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UPDATED Salary vs. Dividends…Which is Right For Me?

17/05/2013


​Tax changes announced in the most recent Federal budget have necessitated this follow-up to my original blog of December 9, 2011.

Advantages of Dividend Tax Strategy No Longer Add Up

Until now, non-eligible or “regular” dividends were preferred over wages in a number of provinces since the total tax paid on the corporate income and subsequent dividends received personally was up to 2% or 3% lower than the tax rate applicable to straight wages. For many business owners, a dividend compensation strategy compared to salary/wages resulted in a lower overall tax liability in the thousands of dollars on an annual basis (not to mention the CPP premiums that were avoided).

This tax advantage of dividends over salary had to do with a tax concept known as “integration,” and in this case “over-integration.” Basically, with perfect integration, an individual would pay the same combined tax between themselves and their corporation, regardless of how they compensate themselves via wages, dividends, etc. Given all of the moving parts, including the corresponding provincial tax rates on the various types of income, integration is not perfect (nor likely ever will be). Fortunately, this imperfect integration model has benefitted many small business owners who paid themselves via dividends as opposed to wages. The Federal government was well aware of this tax leakage, and  now due to the string of recent Federal deficits, has put a stop to it.

The recent Federal budget included a subtle tweak to the dividend tax credit which resulted in an increase in the tax rates applicable to non-eligible dividends, completely wiping out the previous tax advantage of a dividend compensation strategy in many provinces.

It should be noted that the changes only impact non-eligible dividends which are dividends paid out of income subject to the small business deduction and/or investment income earned inside a corporation. Eligible dividends, which are paid out of income subject to the general (or high) corporate tax rate weren’t in need of any tweaking since they were subject to “under-integration.” This means that the government was already collecting approximately 1% extra tax in many provinces where business owners distributed this corporate surplus via eligible dividends as opposed to wages.

Expect to pay more tax on Corporate Investment Income such as Interest and Royalties

One of the unfortunate casualties of this recent tax change is to investment income earned inside a company – specifically interest, rent, royalties, etc. Due to under-integration, these forms of income were already subject to additional tax of 2% or more in many provinces when earned via a corporation and later distributed to the shareholder in the form of dividends; as opposed to being earned directly by an individual. The dividend tax credit changes in the recent Federal budget have now increased this tax disadvantage on certain forms of corporate investment income to 4% or more in many provinces.

Determining Your New Compensation Strategy

So what does this all mean?  Basically, when deciding on your compensation mix between dividends and salary, one of the key tax advantages offered to dividends is likely no longer available so the decision needs to be made based on other factors such as whether you want to create RRSP/IPP room, whether you want to avoid CPP premiums, etc. Please refer to my original blog for a more in-depth explanation of the trade-offs.

As an aside, for interest, rent and royalty income earned inside a corporation, this additional tax cost is an unfortunate result of the Federal budget changes and any tax planning done to try and mitigate this will need to be unique to the specific circumstances involved. One of the main reasons for this is that the option of simply paying out additional wages to the shareholder(s) to avoid this tax premium will likely draw opposition from CRA, as their administrative position to not challenge the reasonableness of wages paid to individual, active shareholders of an operating company does not apply to passive income earned inside a company.

The bottom line is that tax planning is always a moving target and given these recent tax changes, now is the perfect time to revisit your compensation strategy with an MNP tax professional.