Incorporating a Business – A Tax Perspective
As the business grows, entrepreneurs at some point may need to consider, or at least have heard of, the idea of incorporating their business. This is a complex decision that involves several legal, financial and tax implications. This blog will provide a brief overview some of the important consequences of incorporation from a tax perspective.
An informative summary of the legal considerations can be found on the Business Venture Blog here.
A corporation is one of three basic types of business organization, with the other two being sole proprietorships and partnerships. There are two basic differences between corporations from the other forms: [i]
1)Corporations have a separate legal existence. The corporation, rather than the owner, operates the business and bears all the rights and obligations that come with that business.
2)The owners and managers of the corporation become separate and have distinct rights and obligations.
This has an important consequence – the income earned by the corporation running the business and the income earned by the shareholders of the corporation are separately taxable. Because there are two levels of taxation, the differences in the way they are taxed create advantages and disadvantages for the business owner. Some advantages include the ability to reduce taxes by claiming tax credits only available to corporations, controlling the timing of income, or splitting income (to a limited degree). Some disadvantages include the restriction against deducting business losses against personal income, the additional costs of maintaining a corporation such as registration and accounting fees, and the complexity of winding down the corporation when the business ends.[ii]
Taxable Income – Corporations vs Unincorporated Businesses
There are some differences between the tax treatment of business income earned through a corporation and business income from a sole proprietorship or partnership. For a more thorough overview of the tax treatment of business income, see our blog posting here.
In short, the amount of taxes owed from a business is based on Taxable Income, which is calculated as:
1)Net income (or “profit”) based on accounting rules,[iii] then
2)Adjustments are made to calculate Net Income for Tax Purposes,[iv] then
3)Additional deductions are made to arrive at Taxable Income.[v]
This calculation applies to both corporations and individuals with unincorporated businesses. However, there are different kinds of deductions available to each type of business, or the deductions may be treated differently. Deductions available to individuals but not corporations include:[vi]
Deductions that are treated differently include:[viii]
Tax Incentives Specific to Corporations
Several tax incentives available to support incorporated businesses include:
1)Small business deduction – ITA s 125(1)
The federal small business deduction allows Canadian-controlled private corporations (“CCPC”) reduce their taxes payable based on a limited amount of active business income earned in Canada. The business must be a CCPC, which is a private Canadian corporation that is not controlled by one or more non-resident persons or corporations whose shares are publicly traded or listed on a stock exchange.[ix]
Income from an “active business” includes most kinds of business income except for income from a “specified investment business” or “personal services business”.[x] These terms have complicated meanings, but it essentially means that active business income excludes passive income earned merely by owning property (for example, stocks and bonds), and income earned by providing what could be reasonably seen as an employee service.
The deduction is calculated as 19% of active business income (for the 2020 tax year) earned during the year up to $500,000.[xi] This amount would then be deducted from your federal tax payable.
2)Investment tax credits – ITA s 127(5) through s 127.1(4)
Canada offers specific tax credits to support corporations investing into their business. These include credits for scientific research and experimental development (“SR&ED”), employing an eligible apprentice, and purchasing property to run a business in Atlantic Canada.[xii]
3)Foreign tax deduction – ITA s 126
Both individuals and corporations may claim a tax credit to offset foreign taxes paid on business and non-business income earned outside of Canada. The main difference is that, for foreign non-business income, the amount of credit an individual can claim is limited to the lesser of:
a)15% of foreign non-business income, and
b)Another limit based on a formula.
There is no 15% limit for corporations – they may instead claim up to the total foreign taxes paid on foreign non-business income or the formula limit, whichever is lower.[xiii]
4)Manufacturing and processing (“M&P”) profits deduction – ITA s 125.1
The federal government offers a tax reduction based on 13% of profits earned (for 2020) from “manufacturing and processing” activities in Canada. There is no precise definition of manufacturing and processing, but the tax rules exclude activities such as logging; construction; extracting minerals; and producing industrial minerals, natural gas, and heavy crude among many other exceptions.[xiv]
Note that there may not be any actual tax benefits from claiming the M&P profits deduction as any income not included in that deduction is eligible for the general rate reduction, which creates another deduction using same percentage and applies to all other income. However, Ontario, Quebec, and Saskatchewan offer their own tax credits based on M&P activities.[xv]
5)Provincial small business deductions and tax credits
All provinces provide small business deductions to CCPCs like the federal deduction above. Each province also provides tax credits for corporations performing specific activities. For example, Alberta offers the Innovation Employment Grant (beginning January 1, 2021) and tax credits for scientific research and development, foreign taxes paid, capital expenditures, and production and labour costs for film and television productions.[xvi]
Salary vs Dividends
In the case of an owner-managed business corporation, owners have the option to pay themselves a salary, dividends, or a combination of both. This decision depends greatly on the individual circumstances of the owner and their business. Some important considerations are listed below:[xvii]
1)Provincial tax rates and credits
While all Canadian corporations are subject to the same federal tax rates, different provincial tax rates and credits could weigh in favour of salaries or dividends depending on where the business is incorporated. Generally, individuals taxed at higher rates would likely prefer dividends as their tax effects are offset by dividend tax credits. Salaries of course receive no such credit.
2)Types of dividends received
Corporations can pay either eligible or non-eligible dividends, each of which have their own tax treatment. Eligible dividends typically receive (are “eligible” for) more generous tax credits than non-eligible dividends. However, whether a dividend is eligible or not depends on the tax treatment of the corporate income from which the dividends were paid, and the tax credit is intended to offset that difference. Given that and the differences in the provincial tax treatment of dividends, there is no clear answer to whether salaries or dividends should be preferred.
3)CPP and EI contributions
Being paid a salary allows an owner to continue making contributions to the Canada Pension Plan (“CPP”) and Employment Insurance (“EI”), whereas dividends do not. Being paid in dividends will have the effect of lowering the amounts the owner is eligible for under either plan.
Salary payments are used to determine how much an owner can contribute to their Registered Retirement Savings Plan (“RRSP”). RRSP contributions enable individuals to defer taxes by allowing them to deduct their contributions from income. Dividends received are not factored in and so would not increase their total contribution room.
5)Childcare expense deductions
Salary is also used to determine how much an individual can deduct in childcare expenses.[xviii] Dividends do not count towards this limit and so could reduce the amount an owner may claim for this deduction.
A goods and services tax (“GST”) is charged on most goods and services in Canada and is paid by consumers. With some exceptions, the suppliers of these items (including business corporations) are responsible for collecting and remitting GST to the Canada Revenue Agency. For an overview of a business’s GST obligations, please see our blog post here.
Transferring Business Assets to a Corporation
It is often the case that business owners will have worked at and grown their business long before they consider incorporation. If they do decide to incorporate, owners may transfer their business assets to the corporation. However, under normal tax rules this transfer could result in the owner paying additional taxes (through capital gains and CCA recapture).[xix]
Section 85 of the Income Tax Act[xx] provides a solution to this. The owner must notify CRA that he or she intends to transfer their assets to the corporation and elect to have Section 85 apply by filing certain forms. There are many detailed rules around how to properly perform the transfer, including what kinds of assets are eligible for transfer, what the owner should receive in return for the transfer (for example, shares in the corporation), and how the assets should be valued. In essence, this election may prevent owners from facing needless tax liabilities in growing their business.
[i] J Anthony VanDuzer, The Law of Partnerships and Corporations, 4th ed (Toronto, Ontario: Irwin Law Inc, 2018) at 13-16.
[ii] Clarence Byrd, Ida Chen & Gary Donell, Byrd & Chen’s Canadian Tax Principles: 2020-2021 Edition, Volume 2 (North York, Ontario: Pearson Canada Inc) [Byrd and Chen] at 725-727.
[iii] For an explanation of “profit”, see “Basic Tax Implications for Canadian Entrepreneurs”, (30 December 2020), online (blog): Business Venture Blog http://www.businessventureclinic.ca/blog/december-30th-2020.
[iv] Income Tax Act, RSC 1985, c 1 (5th Supp) [ITA], s 9(1).
[v] ITA, supra note iv at s 110(1).
[vi] Byrd and Chen, supra note ii at 585.
[vii] In 2019, the Government of Canada proposed changes to the current treatment of employee stock options, where there will be a $200,000 limit on stock options that qualify for the stock option deduction. Employees with options over this limit would not receive the deduction on those options and include the entire excess benefit in income when the options are exercised. Instead, the employer will be able to deduct the amount that would have been eligible for the deduction. CCPCs and non-CCPC corporations with annual gross revenues of $500 million or less would not be subject to the new rules. The Government’s goal was to “ensure that start-ups and emerging Canadian businesses that are creating jobs can continue to grow and expand and attract key talent, while limiting the benefit of the employee stock option deduction for high-income Canadians who work in mature companies.” The new rules are expected to apply to options granted on or after July 1, 2021. See Department of Finance Canada, “Supporting Canadians and Fighting COVID-19: Fall Economic Statement 2020“ (2020) at 113-114, online (pdf): Her Majesty the Queen in Right of Canada https://www.budget.gc.ca/fes-eea/2020/report-rapport/FES-EEA-eng.pdf
[viii] Byrd and Chen, supra note ii at 585-586.
[ix] ITA, supra note iv at s 125(7).
[x] ITA, supra note iv at s 125(7).
[xi] ITA, supra note iv at s 125(1.1)(c) and 125(2).
[xii] See Canada Revenue Agency, “Line 41200 – Investment tax credit” (date modified: 18 January 2021), online: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/deductions-credits-expenses/line-41200-investment-tax-credit.html
[xiii] Byrd and Chen, supra note ii at 615.
[xiv] See ITA, supra note iv at s 125.1(3) for definition. See also Canada Revenue Agency, “Income Tax Folio S4-F15-C1, Manufacturing and Processing” (last modified: 15 February 2017), online: https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax/income-tax-folios-index/series-4-businesses/series-4-businesses-folio-15-manufacturing-research-development/income-tax-folio.html#N101DD
[xv] Byrd and Chen, supra note ii at 609.
[xvi] See Government of Alberta, “Corporate income tax” (date accessed: 30 January 2021), online: https://www.alberta.ca/corporate-income-tax.aspx#deduction
[xvii] Byrd and Chen, supra note ii at 753-758.
[xviii] ITA, supra note iv at s 63(1)(e)(i).
[xix] Byrd and Chen, supra note ii at 775.
[xx] ITA, supra note iv at s 85(1).
Blog posts are by students at the Business Venture Clinic. Student bios appear under each post.