figure 2: Relationship between AAii and business limit
$2.5M portfolio earning 5% = $125,000 AAii income.
($125,000 - $50,000) x 5 = $375,000 SBD reduction.
$500,000 - $375,000 = $125,000 SBD.
3. Taxes applied to your corporate investments are high
Aside from losing access to your SBD from having too much AAii, what your company invests in can create even more pain at tax time. Bond coupon payments, GIC interest, dividends from non-Canadian companies and even interest from savings accounts are all taxed at rates of over 50% in every province except for Alberta (46.67%).
In places like the Yukon, Saskatchewan, PEI, Nunavut, the Northwest Territories, New Brunswick and Manitoba, the tax rate applied on these investments within your corporation is higher than the highest personal marginal tax rate. This means you’d be better off earning that income in your personal hands even if you had very high taxable income.
Capital gains are taxed at half these amounts and dividends from Canadian companies are hit with a 38.33% rate. This is higher than the highest personal rate for eligible dividends in Alberta, BC, Manitoba, New Brunswick, the Northwest Territories, Nunavut, PEI, Saskatchewan and the Yukon.
It’s not all bad news! The good news about the tax applied to your corporate investment earnings is that a lot of it is refundable. However, to receive the tax refund, you must pay out the income to shareholders via a dividend. This dividend will then be taxed in the shareholders’ personal hands.
Further, if you’re not taking money out of the company, you’re not getting that refundable tax and your investments will compound with a major drag. It’s like putting a block of wood under your gas pedal. Sure, you might reach your destination, but it’ll take a long time to get up to speed. So, is it better to earn investment income in your corporation or in your own personal name? Before answering, we need to discuss a fun little topic known as integration.
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4. Integration and tax deferral
The high-level idea behind integration is that the total tax applied to a dollar, by the time it reaches your personal bank account, should be the same regardless of whether it was earned under your personal name or your corporation. However, integration isn’t perfect, and it rarely works out this way.
For investment income of any sort in 2023, there will generally be a slightly greater overall tax burden (at the highest personal levels) to earning in the corporation and paying out as a dividend instead of earning investment income in your own hands. For general business income, which has applied the SBD, a business owner taking non-eligible dividends would be taxed higher than if those dollars were paid out directly through salary. Only the Northwest Territories and Saskatchewan apply lower overall taxes to business owners in this instance. If you further consider that there are no RRSP or CPP contributions associated with dividend remuneration, salary starts to look more attractive than a dividend payout from a tax saving perspective.
Regardless of the remuneration outcomes, the greatest benefit for shareholders is the tax deferral companies see before taking income out of the company. Since active business income is taxed in the corporation at a much lower rate than personal income, just leaving money in the company allows for greater capital growth through compounding. A business owner may be better off investing excess profits within the company, even with the heavy tax applied to passive investment income.
Figure 3 uses tax rates in Alberta to show a massive tax deferral for business owners leaving money in the company to grow in an investment portfolio, rather than taking it out to invest in their own name. This is because, until money is paid out from the company, integration doesn’t have the chance to work yet: the deferral of tax is only possible because just the corporate tax has been applied. Personal tax isn’t applied until the money comes out of the corporation. That deferred tax will remain in the company and grow year after year.
Figure 3: Tax deferral for business owners
The best tax strategies for you will depend on your personal and business circumstances. If you haven’t already discussed the above strategies with your advisor – now you can. Many of CWB Wealth's advisors have deep expertise in tax strategy, and would be happy to discuss any tax-related queries you have that may or may not appear on this list.
Sources: Taxtips.ca, Alberta, 2023 Tax Facts and Table, Tax Templates Inc.
Robert Bradburn, CFP®, CIM®, CLU®
AVP, CWB Wealth
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