Many Canadian small business corporations can earn two kinds of income:
Refundable Dividend Tax on Hand (RDTOH) is an important tax concept that applies to investment income earned in a corporation. It’s referred to in many of our life insurance concepts, such as the Corporate Retirement Strategy and the Corporate Investment Strategy. This article discusses what RDTOH is, why our tax system has it, and how it’s calculated.
What follows is a general discussion about RDTOH; it is a notional account produced when a Canadian private or subject1 corporation, resident in Canada, earns and pays tax on specific types of income (discussed in more detail below). A Canadian-controlled private corporation (a "CCPC") can generate an RDTOH account from its "aggregate investment income"2 and from the tax it pays on the applicable dividends it receives. Other private corporations can only generate RDTOH account amounts from the tax they pay on the applicable dividends they receive. Public and non-resident corporations cannot generate an RDTOH account.
Subsection 129 of the Income Tax Act (ITA) provides an extensive and complex definition of RDTOH. Briefly stated, refundable taxes are posted to a corporation's RDTOH account(s) as follows:
Investment income consists of taxable capital gains7 minus business investment losses, plus income from property, such as interest, rent and royalties8. This type of income is taxed to the corporation at high rates, approximately 50% (combined federal/provincial marginal rate) depending on the province where the corporation carries on business.
Dividends from "non-connected" Canadian corporations - also called "portfolio dividends" - are dividends received on the shares of corporations that the recipient corporation owns as an investment. A "connected" corporation, on the other hand, is a corporation that:
It's possible for dividends to flow tax-free between connected corporations, but whether a particular dividend being paid from one connected corporation to another is in fact tax-free should be discussed with a tax advisor. Dividends from "non-connected" corporations are taxed to the recipient corporation at a combined federal/provincial marginal rate, after grossing up the dividend and applying the federal and provincial dividend tax credits. An amount equal to the tax the recipient corporation pays on that dividend may be posted to that corporation's RDTOH account.
1Subsection 186(3) of the Income Tax Act defines the terms "subject corporation". Briefly, it is a corporation (other than a private corporation) resident in Canada that is controlled by or for the benefit of a non-trust individual or a group of non-trust individuals. Because subsection 186(5) generally deems a subject corporation to be a private corporation for the purposes of dividend refunds, the remainder of this article will simply use the terms "private corporations" and "CCPCs".
2For simplicity's sake, we'll use the term "investment income" throughout this article instead of "aggregate investment income" (AII). In general terms, AII is the aggregate world-source net capital gains and net income from property (more definition follows below); the term is formally defined in subsection 129(4) of the Income Tax Act.
3Again, this component only accrues to the RDTOH account of a CCPC.
4For taxation years that ended before 2016, this tax rate was 26.67%. [Note that the 30.67% amount is comprised of a base 20% tax rate plus a 10.67% "additional refundable tax" (ART) rate.]
5Note that this amount accrues to the RDTOH account a private corporation whether-or-not it is a CCPC.
6This amount, levied on portfolio dividends, was 33.33% for dividends received before 2016.
7Taxable capital gains are what you get from the sale of a capital asset, minus what you originally paid for it, minus any expenses you incurred in selling it, divided by two. Capital losses are calculated in a similar way and may be used to offset taxable capital gains.
8Foreign investment income, net of the foreign tax credit, is also included.
9e.g. if the dividend-paying corporation controls the recipient corporation, according to the subsection 186(2) definition of "control".
10e.g. if the dividend-receiving corporation owns more than: (i) 10% of the payer corporation's voting shares; and (ii) 10% of the fair market value of the payer corporation's issued shares.
Corporations create RDTOH accounts to track the "extra" tax they are paying on investment income, and to preserve their right to claim a tax credit when they pay a taxable dividend to a shareholder. Why do they go to this trouble, and why do they get a tax credit? In a word, integration. Integration is an important goal of Canada's tax system. When a tax system is perfectly integrated, the tax authorities will not care whether a shareholder earns income personally or as dividends from their corporation. They will collect the same amount of tax from taxing the corporation on its business earnings (and then taxing the shareholder on the dividends received from that corporation) as they would if the shareholder had earned the money personally. A second goal is to discourage using corporations as tax shelters for investment income. Canada's tax system achieves that goal by taxing corporate earned investment income at high rates. If it were otherwise, investors could move money into corporations, benefit from the low tax rates generally available to small businesses, and partially defer taxes on their investment income. But having a high corporate tax rate on investment income inhibits integration when a corporation distributes after-tax investment income to its shareholders. Consider what happens when a corporation pays its after-tax investment income as dividends. $10,000 taxed at a 50% rate inside the corporation leaves $5,000 to distribute to the shareholder as a dividend. If that $5,000 dividend is taxed at 35% in the shareholder's hands (after the gross up and dividend tax credit), only $3,250 remains after-tax for the shareholder. That amounts to a combined 67.5% tax rate on the original $10,000. RDTOH tax treatment provides a tax credit for the corporation to help reduce that overall rate.
As discussed above, when a corporation earns investment income, it can post an amount equal to 30.67% of that income to its RDTOH account. Also, if a corporation earns a dividend from a non-connected Canadian corporation, and pays tax on that dividend, it can post an amount equal to the tax it has paid on that dividend to its RDTOH account. If the corporation never pays a taxable dividend to its shareholders, the RDTOH account grows each year as the corporation earns investment income or dividends from non-connected corporations, and pays tax on those earnings. But having an RDTOH account only confers a benefit on the corporation if it pays a taxable dividend. If the corporation pays a taxable dividend to its shareholders, it can claim a tax credit equal to $0.38 for every $1 it pays11, up to the limit of its RDTOH account. There's no need for the dividend income to come from the corporation's investment earnings. As long as the dividend is taxable in the shareholder's hands, the corporation may claim the RDTOH credit12.
The table at the end of this article shows the varying tax treatments that apply in the following situations (tax rates shown are approximations), and helps show how the RDTOH credit works:
Even though each scenario shows different types of income subject to different tax rates, there is nearly perfect tax integration, with each scenario showing nearly the same after-tax income and overall tax rate. In the far right column, corporate investment income is taxed at high rates, and the dividend is taxed at the same rate as the dividend paid by the corporation earning only small business income. But the RDTOH credit returns some of the money the corporation paid in high taxes on its investment income, so that the overall tax rate approximates that of the individual and the small business corporation.
Of course, the income mixes and tax rates shown in the table are well chosen. If you changed them across the three scenarios, you would reach different results, with greater or less tax integration. But the goal of integration is not to achieve perfectly equal tax rates in all scenarios, but to instead reduce the discrepancies that inevitably result from applying different tax rates to different types of income.
The lower rows in the table show what would happen if we removed the RDTOH tax credit. Overall after-tax income for the scenario showing corporate investment income (the far right column) falls from $113,968 to $95,778, while the overall tax rate on that income jumps from 43% to 52%. The two other scenarios are not affected by this change. High corporate investment tax rates therefore help discourage investors from using their corporations as investment shelters. For corporations that do earn investment income, though, the RDTOH tax credit reduces the overall level of taxation to a level comparable to that paid by those earning personal and business income, but only when the corporation pays a taxable dividend.
11Prior to the December 2016 passage of Bill C-2, CCPCs were subject to a lower refund of $0.33 for each $1 of taxable dividends paid; this was often referred-to as a "1 for 3" refundable rate.
12Note that, because of this, a refund via the RDTOH credit will not be triggered by tax-free dividends that are paid either: (i) between connected corporations; or (ii) out of a CCPC's Capital Dividend Account (CDA).
For taxation years that begin after 201813, private corporations will have two separate RDTOH accounts:
The RDTOH credit - i.e. the "dividend refund" - is then generated as follows. From the non-eligible RDTOH account, a dividend refund will only be generated when the corporation pays a non-eligible dividend. Conversely, RDTOH credits will be generated from the eligible RDTOH account when either: (i) the CCPC pays an eligible dividend, or (ii) the CCPC pays a non-eligible dividend and there is no balance remaining in the non-eligible RDTOH account. Where the corporation receives a dividend from a connected payer-corporation, the character of the received dividend will correspond to the payer-corporation's relevant RDTOH accounts. There is still a requirement that, for those corporations seeking to access the dividend refund, corporate tax returns must be filed within three years of the taxation year in which the dividends are paid.
13These measures were first proposed in Budget 2018, and were subsequently enacted in June 2018. Transitional measures allow a CCPC to allocate its existing RDTOH balance to its new "eligible RDTOH" account in an amount that is the lesser of: (i) the existing RDTOH balance at the time of the new rules take effect; and (ii) 38.33% of the CCPC's general rate income pool ("GRIP") balance. Any remaining RDTOH balance would then be allocated to the CCPC's "non-eligible RDTOH" account.
Canada's tax system tries to deter shareholders from using corporations as investment shelters by taxing corporate investment income at similar rates to those that a shareholder would pay. It also tries to integrate that income to negate the tax difference between money earned inside or outside of a corporation. The RDTOH account is an important tool that helps the tax system achieve both goals. This article is intended to provide general information only. Sun Life Assurance Company of Canada does not provide legal, accounting or taxation advice to advisors or clients. Before your client acts on any of the information contained in this article, or before you recommend any course of action, make sure that your client seeks advice from a qualified professional, including a thorough examination of his or her specific legal, accounting and tax situation. Any examples or illustrations used in this article have been included only to help clarify the information presented in this article, and should not be relied on by you or your client in any transaction.
|INCOME||Personal Income||Corporate business income (no RDTOH account)||Corporate investment income (RDTOH account)|
|(Eligible, Portfolio) Dividends||$33,0001|
|15% on business income||$30,000||$15,000|
|45% on personal income||$90,000|
|50% on coporate interest income||$16,500|
|50% on corporate capital gains (50% inclusion rate)||$8,500|
|38% on dividends||$12,649|
|NRDTOH - On investment income (30.67%)||$15,3352|
|ERDOTH - On dividends (38.33%)||$12,6493|
|Total RDTOH account||$27,984|
|PAID AS DIVIDEND||$170,000||$147,351|
|35% tax on dividends||$59,500||$51,5734|
|RDTOH tax credit ($1.15 for every $3 in dividends paid to a maximum of total RDTOH account)||$27,9845|
|RDTOH credit paid as dividend||$27,984|
|35% tax on dividends||$9,7944|
|RDTOH credit paid as dividend|
|Total after-tax income||$110,000||$110,500||$113,968|
|Overall tax rate||45%||45%||43%|
|After-tax income without RDTOH||$110,000||$110,500||$95,778|
|Overall tax rate without RDTOH||45%||45%||52%|
1These are assumed to be eligible dividends that were received from a non-connected corporation.
2"NRDTOH" is the "non-eligible" RDTOH account, for taxation years that begin after 2018.
3"ERDTOH" is the "eligible RDTOH" account, for taxation years that begin after 2018.
4While eligible-dividends and non-eligible dividends are taxed at different marginal rates in a shareholder's hands, the 35% tax rate here is used as a composite tax rate.
5Recall that a dividend refund will only be generated from NRDTOH when the corporation pays a non-eligible dividend. Conversely, RDTOH credits will be generated from ERDTOH when either: (i) the CCPC pays an eligible dividend, or (ii) the CCPC pays a non-eligible dividend and there is no balance remaining in the non-eligible RDTOH account.