This is the second post in the investment tax series – reading the first post here is essential to understand the next step of discussing the most complicated mechanism in the corporate investment tax structure, the RDTOH. The goal of this blog is to make investment concepts easier to understand by using basic explanations. The RDTOH is the toughest one yet to explain but I will try my best. I have found proper understanding of this post has taken a few reads for most to comprehend. Please feel free to ask questions in the comment section for clarification. Please remember the huge disclaimer that I am not an accountant and any accounting decisions should always be reviewed with your accountant.
Refundable Dividend Tax On Hand (RDTOH)
Basic Concepts and Definitions
The RDTOH is another notional or bookkeeping account tracked by the accountant. A reader asked the perfect question in the previous post about the capital gains tax and the CDA to explain why the RDTOH exists.
The question was once corporate tax has been paid on investment income held within a CCPC, shouldn’t there be a lower tax burden when paid out to a shareholder to compensate for the corporate tax already paid? The answer is a resounding yes! This is the theory of tax integration, which means income should be taxed no differently if it was received in a corporation or personally. The tax code was designed to not unfairly allow corporations to keep excessive amounts of capital within it or to penalize it greatly with excessive tax burden. Another way to word this is it would be unfair to receive double taxation (taxed corporately and personally with no adjustment)
The difficulty in achieving tax integration is there is never a guaranteed timing that investment income is finally going to be passed on to the shareholder personally to level the playing field out tax wise. It would be unfair to not tax the corporate investment income at all until it is drawn out personally, because then it could achieve much better tax deferred growth than if the investment was held personally ( remember the tax leakage section of the last post?)
The RDTOH notional account was the fancy trick the tax code created to give back the corporate tax paid once the shareholder finally receives the investment income. This money back to the corporation would balance the process out to then let the shareholder be taxed fairly in their personal hands at their marginal tax rate.
There are two categories of investment income treatment in reference to the RDTOH account:
- Ordinary Income – this includes the 50% taxable capital gain portion (discussed in the previous post), interest income, dividends received from foreign companies (including the US ) listed on stock exchanges, and investment property rent. The combination of all these forms of ordinary income is called the aggregate investment income (AII) for the tax year. I will discuss AII in more detail later.
- Dividends – do you remember the difference between ineligible and eligible dividends?
An ineligible dividend is the type of dividend that a CCPC or private small business corporation pays out to its shareholders. This dividend has nothing to do with investment income at all. It is a form of income removal to pay out after-tax corporate retained earnings to the shareholder. It differs from salary, which is paid out to the shareholder from pre-tax corporate earnings. In other words, salary is a CCPC expense deduction, but ineligible dividends are not. Since the source of funds for an ineligible dividend has already paid some corporate tax, the ineligible dividend is taxed at a lower rate than the equivalent salary to compensate for this. This is the theory of tax integration at work again. This will be important to remember when I discuss what happens to the adjusted cost basis (ACB) portion of an investment when it is sold and the shareholder wishes to pay it out. The ACB comes from after tax retained earnings and will follow the ineligible dividend route for removal to the shareholder.
An eligible dividend is a form of investment income received from a Canadian controlled public company such as RBC, BMO or Bell. Dividends are a way for companies to pay out a portion of yearly profit to its shareholders who are essentially the owners of the company. Typically a dividend is paid by companies that have consistent predictable cash flow. There is no guarantee a public company will pay a dividend on an ongoing basis – it can stop at any time the management decides there is better use for the cash or if profits decline. This is different than interest income or rent which is typically a contractual obligation to pay a determined amount.
The tax code treats dividends from Canadian companies in a kinder way and helps promote investment in the Canadian economy. It is important to remember that an eligible dividend is being paid out from after-tax profits of the public Canadian company and therefore the federal government has already received some tax on this investment income. This is why the RDTOH treats eligible dividends differently.
As noted above, foreign dividends from companies like Apple are treated as ordinary income and taxed the same as rent or interest income in the RDTOH since the federal government has not yet received any tax on this investment income yet.
How does the RDTOH notional account change in value?
I will start with the way RDTOH treats dividends first since it is easier to understand. Eligible dividends have taxation in a CCPC of 33.3% federal tax and no provincial tax component. In regards to the RDTOH account, all of the 33.3% tax paid by the CCPC is allocated to the RDTOH. This full refund happens because the public Canadian company already paid tax to the federal government before it could pay the eligible dividend out to its shareholders. This favorable tax treatment also occurs on a personal non-registered portfolio where you can receive almost $50,000 of just eligible dividend income and pay zero tax! I discussed this in a prior post under the reduced taxes section.
The following example will help explain:
Lili’s CCPC receives $1000 in eligible dividends in a tax year, $333 in tax (33.3%) would be paid by the CCPC in that tax year. A $333 amount would be added to the notional RDTOH account for tracking purposes. This will keep on happening for every eligible dividend received until the RDTOH account balance is decided to be paid out, which I will cover below. The key concept here will be that 100% of the initial tax paid by a CCPC on receiving an eligible dividend will eventually be given back to the CCPC once the retained corporate amount is finally paid out to the shareholder.
As a reminder, ordinary income includes the 50% taxable capital gain portion, interest income, foreign dividends and investment property rent. The combination of all these forms of ordinary income is called the aggregate investment income (AII) for the tax year.
The actual taxation of ordinary income in a CCPC varies somewhat between the provinces between ~45% and 50% – I will use 50% for this discussion to make the numbers easy.
A complicated process of refunding portions of the federal tax amount occurs based on tax law. The final result allocates 26.67% of the total AII each year into the notional RDTOH account. Remember that no money is actually in this account currently and the full 50% tax on ordinary income was paid by the CCPC initially.
An example here will help for clarity:
Lili’s CCPC receives $7000 of rent from a rental property, $2000 in interest from a bond and has a $1000 equivalent capital gains portion to pay (after a $2000 capital gain because $1000 of the gain is tax free) for a total of $10,000 of combined ordinary income or AII. The tax owed on the AII is 50% and therefore $5000 of tax is paid. To ensure tax integration occurs, the magical number of 26.67% of the total AII or $2667 is added to the notional RDTOH account. This amount will again be available to come back to the CCPC once it pays out some retained corporate earnings to claim the RDTOH refund.
Between amounts accrued from dividends or ordinary income, the notional RDTOH balance will build with time. The fancy calculation is:
RDTOH amount = (.2667 x total yearly AII amount) + (.333 x total yearly eligible dividend amount)
Unlike the CDA, there is nothing that will decrease the value in the RDTOH until it is paid out and there is no formal election process that requires extra administrative cost. It can be done on a yearly basis, no matter how small the amount.
How does the RDTOH refund actually happen?
Obviously something needs to be paid out to the shareholder for the CCPC to receive a refund. In order to actually claim the RDTOH balance, the rule is that you must pay out $3 of ineligible dividend to the shareholder for every $1 of RDTOH balance you wish to claim. I am not sure where this $3 for $1 amount came from (similar to not knowing how they came up with 26.67%) other than it allows optimal tax integration to occur somehow. Remember the ineligible dividend can be paid from any after tax corporate retained earnings sitting in the corporate bank account.
Going back to the example:
Lili had $2667 in the RDTOH from the AII portion and $333 from the dividend portion = $3000 total of notional value in the CCPC RDTOH account.
Lili’s CCPC will have to pay $3 for every $1 claimed or $3 x $3000 available RDTOH balance = $9000 ineligible dividend to herself in order for the CCPC to claim the entire $3000 back into its corporate account. This would be as simple as writing a cheque with the memo “ineligible dividend” from the CCPC to Lili’s personal name. The accountant will now claim the full refund and either offset taxes owes or receive a cheque back from CRA to the CCPC.
Viola! That is the whole process! My understanding is that there is no requirement to refund the entire amount of RDTOH balance each time. Whatever is left over from a partial refund will remain there for a future refund.
Back to Jonathan in Example 2 From The First Post
Here is an excerpt from the last post:
“Jonathan had $1.11 million in realized capital gains. He has $555,000 available in the CDA to pass tax free to himself.
The remaining $555,000 of profit/capital gain will be taxed at the highest rate of ~50% (varies per province between 45-50%).
This equals $277,500 of taxes owed within the CCPC or an effective tax rate of 25% on the original $1.11 million capital gain.
So when the dust settles, Jonathan has the original $1 million ACB from the money he put up to make the investments and $832,500 of the profit left after paying the corporate capital gains tax = $1.8325 million in corporate cash after tax.
He can pay out $555,000 tax free if he makes the capital dividend election, which would still leave $1.2775 million cash in the corporation.
The remaining balance of $1.2775 million can be paid out as well, but it is important to remember that to remove this cash from the corporation into Jonathan’s personal hands, he will be taxed at the marginal rate of that withdrawal.”
Jonathon’s CCPC paid a total tax of $277,500 on its $1.11 million capital gain. Given there was no other form of ordinary income or eligible dividends, the total Aggregate Investment Income (AII) is the 50% taxable capital gain portion of $555,000.
The RDTOH account would get .2667 x ($555000) = ~$148,000 into its notional account.
To receive the full RDTOH refund in the CCPC, Jonathan would have to pay $3 for every $1 claimed ($148,000) = $444,000 ineligible dividend cheque written from the CCPC to himself.
Let’s assume the full refund is claimed and Jonathan lives in BC. Jonathan pays out sole personal income of $444,000 ineligible dividend with an effective 40.95% tax rate or ~$182,000 tax, leaving him with $262,000 leftover in his personal hands. He also chooses to take the whole CDA balance of $555,000 personally tax free. Jonathan’s total personal amount paid out from CCPC = $817,000 out in 1 year
The CCPC has paid out $555,000 in retained earnings and a ineligible dividend of $444,000 = $999,000. It initially paid $277,500 of capital gains tax but gets its $148,000 RDTOH refund back into the corporate bank account for a net corporate tax of $129,500.
Total personal tax ($182,000) + Total net corporate tax $129,500 [$277,500(capital gains tax) – $74,000 (RDTOH refund)] = $311,500 in total tax across personal/corporate process
When viewing the initial $1.11 million corporate capital gain in the CCPC, the $311,500 tax is a 28% effective tax rate through the whole tax process, which closely approximates the 25% effective personal tax rate paid by Julie in her non-registered account in the first example of capital gains tax. The theory of integration has almost worked!
The problem in this example is the very large sum of withdrawal by Jonathan that almost never would practically occur. If he chose to take out a smaller ineligible dividend to not claim the RDTOH all in one year, the ineligible dividend tax rate would decline into the mid 20’s instead of over 40%. Remember there is no need to take the whole RDTOH balance in one year!
Any differences in final effective tax rate can also be influenced by how ineligible dividends are taxed in each province. Some absolute tax savings can happen if the province has a lower ineligible dividend tax rate, with BC being one of them. This is a topic for another post though!
Capital Gains Tax, CDA, RDTOH and Proposed Tax Changes
Everything discussed above applies currently to taxation and the government seems quite committed to ensuring all current investment assets will be grandfathered in.
Many readers will be wondering how corporate capital gains tax or the RDTOH handling of dividends might change with the new government position of allowing a prospective passive $50,000 investment income/year from the corporate passive investment portfolio. Unfortunately, this answer remains unclear as the finer details have been left out. This is likely why you have been hearing the unsatisfying answer from your accountant of “we just have to wait and see”. I feel the lack of clarity and flip-flopping by the Liberals has been the most concerning part of the process. It makes me nervous that even when they announce the final changes, they may suddenly arrange the chessboard again on tax treatment in the CCPC.
Here are just a few of the things I suggest watching out for that will affect the answer of how effective the CDA and RDTOH will be moving forward:
- Does the CDA and RDTOH apply to tax treatment below the $50K threshold? Do they disappear once the threshold is exceeded? I have shown above the power of the CDA account in retirement primarily for removing larger sums of retirement savings to use personally.
- Is the whole capital gain being counted as part of the $50K amount or is it only the taxable 50% portion? For example a $100K capital gain may only have a $50K taxable portion if the CDA operates as usual with $50K of the gain being available to pass onto a shareholder.
- Will there be inflation adjustments to the $50,000 amount? Given that inflation causes costs to double ~ every 18 years, a new professional would be struggling with a cap of ~$12,500 threshold in real purchasing power near the time of their retirement.
Overall, I am cautiously encouraged by the trend of the discussion by the government. Proper corporate portfolio asset allocation can allow the corporate investment portfolio to build into substantially more than the $1 million portfolio quoted without exceeding the proposed $50,000 threshold. My corporate portfolio has a passive income yield of 1.3% via an efficient composition that will allow for a long duration of uninterrupted tax deferred unrealized capital gains growth. This is because I have little significant ordinary income outside of some foreign dividends now that I sold my corporately owned rental property. My Canadian eligible dividends amount is significant, so I will be looking to eventually move portions of these holdings into personal hands over time if the $50,000 threshold comes in. I will also be paying close attention to what the final outcome of the CDA and RDTOH is to determine how easy it will be to remove funds in retirement.
Hopefully with this post, you will better understand the complexities of capital gains tax in a CCPC and be able to know what is truly being proposed once it is announced. If you are finding these posts helpful I suggest you should subscribe for email updates as post frequency can vary. Our family will be having our third child any day now, so I have no idea when the next post might be!