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KPMG Enterprise™
Bonuses or Dividends? New Legislation may
Impact this Decision
Many Canadian controlled private companies (CCPC) choose to pay a bonus rather than a
dividend to their shareholders because it results in lower income taxes. The “bonus down”
strategy is used to reduce corporate income to a level where the corporation would pay tax
at the small business rate.
However, this strategy should be re-evaluated by all CCPCs in light of the draft legislation
released by the federal government on June 29, 2006 (and subsequently by most provinces)
to reduce personal taxes on “eligible dividends” paid after 2005.
The Old Rules
The following table illustrates the tax differences between bonus and dividend under the
“old rules” (prior to the introduction of this new legislation), assuming that the corporation
and shareholder were resident in Ontario and that the corporate income exceeded the small
business limit:
The significant 9.7 per cent difference in taxes paid under the old legislation was attributable
mainly to the double taxation of dividend income.
The New Rules
The personal tax rate on “eligible dividends” has decreased from approximately 31 per
cent to 25 per cent for taxpayers in Ontario. An eligible dividend can be paid by a CCPC on
taxable income that has not benefited from the small business deduction and that is not
investment income. The following table compares the taxes paid on a bonus versus the
new and old dividend rules (again assuming the corporation and shareholder are resident
in Ontario):
The additional tax cost when paying a dividend under the new rules is 5.7 per cent,
compared to 9.7 per cent under the old rules.
In Ontario, this difference will be further reduced by 2010 as Ontario is phasing in an
increase to the dividend tax credit gradually (in 2006 the dividend tax credit is 5.13 per cent;
it will increase to 7.7 per cent in 2010). Other provinces have different transitional measures.
Decision Factors
Cash requirements strongly influence the decision to dividend or bonus. If the cash is not
required immediately, leaving it in the company leaves more available to invest or use in the
business. Based on the examples in the table above, the company can retain an additional
$103 by leaving the money in the business. Therefore there is a return-on-investment factor
to retaining the extra tax money in the business.
Under the old rules, it could be difficult to obtain a rate-of-return on funds retained in the
business greater than the 9.7 per cent difference in the tax cost, making the decision fairly
straightforward. However, earning 5.7 per cent on retained funds under the new rules is
certainly less of a hurdle, so the deferral of tax achieved by keeping the money in the
company may be worthy of consideration. It should be noted that money left in the business
may be at risk to creditors and that this risk factor must be incorporated in the decision.
There are additional decision factors that come into play.
The following factors make dividends more appealing:
- Payroll taxes must be paid on salary/bonus payments. This reduces the after-tax proceeds of a bonus.
- The surtax for small and medium corporations is being eliminated in 2008. This will increase the after-tax proceeds of paying out a dividend.
- A bonus cannot be paid to inactive shareholders; however, a dividend can be paid to any shareholder.
- A shareholder resident in Ontario with no other income can receive up to $41,000 of eligible dividends before paying any tax.
- If a manufacturing and processing deduction is available, this means more after-tax proceeds when paying a dividend.
The following factors make bonuses more appealing:
- Scientific Research and Experimental Development (SRED) tax credits are higher for companies with income below the small business deduction limit. Bonuses reducetaxable income and provide a way to maximize SRED eligibility.
- Paying a salary increases RRSP contribution room (though if your base salary is already above $106,000 a bonus will not increase the RRSP contribution limit).
- The Alternative Minimum Tax (AMT) threshold is higher for bonuses than dividends.
- Bonuses provide a potential income splitting opportunity with family members and further RRSP opportunities.
So How Do Private Company Shareholders Get the Most Money?
This is not an easy decision. If the money is required immediately and the CCPC is over
the small business deduction, a bonus might be the best option. However if the money
is not needed, the decision will depend on the returns obtainable from further
investment in the business versus other investment options, and on how much the
shareholders want to have at risk in the business. Each CCPC’s situation should be
thoughtfully assessed to determine the optimal strategy.
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