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Its a Brand New Game The Impact of the New
Dividend Tax Credit Rules on Real Estate Companies

By Henry Wiebe of BDO Dunwoody LLP, Chartered Accountants           February 9, 2007

Would you like to borrow approximately 10 per cent of your income from the Government of Canada on an interest free basis?

Now that British Columbia has finally joined the Federal Government and announced their new dividend tax credit rules we can expect to see a change in the manner in which real estate is owned. Corporations can now be used in a tax deferral strategy which will allow investors to retain additional funds (being the 10% noted above) for reinvestment.

The recent changes to the dividend tax credit rules now permit certain companies to take advantage of the corporate income tax rates to defer income tax (by approximately 10%) without being harshly penalized in the future when dividends are paid out to investors. The new rules have reduced the income tax rate on eligible dividends from 31.6% to just 18.5% in British Columbia, an absolute tax savings of 13.1% on the amount of the dividend for individual shareholders.

The combined British Columbia tax rate, in 2006, which includes both the corporate income tax and the investors tax on eligible dividends, will be now be 46.3%. This is a significant reduction as compared to the combined tax rate of 54.92% which applied before the recent announcements.

This rate applies to eligible dividends, which are essentially dividends that have been paid out of active business income which has been retained in the company after paying tax at the top corporate income tax rate. Active business income includes profits earned from the sale of real estate inventory as in real estate development projects. Active business income can also include real estate rental income, but only where the rental activities are of a size such that more than 5 full time employees are employed by the corporation.

A windfall - This change has resulted in a substantial benefit for those companies that have retained income (since the year 2001) which has been subject to the top corporate income tax rate. The tax rate on these dividends will now not exceed 18.5%. This is an unexpected windfall, a tax rate reduction of 13.1% on future eligible dividends!

Tax deferral - This also means that companies can now choose to leave income in the company without being too concerned about the future dividend tax that will apply when the retained earnings are eventually paid out. By paying only 34.12% tax at the company level companies can now reinvest the deferred tax (the tax would have been 43.7% if the income was paid to shareholders as a bonus) in the business knowing full well that when dividends are eventually paid, the tax on that dividend will be no more than 18.5% (as compared to 31.6%).

Ownership restructuring? Recently trusts and partnership structures have been used to hold real estate developments. These structures were attractive since they avoided both Federal and Provincial capital taxes and they also avoided the very expensive two layers of tax that previoulsy applied to corporations (54.92% in B.C.).

However, in B.C., and most provinces, capital taxes have been eliminated from the taxation landscape. And, now that new dividend tax credit rules have been announced, the utilization of corporate structures becomes attractive. The top corporate rate of 34.12 per cent compares favourably to the 43.7% that applies to partners and trust beneficiaries. With these new rules, the stakeholders in these structures should re-examine their situation to determine if the conversion to a corporate vehicle may be appropriate at this time.

Canadian controlled private corporations

Bonus strategy

In recent years Canadian controlled private corporations were forced to reduce their income to the small business income level. This was usually accomplished by declaring bonuses to shareholders to reduce corporate income to $300,000. In B.C., this usually resulted in the shareholder paying 43.7% tax on the bonus.

In 2006, while the federal small business rate was capped at $300,000 of business income, the B.C. small business rate was capped at $400,000. Notwithstanding that the federal rate was capped at $300,000, for 2006 taxation years the introduction of the new dividend rates suggest that at least $400,000 should be retained in the company.

For income in excess of the small business rate (that is, on income in excess of $400,000) the comments above apply and the shareholder could choose to take advantage of the 34.12% rate to achieve a 9.6% tax deferral.

Passive income

For those companies that earn both passive income (such as rental income) and active business income a wonderful opportunity exists. Companies which have both significant refundable taxes and active business income will be highly motivated to pay dividends that qualify for the 18.5% dividend tax credit. Passive income earned in a corporation will generate refundable taxes which are refunded when dividends are paid.

For example, a $90,000 eligible dividend can generate a $30,000 tax refund for the company and an individual tax bill of only $16,650. That is, the $90,000 dividend actually generates a net tax refund of $13,350 after all of the taxes are paid!

As in any tax planning strategy, there are numerous other factors that need to be considered such as the impact of this planning on the Alternative Minimum Tax, income tax instalments and the Scientific Research and Development Tax Credits. We recommend that you contact your professional advisors to review your situation to determine the best strategy for your situation.

Additional information, for British Columbia and other Provinces can be obtained from the BDO Dunwoody LLP website.

-- Henry Wiebe

 

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