Chapter 1: Corporate Taxation and Structures

Question 1

What is meant by a “flow-through” nature?

Answer 1

Income (or sometimes expenses) retain its source characteristics as it flows to the owner or investor.

An example is a partnership. If a partnership invests in a dividend-producing investment, the dividends would be ultimately taxed in the partner’s hands, retaining their characteristics as dividends.

Question 2

Where does the opportunity arise with tax deferral?

Answer 2

Not paying tax now at a high rate, and instead timing taxes so that they will be paid when income (and therefore marginal tax rates) is lower, using opportunities presented within the Income Tax Act.

Question 3

What are the limitations associated with a sole proprietorship?

Answer 3

• Unlimited financial liability
• Lack of succession (sole proprietorship ceases to exist upon death of owner, bankruptcy, etc.)
• Sole control over the business (can be positive or negative)

Question 4

What are the differences between tax planning for an individual and a sole proprietor?

Answer 4

Virtually identical, no substantive tax advantages for the sole proprietor beyond those available for the individual taxpayer.

• Tax year is still January 1st to December 31st and taxes are owed by April 30th, but the sole proprietor has a reporting deadline of June 15th.
• Sole proprietors are subject to requirements for quarterly remittances.
• ACB for property owned by sole proprietor is calculated for that specific property (rather than a collection of property). The only exception is identical pieces of property.

Question 5

Which structure are most businesses operating in Canada today structured as?

Answer 5

Sole proprietorship.

Question 6

How do you determine the difference between two or more sole proprietors and a true partnership?

Answer 6

Not all activities involving one or more sole proprietor are necessarily partnerships. Partnership involves a sharing of assets; a partner does not retain individual ownership of the business assets.

Question 7

What will partners in a partnership generally do to overcome the limitations of a province’s Partnership Act?

Answer 7

Create a formal partnership agreement; either verbally or in writing.

The Partnership Acts tend to be very broad and may not meet the needs of a partnership. One area that is severely lacking is the ability of a partnership to survive the death of a partner.

Question 8

How are profits shared in a partnership?

Answer 8

The degree of partnership also determines the degree to which partnership profits would be shared (60/40 partnership sees profits split 60/40). The determination of partnership interests cannot be arbitrary - the partnership interest must be based on each partner’s actual level of contribution to the partnership.

Question 9

What is the proper term for “ownership interest”?

Answer 9

Capital interest.

Question 10

What kind of liability exists in a general partnership?

Answer 10

Unlimited liability. Each partner is liable for the activities of the partnership, as well as activities of the other partners. General partners are exposed to substantial liability risk.

Question 11

If there is no partnership agreement in place, what happens on the death or departure of a general partner?

Answer 11

The partnership must be wound up.

Question 12

Why is a partner able to sell their interest in a partnership as one asset (rather than dividing it up into its individual components) when allowed by a partnership agreement?

Answer 12

The partners are each deemed to own their capital interest as tenants in common.

Question 13

What are the 3 partnership structures?

Answer 13

1. General partnership
2. Limited partnership
3. Limited liability partnership

Question 14

Why would general partners bring in limited partners?

Answer 14

If general partners are seeking a way to attract investors. The limited partner’s liability is limited to their investment (as long as they do not conduct themselves as a general partner), so the most they could lose is their initial investment. This is a more attractive investment opportunity for an investor than becoming a general partner with unlimited liability.

Question 15

How does income from a limited partnership interest differ from income from a general partnership interest?

Answer 15

Limited partnership interest - passive/investment income

General partnership interest - active business income

Question 16

Who typically uses the LLP business structure?

Answer 16

Limited liability partnerships are often used by lawyers and accountants or other professionals when legislation permits it.

Question 17

How does a Limited Liability Partnership differ from a Limited Partnership and General Partnership?

Answer 17

Professionals are able to enter into a partnership like general partners, but not face the full liability faced by general partners. In an LLP, partners are liable for the activities of the partnership, but not for the individual activities of other partners.

Question 18

Are all partners individuals?

Answer 18

Not necessarily, partners can be corporations as well as individuals.

Question 19

What happens from a tax perspective if a partnership pays a salary to someone who is not a partner?

Answer 19

This would create a deduction against the partnership’s income.

Question 20

What is the term used for the amount a partner takes out of the partnership?

Answer 20

A draw.

Question 21

How is the ACB of a partnership interest determined?

Answer 21

The partner’s investment into a partnership creates an ACB. The ACB is then adjusted based on the difference between the income declared and the amount of draw taken. For example, a partner who takes a draw of less than the amount of declared income would increase their ACB.

Question 22

What are the 2 exceptions to the rule about partnerships having a year end of December 31?

Answer 22

• If a partner passes away , the partnership is terminated (according to the partnership agreement or lack thereof) and the year-end for that year becomes the deceased partner’s date of death.
• If all partners are corporations, then a different year end can be chosen.

Question 23

When would a partnership need to file its own tax return?

Answer 23

If all partners are corporations or in a partnership with more than 5 partners. This tax return is for information purposes only.

Question 24

What is ETP?

Answer 24

Elected Transfer Price. Any value between the cost base and fair market value for partnership interest.

Question 25

What happens if the ETP selected is higher than the ACB? What happens if it is lower than the ACB?

Answer 25

If a higher Elected Transfer Price is selected, this will create a capital gain for the partner, but a higher ACB for the partnership.

If a lower ETP is selected, a capital loss would be created for the partner, and the partnership would take on property at a lower ACB than that of the partner. If the partner will own more than a 50% interest in the partnership, this loss would be disallowed.

Question 26

What is another term for a private corporation?

Answer 26

Closely held corporations.

Question 27

Who are typically the shareholders of a private corporation?

Answer 27

Essentially, the owners. They are generally the parties who put up the capital to start the corp, and are most likely the ones who did the original work to bring it into existence. They generally have the greatest risk and stand to earn the greatest reward if the corp succeeds as they hold equity in the corp.

Question 28

What do voting rights generally allow shareholders of a private corp to do?

Answer 28

Shares that include voting rights generally allow the shareholder to exercise control over the company, including the ability to name directors of the corp.

Question 29

How do dividends of a closely held corporation differ from dividends of a public corporation?

Answer 29

Publicly traded Canadian corps generally pay dividends quarterly, their dividends are generally “eligible dividends” for tax purposes. Closely held companies generally have less stability around their dividends, they are normally paid annually and are dependent on the profitability of the company.

Question 30

What could happen if a shareholder of a closely held corporation takes dividends despite a lack of profitability?

Answer 30

May be required to repay those dividends if the company becomes insolvent.

Question 31

Which right of shareholders is seldom exercised?

Answer 31

Equity rights - shareholders’ net worth comprises the net worth of the corporation. Upon dissolution, all debts are paid. Any amounts remaining are distributed proportionately (as a liquidating dividend) to shareholders based on shareholdings.

Question 32

How are liquidating dividends taxed?

Answer 32

The same way as any other dividend.

Question 33

What do shareholders file to start a company?

Answer 33

Articles of incorporation.

Question 34

Can a provincially incorporated corp carry on business in provinces outside of its home province?

Answer 34

May be able to like a federally incorporated business, but there may be some restrictions (depending on the province).

Question 35

What is the purpose of a shareholder agreement?

Answer 35

Shareholder agreements allow shareholders to place restrictions on how they treat one another, specifically if a problem arises within the corporation. The agreement may prevent the issue of new shares or limit the ability of shareholders to make certain decisions without unanimous consent.

Question 36

What is also used along with a shareholder agreement to provide a framework for a corporation?

Answer 36

The articles of incorporation. They may create restrictions on share transfers, issues of new shares, and the rights of shareholders. The articles normally restrict the authorized share capital of the corporation (how many shares the corp could issue).

Question 37

What is paid-up capital and authorized share capital?

Answer 37

Paid-up capital refers to the number of shares owned by shareholders who have directly or indirectly injected capital into a corp (initial issue of shares). Authorized share capital gives the ability to issue more shares later if necessary.

Question 38

What are corporate by-laws?

Answer 38

Either included within articles of incorporation or separate. Place restrictions on who can be director of a corporation, on the powers of directors, on powers of expenditure, and on the issue of dividends (as well as other purposes).

Question 39

What is the USA (when referring to corporations)?

Answer 39

Unanimous shareholder agreement

Question 40

What are the 2 broad classes of shares and the subdivisions within those classes?

Answer 40

1. Common shares
   - Can specify “Class A” and “Class B” which have different voting rates and/or opportunity for dividends.
2. Preferred shares

Question 41

What are the main differences between common and preferred shares?

Answer 41

Common shares generally represent voting rights and the ability to collect dividends (that are not guaranteed).

Preferred shares are more of an investment vehicle than an ownership vehicle. They represent an opportunity to earn dividends, but do not usually represent voting rights. Preferred shareholders will receive dividends before common shareholders (potentially in arrears). Preferred shareholder also has access to liquidating dividends before common in the event of insolvency.

Question 42

How are preferred shares issued?

Answer 42

Issued with a par value that it will retain throughout its life. Generally structured without maturity dates. Shareholders are generally separate entities from the corp., which means they can sell their shares, compete with the company, etc.

Question 43

What are the tax consequences and the impact of ACB if an individual sells shares worth $100K to a family member for $20K?

Answer 43

As a non-arm’s length party is paying a price other than FMV, there would effectively be double taxation. The seller would face tax consequences on the full $100K, while the buyer would have an ACB of only $20K, meaning the buyer will face significant tax consequences when they eventually sell.

Question 44

What are the responsibilities of a board of directors?

Answer 44

They are a separate entity from the corporation, but set the direction of the corporation by selecting a management team. They also determine the dividends that will be paid out. Directors are held to a fiduciary standard.

Question 45

How are directors of a corporation held to a fiduciary standard?

Answer 45

They must put the best interests of a corporation ahead of their own. An example would be a competitive opportunity: a director who becomes aware of a relevant business opportunity by virtue of his role as a director must present that opportunity to the corporation where he is director. If the director instead personally benefited from the opportunity, that would be a violation of his responsibility as director.

Question 46

Can directors also be shareholders?

Answer 46

In a small company, it’s common for directors and shareholders to be the same people. Most publicly traded companies impose restrictions that directors must own a certain number of shares, so directors are most often shareholders as well.

Question 47

What is the legal concept of vicarious liability and when does it apply and not apply?

Answer 47

If an employee in their normal course of duties does something that creates legal liability, the company (employer) is responsible. An exception would be employees with explicit fiduciary obligations (such as engineers and actuaries).

Question 48

Why would the advantage of limited liability not exist for a small businessowner who incorporates?

Answer 48

In a corporation’s early stages, the business owner will likely have to find collateral outside the business in order to be able to borrow. This often leaves shareholders providing personally owned assets as equity.

Question 49

Why can it be difficult to find buyers of shares of private corporations?

Answer 49

Unlike a public corporation, private corporations are not required to file regularly with their securities regulators, so less information is available.

Question 50

If a corporation hires an expert to manage the company, what can they do to ensure the individual has a vested interest in the company?

Answer 50

Enter an arrangement where managers will also become shareholders.

Question 51

When would a (small) corporation have retained earnings?

Answer 51

When the corporation earns more income than is required personally. The corporation would pay out only the income that is required, and the remainder would be left in the corporation as retained earnings until they can be removed in a tax efficient manner.

Question 52

What are the 2 ways that shareholders (if also employees) can be compensated by their corporations? What are the tax consequences of each?

Answer 52

1. Dividends - not a deduction for corp., but more tax favourable for individual.
2. Salary - tax deduction for corp., fully taxable for individual.

Question 53

Which rules make it more difficult for a spouse who is not active in the business to hold shares and collect dividends?

Answer 53

The complex set of rules known as Tax on Split Income (TOSI) which limits the ability of family businesses to use share structures as a tax savings opportunity.

Question 54

What are the 3 different tax rates that may apply to a corporation under most circumstances?

Answer 54

1. Corporate general tax rate
2. Small business rate
3. Investment income

Question 55

How does the corporate general tax rate work?

Answer 55

Applied to all active business income earned by a corporation. The federal rate is 15%, Ontario rate is 11.5% (combined 26.5%). These tax rates are not progressive, it is a true flat tax system.

Question 56

What is the small business rate and how does it work?

Answer 56

If a small business qualifies for the small business deduction (SBD), tax rates for corporations are decreased even further. Federal rate is 9%, Ontario rate is 3.2%, combined 12.2%.

Question 57

Which corporations would qualify for the Small Business Deduction (SBD) and subsequently lower taxes?

Answer 57

• Must be a CCPC
• Must have active business income
• SBD only qualifies on first $500K of active business income, general rate applies above $500K
• Only income from Canadian sources qualifies
• “Personal services businesses” do not qualify for the SDB, these are businesses where incorporation was done to fill a role that normally would have been filled by an employee. (5+ employees would not be at risk of being declared a personal services business)
• Corporations associated with other corporations where income has grown to over $500K would not qualify
• Excessive passive income could result in a reduction in the SBD limit

Question 58

Which dividends are considered eligible dividends and why?

Answer 58

Dividends paid by CCPCs are generally considered ineligible, they are paid out of the Low Rate Income Pool (LRIP) as they are paid with income taxed at the small business rate.

If CCPCs have income in excess of $500K, they are considered to pay dividends out of the General Rate Income Pool (GRIP) and these dividends are taxed as eligible dividends.

Question 59

What is the concept of a Personal Services Business?

Answer 59

A personal services business is considered by the CRA to be a business that was incorporated to fill a role that would have normally been filled by an employee. The CRA considers this person an incorporated employee, so the business would not qualify for the Small Business Deduction and would be taxed at the corporate general tax rate.

Question 60

What is the rate that is generally applied to investment income of corporations? Why is this rate so high/low?

Answer 60

Around 50%. High to prevent corporations from sheltering investment income.

Question 61

What is the difference between Part I and Part IV of the Income Tax Act?

Answer 61

Normal income tax is collected under Part I of the ITA, and some corporate investment income is taxed this way. Some investment income is taxed under Part IV, which calls for a refundable withholding tax to be applied to certain types of income, such as dividend income.

Question 62

What is the basic concept of Part IV tax?

Answer 62

The CRA withholds roughly a quarter of the amount received by a corporation on certain investment income (such as dividends from a CCPC) creating a RDTOH (Refundable Dividend Tax on Hand) balance. Then when the corporation pays out that amount to its shareholders as a dividend, the RDTOH will be refunded.

Question 63

If a CCPC receives dividends as investment income, what are the 2 situations that could occur?

Answer 63

1. Company declares a dividend to shareholders within fiscal year. No amount is withheld because the dividend is paid immediately, resulting in a flow-through of dividends.
2. Company does not pay a dividend in same fiscal year. CCPC would then pay a refundable tax (refundable dividend tax on hand RDTOH), which would be refunded when the dividend is eventually paid out to shareholders.

Question 64

Is the RDTOH (refundable dividend tax on hand) a source tax or withholding tax?

Answer 64

It is not withheld, it would be paid at year-end if a dividend is not declared within same fiscal year.

Question 65

If a RDTOH is created for a corp (refundable dividend tax on hand) and then a dividend is declared within that fiscal year, no tax is paid. When will tax be paid?

Answer 65

Shareholder who ultimately receives dividend pays tax on it.

Question 66

If a corporation receives a dividend, why would they not want to create a RDTOH (refundable dividend tax on hand)?

Answer 66

If they don’t declare a dividend within the same fiscal year, tax will be withheld as an RDTOH and it will essentially be “put under the mattress” by the CRA. That balance does not have the opportunity to grow.

Question 67

As of the 2018 Federal Budget, there are now 2 pools of RDTOH (refundable dividend tax on hand) available, what are they?

Answer 67

NERDTOH - non-eligible refundable dividend tax on hand
ERDTOH - eligible refundable dividend tax on hand

Non-eligible dividends must be paid to shareholders to receive NERDTOH and eligible dividends must be paid to shareholders to receive ERDTOH

Question 68

How is the small business deduction SBD impacted by investment income?

Answer 68

As of the 2018 Federal Budget, corporations with investment income in excess of $50,000/annum will lose access to the SBD on a 1:5 basis over that amount.

Example: a corporation with $70,000 of investment income will lose ($20,000 x 5 = $100,000) of its SBD, effectively reducing the SBD from $500K to $400K.

Question 69

What are the AAII (Adjusted Aggregate Investment Income) rules that came in force in 2021?

Answer 69

When a small business corp has passive income in excess of $50,000, access to the SBD is reduced in the following year. Every $1 of passive income in excess of the $50,000 results in a loss of $5 of SBD for the following year.

Question 70

What is included as passive income in the AAII (adjusted aggregate investment income) calculation?

Answer 70

• Dividend income from non-connected corporations (portfolio dividends)
• Interest income (even if not received, such as in the case of a GIC unless it is a market-linked GIC, in which case income only counts against AAII at maturity.
• Taxable portion of capital gains. (Cannot be reduced by losses)
• Taxable disposition of a life insurance policy.
• Net rental income where the income is passive.

Question 71

What would constitute active net rental income (vs passive net rental income)?

Answer 71

Active rental income generally means more than 5 full-time, non-family members are directly involved in the rental business.

Question 72

The taxable disposition of a life insurance policy counts as passive income and impacts the AAII (adjusted aggregate investment income). What are the impacts of growth of life insurance and death benefits?

Answer 72

Tax exempt growth in a life insurance policy does not count against the AAII limit. Death benefits from life insurance, CI, or commercial general liability insurance also do not count against the AAII limits.

Question 73

What are the tax advantages to corporate structures?

Answer 73

• Carry forward of losses (negative income) to offset against future gains.
• Ability to defer income taxes.
• Lower tax rates, especially for income eligible for the small business deduction.
• Choice of dividends or salary.

Question 74

What are the advantages of dividend income and salary income from a corporation?

Answer 74

Dividend income - taxed at a lower rate than salary (though not deductible for corp).
Salary income - taxed at a higher rate than dividends (deduction for corp), attracts CPP and possibly EI, also useful for determining qualification for disability insurance and creditworthiness of a borrower.

Question 75

How can an individual use their corporation’s fiscal year end to defer income?

Answer 75

The business can declare a bonus to be paid to its shareholders prior to its fiscal year end (example: declare bonus Oct 31, 2023). The Income Tax Act allows the bonus to be paid up to 179 after it was declared. Therefore, the corp could pay the bonus in 2024.
This can create a one-time tax advantage if the corp would benefit from a deduction in 2023 but the individual would have lower income in 2024.

Question 76

Why do corporations have less audit risk than individuals?

Answer 76

Personal tax returns have relatively little detail in them, so they are frequent audit targets for the CRA. Corporate tax returns though are highly detailed, so it’s more likely that a corporate tax return already contains whatever information is required and an audit is not needed.

Question 77

What are the exceptions to the rules on income splitting through making family members shareholders in a business?

Answer 77

• Family member is at least 25
• Contributing meaningfully to the business
• Business is not primarily engaged in offering services
• Business is not a professional corporation

Question 78

What is a CDA?

Answer 78

Capital Dividend Account - allows for certain income to flow through to shareholders using a tax-free capital dividend. CDA is best thought of as a notional account from which the business owners can pay out tax-free dividends as required. There are only 3 scenarios from which a CDA credit can arise.

Question 79

What are the 3 scenarios in which a CDA (capital dividend account) credit can arise?

Answer 79

1. Half of capital gains that is not taxed creates a credit to the CDA.
2. Death benefit from a life insurance policy where the corporation is the beneficiary creates a credit to the CDA.
3. Transfers of CDA from other related companies.

Question 80

Which types of insurance benefits can create a credit in a Capital Dividend Account?

Answer 80

Only death benefits from life insurance policies where the corporation is the named beneficiary. Other sorts of insurance (DI, DI, AD&D) do not create a CDA credit.

Question 81

What is the purpose of holding companies? Why set one up?

Answer 81

Corporation that exists for the purpose of owning shares in other corporations, may also own other sorts of passive-income-generating assets.

A corp may want to set up a holding company to hold assets (and shares) of the OpCo and alleviate risk associated with liability claims (creditors repossessing assets).

Question 82

Why are certain professionals barred from incorporating?

Answer 82

Consumer protection. Legislators and courts don’t want professionals to be able to limit their liability through incorporation - they want consumers who have suffered harm to be able to sue and access personal assets.

Question 83

What are the limitations associated with professional incorporation?

Answer 83

• Small business deduction may not be available if an employee has incorporated (personal services business)
• Limits on share ownership (example: a doctor’s professional corp. may have to be owned solely by doctors)
• Limits on the corporation’s activity (often restricted from carrying on activities outside of the very specific nature of the corporation).
• Professional liability - while a professional will not be exposed to liability of the activities of the corp., their professional liability will not be limited.

Question 84

What is the purpose of a joint venture?

Answer 84

Generally entered into by 2 or more businesses who will be working together for a limited time on a project of limited scope.

Question 85

What is the structure of a joint venture and how is it taxed?

Answer 85

A joint venture is not a separate legal entity. Each party retains liability for its own activities. Unlike a partnership, the venturers do not assume liability for one another’s activities. It’s possible for the joint venture to acquire property of its own, but profits and expenses generally flow back to venturers. It is not a separate tax entity, there are no income tax provisions that apply explicitly to joint ventures.