Changes to the Dividend Tax Credit – How does this affect the self-employed?

Written by Ciarán P. Lynch, M.A. | Market Research Analyst
August 28, 2013

In recent years, it has been economical for the owners of a Canadian-controlled private corporation (CCPC) to pay themselves dividends as opposed to drawing a salary. Jamie Golombek, the Managing Director of Tax and Estate Planning at CIBC, was one of the first to propose a dividend-only strategy through his 2010 article ‘Rethinking RRSPs for Business Owners: Why Taking a Salary May Not Make Sense’. When written, this article challenged the assumed notion that Canadian small business owners should pay themselves a salary to maximize RRSP contributions, and either pay remaining profits as a dividend, and/or leaving remaining money within their company. However, with the changes to the dividend tax credit set to be introduced in 2014, there is a need to re-evaluate this strategy.

Budget 2013 delivered a blow to small business owners by increasing the federal effective tax rate on non-eligible dividends from 19.58% to 21.22%. This article will explore how these changes impact a business owner’s tax liability, as well as the intangible effects of choosing not to draw a salary. The model used is based on a series of assumptions – the most significant of which is that in order to find a clear tax saving number, I felt it was necessary to exclude CPP contributions (as a payroll tax) on a business owner’s salary. Reason being, CPP contributions are notionally repaid in retirement (i.e. it is more of an investment than an outright tax). Furthermore, the tax differential would increase when excluding CPP contributions.

Consider the example of a majority owner of a CCPC based in Ontario. In 2013, the final tax year before the proposed dividend tax credit changes take effect, assume the CCPC’s income is $250,000 after all deductions, but for the owner’s compensation. If this $250,000 is paid as a salary, total tax (not including the CPP deductions) would be $95,898.31. If the CCPC’s profits were paid with a salary to maximize RRSP contribution room and the remainder as a dividend, the total tax would be $91,767.80. Conversely, a dividend-only strategy would lead to a tax bill of $87,433.39. In practice, the immediate annual tax saving using the dividend-only strategy would be higher due to the 9.9% self-employed CPP deduction on pensionable earnings – but as discussed above, to find the absolute tax saving, this was excluded from the model.

Table 1: 2013 Taxation on Self-Employed Compensation of $250,000

Strategy Tax Payable 2013 Absolute Tax
Saving 2013
Salary Only $95,898 n/a
Maximizing RRSP $91,768 1.65%
Dividend Only $87,433 3.38%

Budget 2013 has changed several aspects of this tax benefit for 2014. The gross-up factor of non-eligible dividends is set to decrease from 25% to 18% and the Federal Dividend Tax Credit will decrease from 13.33% of the grossed up amount to 11.0169%. There will be similar changes to the respective provincial dividend tax credits – these will be made public in each province’s individual budget announcement. This projection assumes that the Ontario Dividend Tax Credit will decrease from 4.5% to 3.72%1. The results turned out as such:

Table 2: 2014 Taxation on Self-Employed Compensation of $250,000 using 2013 Tax Rates

Strategy Tax Payable 2014 Absolute Tax
Saving 2014
Salary Only $95,898 n/a
Maximizing RRSP $94,132 0.71%
Dividend Only $92,398 1.40%

Paying $250,000 as a salary, total tax not including the CPP deductions is, again, $95,898.31. The RRSP Maximizing strategy boasts a total tax bill of $94,131.51. The dividend-only strategy would lead to a tax liability of $92,397.78.
Looking at Tables 1 and 2, the absolute tax saving decreases from 3.38% to 1.4% for a dividend-only strategy and from 1.65% to 0.71% using a Maximizing RRSP strategy. So if you subscribed to a dividend-only strategy, how do the changes to the dividend tax credit mechanism affect you from 2014 onwards?

As you can see, in 2013 and prior years, there was a larger absolute tax saving to paying out dividends from a CCPC’s profits. That said, to truly answer the question of whether or not this will continue to be a prudent strategy, we must consider the downsides attributed to non-salaried remuneration:

  1. No RRSP contribution room
  2. No Canada Pension Plan
  3. Grossed-up dividend income impacts the OAS claw back (should an individual continue to receive dividends into retirement)
  4. A salary is needed to claim childcare and/or employment expenses on an individual income tax return

There is a comfort level heading into retirement having contributed to the CPP, having an RRSP, and increased OAS eligibility2.

It could be argued that some of the tax deferral benefits of an RRSP (this article discusses the tax liability associated with the tax deferred RRSP accounts) can be realized through retaining and investing profits through the business. That said, there are key differences between funds held within an RRSP, and funds held within a HoldCo. Most significantly, RRSPs can offer creditor protection. Conversely, the HoldCo investments would be among the first to be seized. Additionally, should a business have any resale value, the owner would not be entitled to the $800,000 Lifetime Capital Gains Exemption if the company is used purely as an investment vehicle in retirement.

To address the lack of CPP income in retirement (see an article by Matthew J. Ardrey discussing when to start your CPP), consider that a 30 year career, with employment income equaling the minimum pensionable earnings of $50,100 would only require an aggregate return of 3.14% to equal the total amount receivable from the CPP over 30 years of retirement3. If you consider historical returns and the tax saving beyond CPP contributions (e.g. a $3,500 saving for a $250,000 dividend-only strategy), it is clear that even with the reduced dividend tax credit that the dividend-only compensation strategy still has an absolute tax saving.

Ultimately, the likelihood of someone continuing to choose this dividend-only strategy depends on their risk aversion as there is still an absolute tax saving to be found. So to conclude, I feel the majority of those who use this strategy should expect to continue to do so, with one eye on the provincial budget announcements.

[divider_line] 1PricewaterhouseCoopers – 2013 Ontario Budget
2The dividend gross-up factor increases line 234 of your tax return which is used to calculate the claw back on Old Age Security.
3Inflation in the form of contributions, returns or pension income is ignored for parity reasons. This is a somewhat conservative estimate, with only 30 years of contributions included and paying out for another 30. It is important to remember this could easily be twisted into a more favourable returns figure using 40 years of contributions and 25 years of CPP income.

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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

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