Canada

Plan now for 2019 refundable dividend tax on hand transition

TAX ALERT  | 

The 2018 Federal Budget confirmed the Canadian government’s intent to address Canadian controlled private corporations (CCPC) that earned significant investment income by targeting the Refundable Dividend Tax On Hand (RDTOH) regime. RDTOH is created from passive income earned by a CCPC and as implied in the name, is refunded to the corporation upon payment of taxable dividends. Investment income subject to the RDTOH regime is typically not added to a CCPC’s General Rate Income Pool (GRIP) from which eligible dividends are paid.

Under the historical RDTOH rules, an eligible dividend paid by CCPC could allow for a refund of  RDTOH. This provided an opportunity to pay eligible dividends and still recover RDTOH created from investment income, which did not accrete to the CCPC’s GRIP from which the eligible dividend was paid. The eligible dividend would then be taxed at approximately 39 per cent personally rather than the approximate 46 per cent rate for non-eligible dividends (highest personal dividend tax rates in Ontario). Therefore, the individual is subject to a lower personal tax rate in comparison to receiving a non-eligible dividend that would otherwise be paid from passive investment income earnings, and the corporation continues to enjoy a RDTOH refund.

Under the new rules introduced in the 2018 Federal Budget, the existing RDTOH account will be split into eligible RDTOH and non-eligible RDTOH pools. RDTOH created from passive income will accrete to a CCPC’s non-eligible RDTOH account. This will be the case with most passive income apart from eligible dividend receipts. Only non-eligible dividends will result in a refund of non-eligible RDTOH balances. Further, ordering rules will also provide that amounts cannot generally be refunded from a CCPC’s eligible RDTOH account until the non-eligible RDTOH balance has been fully refunded. The character of RDTOH paid on dividends received from a connected corporation would match their payer’s eligible/ non-eligible RDTOH accounts.

The above rules will apply to taxation years beginning on or after January 1, 2019 and transitional measures have been included to compute the opening eligible RDTOH and non-eligible RDTOH balances of a CCPC. The eligible RDTOH balance will be calculated as the lesser of:

  • The existing RDTOH balance at the time of the transition; and
  • 38 1/3 per cent of the GRIP balance, at the time of the transition

Once the above allocation has been calculated, any remaining RDTOH would be allocated to the non-eligible RDTOH pool. Budget 2018 alludes to the fact that existing RDTOH should not be negatively affected on transition and should be in the eligible RDTOH pool. However, the transition rules included in the legislation create a problem.

How does this change play out?

For example, let us assume that Mr. A owns 100 per cent of his holding company (“HoldCo”) and the HoldCo owns 100 per cent of an operating company (“OpCo”). Furthermore, let us assume that OpCo has a GRIP balance of $10,000,000 and RDTOH of NIL while HoldCo has a RDTOH balance of $2,000,000 and no GRIP.

On transition, HoldCo will have its eligible RDTOH balance calculated as the lesser of:

  • The existing RDTOH balance at the time of the transition ($2,000,000); and
  • 38 1/3 per cent of the GRIP balance, at the time of the transition ($NIL)

Therefore, HoldCo’s entire RDTOH balance will be included in the non-eligible RDTOH pool and block any refund of RDTOH when GRIP dividends are paid from OpCo through HoldCo to the individual shareholder. As a result, there is no transitional relief on HoldCo's RDTOH earned before the new legislation became law.

How to plan for transition

A simple planning decision, that can be undertaken prior to the new regime coming into effect, is to pay an eligible safe income dividend to cause the GRIP balance in HoldCo to equate to the RDTOH balance in HoldCo. To continue our previous example, OpCo would pay an eligible safe income dividend of at least $5,217,392 prior to the transition. On transition, the eligible RDTOH balance of HoldCo will now be calculated as the lesser of:

  • The existing RDTOH balance at the time of the transition ($2,000,000); and
  • 38 1/3 per cent of the GRIP balance, at the time of the transition ($2,000,000)

The resulting eligible RDTOH balance of HoldCo will now equal at least $2,000,000 with no amounts added to HoldCo’s non-eligible RDTOH pool. Accordingly, eligible dividends can continue to be paid from OpCo through HoldCo to the individual shareholder and still provide for a refund of HoldCo’s RDTOH balances.

Taxpayers should examine their corporate structures prior to the rules coming into force on January 1, 2019 to determine potential planning opportunities.

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