Trust Funds

You may not know it yet, but there’s a whole new tax system. Last year, members of the Liberal government spent sleepless nights worrying about the growth of the income trust market. Investor interest in trusts has grown because of the tax advantages that trusts enjoy over corporations. Income distributed by trusts is taxed once, usually when funds are distributed. Corporate distributions are taxed twice — first when the corporation earns income and then again when retained earnings are paid out as dividends.

This unique trust advantage led investors to abandon traditional investments like GICs and bank stocks in favour of income trusts. The problem is that many of those investors are psychologically risk-averse. They’ve bought income trusts expecting that the cash flows generated are secure. In many cases, they simply aren’t. But since income trusts are such a new innovation, people are not aware of the risk in buying them. That led to fears in Ottawa and on Bay Street of a trust meltdown.

To slow down the shift in investments from corporations to trusts, then Finance Minister Ralph Goodale brought out a budget that liberalized (yes, the pun’s intentional) the taxation of dividends. His goal was to make traditional investments more competitive with trusts.

Beginning in 2006, the maximum tax rate on eligible dividends was reduced from 31% in Ontario to 20%. The new rules will not only affect dividends paid by Canadian public companies, but also dividends paid by Canadian private companies out of active business income that has not benefited from the small business tax rate.

The changes will have a large impact and are especially important for how business owners deal with their companies’ earnings.

Impact on investors

If you’re like most people, you hold equities in your registered retirement savings plan, or RRSP. You may be surprised to know that approach is a subject of some controversy among accountants and the investment advisors. Investment advisors often suggest that equities be put in RRSPs since these registered plans are where most Canadians have the bulk of their savings. Tax people, on the other hand, are generally against putting equities inside registered plans. It hurts us to think that you’ll end up paying full tax on dividends and capital gains — just because that income was earned inside an RRSP. If you kept your equities out of your RRSP, you’d end up with more money after tax. For that reason, tax advisors suggest that people invest both inside registered plans (where the fixed income portion of your portfolio can be held without a tax penalty) and outside registered plans (where equities can be held in order to reap their tax advantages).

Now with the tax even lower on public company dividends, the tax people have a stronger argument for holding equity investments outside registered plans. For example, if you’re an Ontario resident with income of $60,000, you’d pay tax of $13,700 in 2005. If you added $5,000 of eligible dividends to your income, how much extra tax would you pay under the new rules?

The answer is none. In fact your taxes would actually drop by about $50. How is that possible? This anomaly occurs because the new dividend tax credit actually exceeds the marginal tax rate at that level of income.

How much would you pay on that $5,000 of income if it was in your RRSP? My guess is 30%-40%. The actual amount will depend on your tax rate when you retire. But, when you withdraw amounts from your RRSP or Registered Retirement Income Fund (RRIF) you’ll be paying tax at full rates on that income.

So the new rules make it even more favourable to invest in equities outside your RRSP.

Impact on business owners

It’s been standard practice for business owners to bonus their company’s income down to the small business threshold of $300,000. Paying yourself a bonus in most cases immediately triggers personal taxes at the highest personal rate — 46%. That’s a heavy hit, but it’s better than the alternative — having the company pay tax at the full business rate and then having the shareholder pay tax again on the dividend. Following the latter course leads to a tax rate of about 57%.

The new regime will change that. Under the new rules, the combined personal and corporate rates will be only slightly higher than the top personal rate. In addition, the government has proposed that corporate tax reductions will be phased in over the next several years. That means that business owners should reconsider their habit of bonusing out income in excess of the small business limit. We may see these bonuses becoming a thing of the past.

Holding companies

If the use of bonuses does decline, the retained earnings in Canadian-controlled private corporations (CCPCs) are likely to grow very rapidly. It’s probable that more portfolio investments will be made within corporate groups. In that case, it will be important to separate funds not required for the business operations from funds at risk. Business owners would be wise to shift their excess corporate savings to holding companies as a means of protection against lawsuits and other creditors.

The implications of these changes are substantial, but so far haven’t been much recognized by the business community. As an individual engineer or company owner, you should start to consider how the changes in dividend rules will affect you.

Joan Cullemore, CA is a principal with Bulmash Cullemore, chartered accountants of Toronto. To receive more information, e-mail Hank Bulmash at hank@businesslab.ca