Tax II Chapter 1 Spring 2013
Notes
Chapter 1 Lecture Notes
Basic Legal Principles and Base Tax Rates
David Christian Spring Term 2013
Thorsteinssons LLP UBC Faculty of Law
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Notes
Income tax law is not a matter of pure reason. It is … interpretation of changing statutory provisions.
Frank J. (1942)
Basic Corporate Law Principles
1. As you will recall from corporate law, the “corporation” is an artificial legal person, possessing the legal capacity of a natural person. It follows that:
(a) a shareholder can lend money to the corporation, and thus be a creditor of the corporation as well as its shareholder; and
(b) a shareholder can be an employee of the corporation, and thus be both a shareholder and an employee of the corporation.
2. A corporation must have a directing mind, and this must by definition be a natural person or persons – being the directors, officers and other employees. The corporation in effect acts through the agency of these persons when they are acting in their capacity as directors, officers and other employees.
3. The following symbols and acronyms are sometimes used in this course:
4. In corporate tax law, the corporation’s separate legal existence is usually respected – even if a shareholder wants to ignore it for tax purposes. A corporation is treated as a separate “taxpayer” (see subsection 248(1) and the definitions of “taxpayer” and “person”). As a legal person the corporation owns assets, earns income, has expenses, and pays an income tax on its “taxable income” just as any other taxpayer. Recall Tax I – “taxable income from a source”. The shareholder of a corporation is also a separate legal person and is thus a “taxpayer”. The rate of tax that applies to the corporation’s taxable income, and to amounts paid out to the shareholder, is the subject matter of Part A of this Course.
5. As you know from constitutional law, Canada is a federation. The federal, each provincial, and each territorial government imposes an income tax. In British Columbia’s case (as with all of the other provinces and territories except Alberta and Quebec), the provincial income tax is administered and collected by the federal government, and thereafter remitted to the provincial or territorial government.
“Base Case” Corporate Tax Rate
6. Consider, for now, a public corporation (definitions will be examined in Chapter 2) earning income from carrying on a business in British Columbia. I use this example because such a corporation is subject to the “base case” tax rate applicable to corporations in Canada. In Chapters 3 and 4 important special cases are examined that deviate from this base case. The base case is the starting point, because each special case in the later chapters can only be understood with reference to the “base case”.
“Base case” tax rate to be applied to the corporation’s taxable income to arrive at the tax owing by the corporation / % / Section references and notesstart with (historical) federal tax rate / 38 / 123(1)(a) - most recent, but still historical, base federal rate
subtract the federal “general rate reduction percentage” / 13 / 123.4(2) - this gives us the current base federal rate of 25% before making “room” for the provincial and territorial taxes - assume here the corporation’s income is basic “full rate taxable” income
subtract the “provincial abatement” / 10 / 124(1) – makes “room” for the provinces and territories to impose their own tax rate on the corporation’s “taxable income earned in a province” – this gives us the net current federal rate of 15% where the corporation’s income is subject to provincial or territorial tax
add the base case provincial tax rate on the corporation’s income earned in the province / 10 / the provincial rate here is the base rate of 10% in subsection 14(2) Income Tax Act (British Columbia) or the “BC Act” for short[1]
thus, the total tax “base case” tax rate on the corporation’s taxable income in Canada is / 25 / the base corporate tax will vary across Canada as provinces and territories impose tax a rates different from British Columbia
Notice, the base case corporate tax rate is a combined “federal-provincial rate”, and it is “built” by applying the various sections. This is the result of many years of preferences and amendments by both levels of government, and is a fact of life in determining corporate tax in Canada (i.e., arriving at net results by applying, in some cases, many sections at one time).
“Base Case” Individual Tax Rate
7. An individual who resides in British Columbia on the last day of a taxation year is taxed at the top tax bracket (which is often used as the reference point for policy and planning) at the following combined federal-provincial tax rate on the individual’s taxable income from a source:
start with the federal rate / 29 / the top rate in 117(2)(d) – the low rate is 15% (up to $44,561)add the provincial rate / 14.7 / the top rate in 4.1(1)(e) of the BC Act - again, top individual tax rates vary from province to province – the low rate is 5.06% (up to $37,568)
combined federal-provincial rate / 43.7
The “Gross-up & Dividend Tax Credit” System for Individual Shareholders
8. What do you see thus far about the “corporate tax system”? Assume a corporation carries on a profitable business and earns in a year business income of say $100. This is its “taxable income” from a business for the year. Also assume the corporation pays income tax on the $100 of this taxable income, and declares and pays a dividend to its individual shareholder(s) who is at the top individual tax bracket.
9. The dividend received by the individual shareholder(s) must be included in the shareholder’s income by reason of paragraph 12(1)(j) and paragraphs 82(1)(a) and (a.i). It has long ago been held that a dividend declared and paid by a corporation is not a deductible expense to the corporation in earning income from its business. The dividend is not incurred for the purpose of earning profits (and thus, no section 9 deduction is available), but rather the dividend is simply a non-deductible application of the corporation’s profits once earned.
10. What is the total tax on the $100?
the corporation’s tax, at the “base case” federal-provincial corporate tax rate of 25%, on the $100 of business income is / $25.00the individual shareholder’s tax on the available $75.00 dividend received, at the top individual federal-provincial tax rate of 43.7%, is / $32.76
thus the total tax paid is $57.76 / $57.76
the total effective tax rate on the $100 of business income is computed as the total $57.76 of tax paid by the corporation and the shareholder as a percentage of the $100 of business income earned, or approximately … / 58%
11. Why would shareholders, who have the choice, carry on business through a corporation? Incorporating a business can make commercial sense – i.e., limited liability. What about the total taxes paid? If the $100 of taxable income could be earned directly by the individual as a sole proprietorship, and taxed at only the top individual rate of 43.7%, why incorporate the business and pay a total tax of approximately 58% - some 15% more?
12. This question was addressed in part during the 1972 tax reform process in Canada. The (i) “gross-up” and (ii) “dividend tax credit” system was invented for all dividends received by individual shareholders from corporations resident in Canada. This is largely the system we have today. In short, the individual shareholder is “given some credit” for corporate tax that is assumed to have been paid. When the system was invented the assumed corporate tax rate was approximately 20%.
13. It is important to understand the original tax policy behind the gross-up and the dividend tax credit:
/ assume the corporation’s income is / $100assume the corporation’s tax at 20% is / $20
assume the actual dividend paid to the shareholder is / $80
the “gross-up” (or add-back) to the actual $80 dividend paid was fixed at an amount equal to “¼ of the dividend paid” - i.e., $20 here … / $20
… both the actual dividend and this “gross-up” go into the shareholder’s taxable income / $100
now compute the shareholder’s tax on this “gross-up dividend amount” at the top tax rate of say 43.7% / $43.7
deduct from this tax a “dividend tax credit”, which is equal in theory to the to the gross-up amount (i.e., the tax paid at the corporate level / $20
the shareholder’s net tax is / $23.7
the total tax is ($20 plus $23.7) / $43.7
the total “effective tax rate” is the $43.7 as a percentage of the $100 / 43.7%
The theory of the “gross-up” and “dividend tax credit” is to the effect that if the actual corporate tax rate was 20%, there would be no advantage or disadvantage to “incorporating” the source of income - from the tax perspective. The same tax is paid if the $100 of taxable income is earned “through a corporation” (i.e., 43.7% in the above example) or directly by the individual (43.7%). This concept is sometimes described as “integration” if you are focusing on the net all-in tax rate; and “neutrality” if you are focusing on the incentive or disincentive to incorporate.
14. Before 2006 the integration system had one glaring hole: corporate income taxed at the general corporate rate did not integrate with shareholder income (because the dividend tax credit did not compensate the shareholder for the full amount of corporate tax paid). This was fixed for 2006 and subsequent years. The “fix” was the creation of different gross-up and dividend tax credit rates for corporate income taxed at the general “base case” rate. Taxable dividends paid from corporate income taxed at the “base case” rate are called “eligible dividends” (because they are eligible for the higher dividend tax credit).[2] Taxable dividends that are not eligible dividends are called “ordinary dividends”.
15. Now move from policy to law. The “gross-up” for “ordinary” dividends is 1/4 (or 25%) of the actual dividend received (by reason of paragraph 82(1)(b)) (eligible dividends are discussed in more detail in paragraphs 21 – 25). This grossed-up income applies for federal and provincial income tax purposes because individual provincial income is largely the same as federal income. The gross-up is fixed, and is based on the theoretical 20% corporate tax rate in the chart above. Moreover, the gross-up applies regardless of the actual corporate tax rate or amount of corporate tax paid by the corporation.
16. The “dividend tax credit”, in policy terms, should equal the gross-up. The idea is that the shareholder is given a credit (federally and provincially) against the shareholder tax for the assumed corporate tax already paid. Under the existing law, the dividend tax credit is indeed granted in part by the federal government and in part by the provincial government. Two-thirds (2/3rds) of the dividend tax credit is granted by the federal government as credit against the individual’s federal income tax (see section 121). Historically, one-third (1/3rd) has been granted by provincial governments as a credit against provincial individual income tax. This split has reflected the historical fact that provincial individual tax has been roughly half of the federal tax (or 1/3rd of the total individual tax).
17. In British Columbia the matter is further refined (or complicated, depending on your perspective). The current provincial portion of the dividend tax credit for ordinary dividends is only 17% of the gross-up, not 1/3rd (see section 4.69 of the BC Act).[3] The reason for the reduction was a policy choice made by the government of the day; it reduced the dividend tax credit to ensure that the top provincial tax rate was equal to the top provincial tax rate, plus surtaxes, under the prior system.[4]
18. In any event, it is clear the total dividend tax credit available to an individual resident in British Columbia on an ordinary taxable dividend is not equal to the full amount of the gross-up, but rather equals the federal portion under section 121 (2/3rds or 66.67% of the gross-up) plus the British Columbia portion under the BC Act (17% of the gross-up). Thus, rather than the individual shareholder being entitled to a dividend tax credit equal to 100% of the gross-up amount, the individual is entitled to 83.67% of the gross-up amount as a tax credit.
19. We now know, of course, that the “base case” corporate tax rate is not 20% but rather 25%. (We will see different rates in Chapters 3 and 4). And we now know that there is less than 100% tax credit for the gross-up through the dividend tax credit mechanism. Using the 25% base case rate, and the dividend tax credit at 83.67% rather than 100% of the gross-up, a distinct lack of integration arises:
/ the corporation’s tax on the $100 at the base rate of 25% is / $25.00the actual dividend paid to the shareholder, being the $100 less the $25.00 is / $75.00
“gross-up” the dividend by ¼ of the actual dividend, or $18.75,[5] for a total amount included in the shareholder’s income of / $93.75[6]
shareholder tax at the top federal-provincial tax rate of 43.7% / $40.97
deduct the “dividend tax credit”, being the 83.67% of the $18.75 gross-up, or / $15.69
net shareholder tax / $25.28
the total $50.28 of tax on $100 of income translates to an effective tax rate of 50.2%, or rounded to / 50%
20. Thus, where the “base rate” of corporate tax applies to the corporation’s income (i.e., 25%), the individual shareholder pays an additional tax of approximately 6.3% by earning the $100 of taxable income “through the corporation” as opposed to earning the $100 directly and being subject only to the personal tax rate at 43.7%. However, there is, while the profits are retained by the corporation and not paid out as a dividend, a “deferral” of tax of 18.7% - being the difference between the 43.7% personal tax that would be paid if the source of income was held personally and the base case corporate tax rate of 25%.