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The New Eligible Dividend Rules – A Closer Look

Presented for The Canadian Institute of Financial Planners – National ConferenceKim G C Moody, CA, TEPRSM Richter LLPJune 11, 2007, Calgary, Alberta

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A Closer Look at the New Eligible Dividend Rules

Agenda• Brief history• What is GRIP and why is it so important?• Traditional remuneration strategies – revisited.• Asset vs. share example• Use of a triangle structure• Shareholder agreements• How should advisors and their clients deal with the changes?

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Brief History

• November 23, 2005 – Department of Finance News Release.• Announces that, effective January 1, 2006, taxation will be reduced

for “eligible dividends” in order to level the playing field for corporations and income trusts.

• Many questions/issues.• Draft legislation released June 29, 2006 – 66 pages of draft

amendments and explanatory notes.

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Department of Finance ReleaseBrief History (cont’d)

• September 29, 2006: CICA-CBA Joint Committee on Taxation releases comments to Department of Finance.

• 2nd round of draft legislation released October 16, 2006 – mostly minor changes but some changes noteworthy.

• Bill C-28, which contains eligible dividend draft legislation, received First Reading October 18, 2006 and passed by the House of Commons on December 11, 2006.

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Department of Finance ReleaseBrief History (cont’d)

• Received 3rd reading on February 14, 2007 and Royal Assent on February 21, 2007.

• October 31, 2006 – Department of Finance News Release – new “Distribution Tax” for publicly traded income trust and partnerships.

• October 31, 2006 Release appears to be a response to recent announcements of BCE and Telus and Jack Mintz’s paper “Income Trust Conversions: Estimated Federal and Provincial Revenue Effects”

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The New Tax Pools

• By definition, dividends are paid out of after-tax corporate retained earnings.

• New rules introduce two new tax pools:a) General-rate income pool (“GRIP”); andb) Low-rate income pool (“LRIP”)

• At most, a given corporation will have one GRIP or one LRIP at any time.

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What is GRIP and Why is it Important?

• Company can pay eligible dividends to the extent that it has a GRIP balance.

• Preferential tax treatment to Canadian residents for receipt of an eligible dividend.

• Gross up of 45% and dividend tax credit of 11/18 of the grossed up amount.

• Results in an effective tax rate of 17.4493% for 2007.• Effective tax rate to decrease to 14.549% in 2009.

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General Rate Income Pool (“GRIP”)

• New definition of GRIP will appear in subsection 89(1) of the Act.• Applicable only for a taxable Canadian corporation that is a

Canadian-controlled private corporation (“CCPC”) or a deposit insurance corporation (“DIC”).

• DIC’s are ignored for the purposes of this presentation.

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GRIP - Timing

• GRIP is calculated at the end of a particular taxation year.

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GRIP – Calculation – Overview

• Calculated by formula A – B• Can be a positive or negative amount.• In broad terms, A is the corporation’s GRIP at the end of the taxation

year determined without reference to any specified future tax consequences.

• Specified future tax consequences includes the carryback of non-capital losses under paragraph 111(1)(a).

• B adjusts that amount calculated under A to the extent that specified future tax consequences for preceding taxation years reduce the corporation’s taxable income subject to the general corporate rate.

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GRIP – Calculation of “A”

• A = the positive or negative amount that would, before taking into consideration the specified future tax consequences, be determined by the following:

• A = C + .68 (D-E-F) + G + H – I• C = corporation’s GRIP at the end of its preceding taxation

year.• D = the corporation’s taxable income for the particular taxation

year

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GRIP – Calculation of “A”(con’td)

• E = the amount determined by multiplying the amount, if any, deducted by the corporation under subsection 125(1) (the

small business deduction) for the particular taxation year by the quotient obtained by dividing 100 by the rate of deduction provided under that subsection for the particular taxation

year.• F = if the corporation is a CCPC, the lesser of the

corporation’s aggregate investment income or the taxable income for the particular taxation year of a CCPC and if the corporation is not a CCPC nil.

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GRIP – Calculation of “A”(cont’d)

• G = the total of:a) An eligible dividend received by the corporation in the

particular taxation year; orb) An amount deductible under section 113 in computing

the taxable income of the corporation in the particular taxation year

• H = the total of all amounts determined under new subsections 89(4) to (6) in respect of the corporation for the particular taxation year – this is to be discussed in later slides.

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GRIP - Calculation of “A”(cont’d)

• I = a) unless paragraph (b) applies, the amount, if any, by which

i) the total of all amounts of each of which is the amount of an eligible dividend paid by the corporation in its preceding taxation year

exceedsii) the total of all amounts each of which is an excessive

eligible dividend designation made by the corporation in its preceding taxation year, or

b) if subsection (4) applies to the corporation in the particular taxation year, nil

• Note that, as stated earlier, the calculation of ‘A’ is calculated before taking into consideration the specified future tax consequences.

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GRIP – Calculation of “B”

• B = 68% of the amount, if any, by whicha) the total of the corporation’s full rate taxable incomes (as would be

defined in the definition “full rate taxable income” in subsection 123.4(1), if that definition were read without reference to its subparagraphs (a)(i) to (iii)) for the corporation’s preceding three taxation years, determined without taking into consideration the specified future tax consequences, for those preceding taxation years, that arise in respect of the particular taxation year,exceeds

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GRIP – Calculation of “B”(cont’d)

b) the total of the corporation’s full rate taxable incomes (as would be defined in the definition “full rate taxable income” in subsection 123.4(1), if that definition were read without reference to its subparagraphs (a)(i) to (iii)) for those preceding taxation years

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GRIP – Calculation of “B”(cont’d)

• See subsection 248(1) for the definition of “specified future tax consequences”.

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GRIP Summary

• GRIP is generally the amount of after-tax income that was subject to the general corporate tax rate, i.e. no small business deduction.

• “GRIP bump” allowed for the 2000-2005 taxation years.• Includes receipt of “eligible dividends” and foreign dividends

deduction under subsection 112.• Does not include “aggregate investment income”.• Deduct “eligible dividends” paid.• Adjusted for specified future tax consequences for preceding

taxation years.

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AlbertaDividend Tax Rates

< $300,000 > $400,000 < $400,000 > $430,000 < $400,000 > $460,000 < $400,000 > $500,000 < $400,000 > $500,000 < $400,000 > $500,000Federal - dividend gross up 25.000% 45.000% 25.000% 45.000% 25.000% 45.000% 25.000% 45.000% 25.000% 45.000% 25.000% 45.000%Alberta - dividend gross up 25.000% 45.000% 25.000% 45.000% 25.000% 45.000% 25.000% 45.000% 25.000% 45.000% 25.000% 45.000%Federal dividend tax credit 13.333% 18.966% 13.333% 18.966% 13.333% 18.966% 13.333% 18.966% 13.333% 18.966% 13.333% 18.966%Alberta dividend tax credit* 6.000% 7.500% 5.500% 8.000% 4.500% 9.000% 3.500% 10.000% 3.500% 10.000% 3.500% 10.000%

Dividend tax rate 24.5838% 18.1743% 25.2088% 17.4493% 26.4588% 15.9993% 27.7088% 14.5493% 27.7088% 14.5493% 27.7088% 14.5493%

2009 2010 2011

* The Alberta dividend tax credit on non-eligible dividends (i.e. income subject to the small business rate) may require minor adjustments due to technical issues related to different Federal and Alberta small business thresholds.

2006 2007 2008

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Combined Top Eligible Dividend Amount of Eligible

Marginal Rates Tax Credit Rate Dividends Received Tax Free

Eligible Applied to Applied to Actual Taxable

Dividends Actual Dividend Taxable Dividend Dividend Dividend

Federal 14.55% 27.50% 18.97% $66,420 $96,310

British Columbia 18.47 17.40 12.00 150,840 218,720

Albertab 17.45 11.60 8.00 53,225 77,175

Saskatchewan 20.35 15.95 11.00 59,780 86,680

Manitoba 23.83 15.95 11.00 46,930 68,050

Ontarioc 24.64 9.72 6.70 45,535 66,025

Québec 29.69 17.26 11.90 26,580 38,540

New Brunswick 23.02 17.40 12.00 56,715 82,235

Nova Scotia 28.35 12.83 8.85 28,045 40,665

Prince Edward Island

24.44 15.23 10.50 40,890 59,290

Newfoundland 32.52 9.64 6.65 13,780 19,980

2007 Top Marginal Rates, Dividend Tax Credit Rates and Amount of Dividends that May be Received Without Incurring Tax in 2007*

*Source: taxnetpro.com; Carswell.

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Proposed Corporate Tax Rates

• Source – Department of Finance Backgrounder – October 31, 2006

Table 3: Proposed Corporate Income Tax Rates, 2007 - 2011

2006 2007 2008 2009 2010 2011

(percent)

Federal Rates 22.12 21.0 20.5 20.0 19.0 18.5

Alberta 10.0 10.0 10.0 10.0 10.0 10.0

Total 32.12 31.0 30.5 30.0 29.0 28.5

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Traditional Remuneration Strategies - Revisited

• The following slide illustrates the cash flow difference between paying a bonus from a Corporation versus incurring full corporate taxes and paying taxable (non-eligible and eligible) dividends.

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Traditional Remuneration Strategies - Revisited (cont’d)Alberta - Bonus v. No Bonus

Bonus No Bonus Bonus No Bonus Bonus No Bonus Bonus No Bonus Bonus No Bonus Bonus No Bonus

Taxable income 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ 1,000,000$ Bonus 700,000$ -$ 600,000$ -$ 600,000$ -$ 600,000$ -$ 600,000$ -$ 600,000$ -$ Taxable income after bonus 300,000$ 1,000,000$ 400,000$ 1,000,000$ 400,000$ 1,000,000$ 400,000$ 1,000,000$ 400,000$ 1,000,000$ 400,000$ 1,000,000$

Corporate income taxFederal - small business rate 39,360$ 39,360$ 52,480$ 52,480$ 46,000$ 46,000$ 44,000$ 44,000$ 44,000$ 44,000$ 44,000$ 44,000$ Federal - general rate -$ 154,840$ -$ 132,720$ -$ 123,000$ -$ 120,000$ -$ 114,000$ -$ 111,000$ Alberta - small business rate 9,000$ 12,000$ 12,000$ 12,900$ 12,000$ 13,800$ 12,000$ 15,000$ 12,000$ 15,000$ 12,000$ 15,000$ Alberta - general rate -$ 62,220$ -$ 57,000$ -$ 54,000$ -$ 50,000$ -$ 50,000$ -$ 50,000$ Total corporate income tax 48,360$ 268,420$ 64,480$ 255,100$ 58,000$ 236,800$ 56,000$ 229,000$ 56,000$ 223,000$ 56,000$ 220,000$

Dividend PoolNon-eligible - Federal 251,640$ 248,640$ 335,520$ 334,620$ 342,000$ 340,200$ 344,000$ 341,000$ 344,000$ 341,000$ 344,000$ 341,000$ Non-eligible - Alberta 251,640$ 348,640$ 335,520$ 364,620$ 342,000$ 400,200$ 344,000$ 441,000$ 344,000$ 441,000$ 344,000$ 441,000$ Eligible - Federal -$ 482,940$ -$ 410,280$ -$ 423,000$ -$ 430,000$ -$ 436,000$ -$ 439,000$ Eligible - Alberta -$ 382,940$ -$ 380,280$ -$ 363,000$ -$ 330,000$ -$ 336,000$ -$ 339,000$

Personal income taxSalary - Federal 203,000$ -$ 174,000$ -$ 174,000$ -$ 174,000$ -$ 174,000$ -$ 174,000$ -$ Salary - Alberta 70,000$ -$ 60,000$ -$ 60,000$ -$ 60,000$ -$ 60,000$ -$ 60,000$ -$ Total personal income tax on Salary 273,000$ -$ 234,000$ -$ 234,000$ -$ 234,000$ -$ 234,000$ -$ 234,000$ -$

Personal income taxEligible Dividend - Federal -$ 70,264$ -$ 59,693$ -$ 61,544$ -$ 62,562$ -$ 63,435$ -$ 63,871$ Eligible Dividend - Alberta -$ 13,882$ -$ 11,028$ -$ 5,263$ -$ -$ -$ -$ -$ -$ Total personal income tax on eligible dividend -$ 84,146$ -$ 70,721$ -$ 66,807$ -$ 62,562$ -$ 63,435$ -$ 63,871$

Personal income taxNon-eligible dividend - Federal 49,281$ 48,693$ 65,707$ 65,531$ 66,976$ 66,624$ 67,368$ 66,781$ 67,368$ 66,781$ 67,368$ 66,781$ Non-eligible dividend - Alberta 12,582$ 17,432$ 18,873$ 20,510$ 23,513$ 27,514$ 27,950$ 35,831$ 27,950$ 35,831$ 27,950$ 35,831$ Total personal income tax on non-eligible dividend 61,863$ 66,125$ 84,580$ 86,041$ 90,489$ 94,138$ 95,318$ 102,612$ 95,318$ 102,612$ 95,318$ 102,612$

Total taxes 383,223$ 418,691$ 383,060$ 411,862$ 382,489$ 397,745$ 385,318$ 394,174$ 385,318$ 389,047$ 385,318$ 386,483$

Net cash flow (income minus total taxes) 616,777$ 581,309$ 616,940$ 588,138$ 617,511$ 602,255$ 614,682$ 605,826$ 614,682$ 610,953$ 614,682$ 613,517$

Net cash flow after tax per $ of income 0.61678$ 0.58131$ 0.61694$ 0.58814$ 0.61751$ 0.60226$ 0.61468$ 0.60583$ 0.61468$ 0.61095$ 0.61468$ 0.61352$

2010 20112006 2007 2008 2009

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Traditional Remuneration Strategies - Revisited

Summary of cash flows:

2006 2007 2008 2009 2010 2011

Bonus 616,777 616,940 617,511 614,682 614,682 614,682

No Bonus 581,309 588,138 602,255 605,826 610,953 613,517

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Traditional Remuneration Strategies - Revisited Summary

• By 2009 there is a nominal difference between a bonus down to small business deduction (“SBD”) limit and no bonus (i.e. full dividend).

• Allows for a deferral of personal taxes if funds kept inside the corporation, i.e. tax deferral of approximately 8% for 2007 (increasing to 10.5% for 2011).

• Need to determine what the cash needs are of shareholder and corporation; automatic bonus down to SBD limit is not necessary.

• Reduction of bonus will reduce section 67 risks.• Watch SR + ED issues.

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Asset Sale vs. Share Sale

• The following example illustrates the cash flow difference between:

1. Selling the shares of a corporation personally, and2. Selling the assets of a corporation and paying a dividend to the shareholder.

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Asset Sale vs. Share Sale - Example

Facts – Share sale

• Mr. Apples sells shares.• FMV = $1,000,000• ACB = $0• Mr. Apple is a resident of Alberta.• No ECGD

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Asset Sale vs. Share Sale – Example(cont’d)

Proceeds 1,000,000

ACB 0

Capital Gain 1,000,000

½ Taxable 500,000

Tax Rate 39%

Personal Tax 195,000

Total Cash Flow

Proceeds 1,000,000

Personal Taxes (195,000)

Total Cash Flow 805,000

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Asset Sale vs. Share Sale – Example(cont’d)

Facts – Asset Sale

• Mr. Apples owns 100% of Opco.• Opco’s only asset is goodwill.• FMV = $1,000,000• Corporation and Shareholder are resident of Alberta.• Assume SBD for Opco is not available.

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Asset Sale vs. Share Sale – Example(cont’d)

Corporation

Proceeds 1,000,000

Taxable portion – 50% 500,000

Tax Rate 31%

155,000

Proceeds 1,000,000

Corporate Taxes (155,000)

Cash to Distribute 845,000

CDA Dividend (500,000)

Eligible Dividend (340,000)

Non-eligible Dividend (5,000)

$ 845,000

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Asset Sale vs. Share Sale – ExampleConsequences

Dividend Tax Rate Tax Payable

CDA Dividend 500,000 0% 0

Eligible Dividend 340,000 17.45% 59,330

Non-Eligible Dividend 5,000 25.2% 1,260

$845,000 $60,590

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Asset Sale vs. Share Sale – ExampleConsequences (cont’d)

Total Cash Flow

Proceeds 1,000,000

Corporate Taxes (155,000)

Personal Taxes (60,590)

Total Cash Flow $ 784,410

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Asset Sale vs. Share Sale – ExampleSummary

Total Cash flow:

Share Sale $805,000Asset Sale $784,410

• Difference between proceeds share sale and asset sale is narrowing.• Not as big a bias for seller to sell shares.• May defer taxes personal taxes if funds are invested in corporation.

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Triangle Structure

Trust

HoldCo

OpCo

100%

99%

1%

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Advantages of Triangle Structure

• Can push GRIP to Holdco.• QSBC preservation.• Reinvest after-tax corporate proceeds in Holdco (by paying tax-free

inter-corporate dividends from Opco to Holdco).

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Shareholder Agreements

• Should be flexible to allow manipulation and distribution of GRIP.• Necessity if have non-resident shareholders.

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How Should Advisors and Their Clients Deal With the Changes?

• New rules are complicated.• Rules of thumbs no longer applicable.• Each situation must be evaluated to ensure proper tax planning is

undertaken.• General practitioner need to exercise extreme caution.