Noh Review Taxation: Integration and Avoiding Double Taxation

After a long wait, Noh Review Taxation is back. Today, we will briefly go over the concept of integration. 

As you may be aware, a corporation is a taxpayer which is taxed separately from its shareholders. We file T2 corporate tax returns for corporations while we also file T1 personal tax returns for individuals. Accordingly, there is always a chance of double taxation, with the same income being taxed at the corporate level and then at the individual shareholder level. 

Integration should cause the total tax paid by a corporation and its shareholders to be equal to the total tax paid by a separate individual who carries on the same economic activity directly outside of the corporation. By integrating the corporate and personal tax systems, the double taxation of corporate income can be avoided.

Perfect integration is possible under 2 conditions:

1. The shareholder should include in income and pay taxes on the full pre-tax income earned by the corporation and then receive a full credit for all of the income tax paid by the corporation. 
2. All after-tax income of the corporation should be either paid out as dividends in the year earned or taxed at the shareholder level in that year.  

       The Gross-up Process is as follows:    

•    The gross-up is equal to the total income tax paid by the corporation, which is added to the dividend received by the individual shareholder. 
•    Now, the grossed-up dividend is the corporation's pre-tax income. 
•    Then, the shareholder will pay tax on the grossed-up dividend at his personal tax rate.
•    This process will equalize the tax paid on the income that is flowed through the corporation to its shareholders, with the tax paid on the same income that is earned directly.
  

I'll throw an example of perfect integration to make this easier:

1. Corporation A made income of $1,000. This corporate income gets taxed at 20% for $200. The after-tax earnings available for dividends is now $800. 
2. Now, the individual shareholder has a dividend of $800, but with the gross-up of $200 (equal to corporate tax), the taxable income goes back up to $1,000 which is equal to pre-tax corporation income. 
3. Then, the $1,000 pre-tax income gets taxed at his personal tax rate of 34%. 
4. This personal tax of $340 gets reduced after the dividend tax credit equal to the gross-up of $200. 
5. Now, the net personal tax is $140 for the individual shareholder.
6. Overall, the total taxes paid are $200 for the corporation and $140 for the shareholder.  This total of $340 is equal to marginal tax rate @ 34% earned directly by an individual.

There is a potential deferral of tax under perfect integration. The potential deferral is the shareholder net tax rate, which is the difference between individual tax rate and corporate tax rate. For example, if the individual tax rate is 34% and the corporate tax rate is 20%, the potential deferral is at 14%.

Before I let you go, I need to let you know that there are two different percentages for the gross-up.

Dividends eligible for 25% gross-up are:

• Dividends from the active business income of CCPCs that is eligible for the small business deduction
• Dividends from the investment income of CCPCs

Dividends eligible for the 41% gross-up are:

• Dividends from the active business income of CCPCs that is not eligible for the small business deduction.
• Dividends from Canadian public companies resident in Canada