In the world of Canadian taxation, understanding the nuances of how income is treated can make a significant difference for business owners, especially those operating under the banner of Canadian Controlled Private Corporations (CCPCs). In this article, we’ll delve into the intriguing world of active and passive income and how they are taxed differently within CCPCs.
Active Business Income: A Tax-Friendly Treat
Active business income is the lifeblood of many CCPCs. It represents the money generated from regular operations, such as plumbing, electrical services, accounting, or even running a pizza shop. The Canadian tax system extends a warm welcome to active business income through the “small business deduction.” This deduction allows CCPCs to enjoy a lower tax rate on their active income, serving as an incentive to support small businesses and reinvest in their growth.
Passive Income: Taxed at a Higher Rate
Now, let’s switch gears to passive income, which encompasses earnings like interest, capital gains, and even rental income. Yes, you read that right – even long-term rental income is considered passive by the Canada Revenue Agency (CRA). Despite the potential hard work involved in managing rental properties, passive income doesn’t benefit from the same tax advantages as active income. In fact, it is usually subject to significantly higher tax rates, occasionally exceeding 50% in certain provinces.
The government’s rationale for this discrepancy is to discourage individuals from utilizing CCPCs solely as a means to reduce their personal tax liabilities by earning passive income through their corporations.
The government’s rationale for this discrepancy is to discourage individuals from utilizing CCPCs solely as a means to reduce their personal tax liabilities by earning passive income through their corporations.
Understanding the “Refundable Dividend Tax on Hand” (RDTOH) Account
Now, let’s demystify a peculiar element of the tax system – the “refundable dividend tax on hand” (RDTOH) account – as it used to be called. Think of this account as an non-interest-bearing bank account for your CCPC, held at the CRA. This accountant as has a unique withdrawal mechanism – dividends.
Here’s where it gets interesting: when your corporation distributes dividends to its shareholders, it may be eligible for a “dividend refund.” This mechanism aims to partially offset the higher taxes paid on passive income. Essentially, it allows the corporation to recoup approximately 50% of the taxes previously paid when distributing dividends to shareholders.
The purpose of this system is to bridge the gap between the tax rates on passive and active income, making the overall tax burden more equitable.
An Everyday Example: The Pizza Shop Analogy
To simplify this complex tax scenario, let’s use an everyday example. Imagine your Canadian business is akin to a pizza shop, where you make money in two ways: selling pizzas (representing active business income) and renting out a room in your shop to a neighbor (representing passive income).
For your pizza sales, the government provides you with a “small business deduction” discount, which reduces your tax burden, similar to a reward for being a small pizza shop.However, when it comes to the income generated from renting out the room, the government imposes a higher tax rate.To balance things out, envision a special savings jar called the “refundable dividend tax on hand” jar. Every time you pay extra taxes on your rental income, you deposit that extra amount into the jar.
Later, when you decide to share pizza profits with your shareholders, you can dip into the jar to assist with the payouts. This way, you use the saved-up tax money to make the sharing of pizza profits more equitable.
In a nutshell, the government provides a discount for your pizza income (active business income) while taxing your room rental income (passive income) more. The jar of saved-up tax helps level the playing field when distributing pizza profits to your friends.
Conclusion:
In conclusion, understanding the tax treatment of active and passive income within CCPCs is crucial for business owners in Canada. The tax system aims to promote small businesses by offering incentives for active income while discouraging the use of corporations solely for passive income tax advantages.
We hope this article has shed some light on this complex topic. And while we discussed pizzas, why not treat yourself to a slice? Stay hungry, my friends!
Check out our video on Taxation of Corporate Passive vs. Active Income in Canada
