Generally a corporation can produce two different types of income; business income and investment income. Business income includes most active income generated by the corporation. In essence, business income is the product of active and direct involvement of a corporation in an intensive business, such as manufacturing. Investment income, on the other hand, includes dividends, capital gains, and other income from property. Business income is taxed at roughly half the rate applicable to investment income at the corporate level.
Once a corporation has generated after tax income, it may declare a dividend to its shareholders which attracts a second level of tax. If you are thinking that there is double taxation, whereby the same income is taxed first at the corporate level, then again at the individual shareholder level, you are correct. This is where the concept of integration plays a paramount role.
The theory behind integration is that the total tax should be the same whether the income is earned through a corporation, or directly by an individual. Integration seeks to achieve tax neutrality with respect to the form of organization. To achieve this, two major tools are utilized.
The first tool is the “dividend gross-up.” By gross-up, we’re referring to an arbitrary increase in income for tax reporting purposes of actual dividends paid. Dividend gross-up adds to the dividend received by the individual shareholder an amount to total corporate income tax paid by the corporation on the income that gave rise to the dividend.
The second tool is the “dividend tax credit.” The dividend tax credit gives a shareholder credit against taxes otherwise payable for taxes paid by the corporation on the shareholder’s behalf.
In theory, perfect integration results when the gross-up amount and the dividend tax credit amount equal the total corporate tax paid by the corporation. In practice, this usually is not the result, with small favorable or unfavorable arbitrage amounts arising, depending on the province where the corporation is taxed.
Invitation for Discussion:
If you would like to discuss this article in greater detail, or any other business law matter, please do not hesitate to contact one of the lawyers in the Tax group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.