In our November 2018 Tax Letter, we discussed the refundable Part IV tax that can apply to a Canadian-controlled private corporation (“CCPC”) on certain dividends that it receives from another corporation.
In general terms, the 38 1/3% Part IV tax applies to dividends that a CCPC receives from a corporation where the CCPC owns 10% or less of the shares of the corporation (based on either votes or fair market value). These dividends are often referred to as “portfolio dividends”.
The Part IV tax can also apply if the CCPC receives dividends from another corporation that are not portfolio dividends (that is, where the CCPC owns more than 10% of the other corporation), if the other corporation receives a dividend refund on the payment of the dividends to the CCPC.
The Part IV tax is added to a notional account called the refundable dividend tax on hand (RDTOH) account.
The CCPC then receives a refund of the Part IV tax equal to 38 1/3% of the taxable dividends it pays to its shareholders, to the extent of its RDTOH account. (Examples were provided in the November Letter.)
However, there are two types of dividends that the CCPC can pay to its shareholders: eligible dividends and non-eligible dividends. Eligible dividends are generally paid out of the CCPC’s income that was subject to the general corporate tax rate. Non-eligible dividends are generally paid out of the CCPC’s active business income that was eligible for the small business deduction, or investment income where the tax is refundable, such as the refundable Part IV tax.
A shareholder receiving an eligible dividend receives a dividend tax credit that is more generous than the dividend tax credit in respect of a non-eligible dividend. The more generous dividend tax credit for eligible dividends reflects the fact that the general corporate tax rate for a CCPC is higher than the rate that applies to business income that qualifies for the small business deduction, and higher than the rate that applies to investment income after the refund of the refundable tax on such investment income.
Under the pre-2019 rules, a CCPC could receive a refund of Part IV tax whether it paid eligible or non-eligible dividends, as long as it had enough of a balance in its RDTOH account. Apparently, the Department of Finance felt that this result was not always appropriate, since a CCPC could receive a refund of its Part IV tax even though the shareholder received an eligible dividend and therefore the more generous dividend tax credit.
As a result, in the 2018 Federal Budget, the Department addressed the situation, and amended the rules to split up the RDTOH account into two accounts: the eligible RDTOH and the non-eligible RDTOH.
The eligible RDTOH account of a CCPC will include the Part IV tax payable on eligible portfolio dividends it receives, plus the Part IV tax payable on other dividends it receives to the extent the corporation paying the dividends receives a refund of tax out of its eligible RDTOH.
A CCPC’s non-eligible RDTOH account will generally include the Part IV tax payable on any other dividends that the CCPC receives.
When the CCPC in turn pays eligible dividends to its shareholders, it can receive a refund of its Part IV tax out of its eligible RDTOH account. Furthermore, under the ordering rule noted below, the payment of non-eligible dividends can generate a refund out of the eligible RDTOH account.
When the CCPC pays a non-eligible dividend, it can receive a refund of its Part IV tax out of its non-eligible RDTOH account.
An ordering rule provides that upon the payment of a non-eligible dividend, a refund is first taken out of the non-eligible RDTOH account, and any remaining amount of the dividend can generate a refund out of the eligible RDTOH account.
These new rules apply to taxation years that begin after 2018, so if your corporation has a December 31 year-end, then the rules are already in force for it, for the year beginning January 1, 2019. A transitional rule splits up the pre-existing RDTOH of the CCPC for its first affected taxation year. In general terms, the lesser of the RDTOH balance at the end of the previous year and 38 1/3% of the CCPC’s “general rate income pool” (basically, income that was subject to the general corporate tax rate), is allocated to the CCPC’s eligible RDTOH account. Any remaining balance is allocated to its non-eligible RDTOH account.