All About Private Corporations – Taxation of Passive Investment Income

This article explores the principles of tax integration in Canada, focusing on how passive investment income is earned through Canadian-controlled private corporations (CCPCs) and compares that same investment income against someone earning it personally. It then reviews some advantages and disadvantages on the use of holding companies.

Passive investment income and Canadian private corporations

A corporation may have excess cash not needed for its business operations. When that cash is invested, “passive income” is earned that includes the taxable portion of capital gains, interest income, foreign non-business income and Canadian-sourced dividends.

Among those income types, Part I tax applies to the aggregate of taxable capital gains, interest income and foreign non-business income. This income is defined as adjusted aggregate investment income (AAII). The total federal Part I tax rate applicable to Canadian private corporations on AAII is 38.67%, calculated by taking the general corporate tax rate of 38%, subtracting the federal abatement for the provinces (10%) and adding the additional refundable tax rate of 10.67%. The provincial rate is then added, often yielding a total tax rate on AAII of more than 50%.

A separate Part IV tax applies instead of Part I tax only to Canadian-sourced dividends, often referred to as “portfolio dividends”. Part IV tax on portfolio dividends is a flat 38.33%.

The issuance of dividends permits a refund of some that initial tax paid through the refundable tax on hand (RDTOH) account.

Refundable tax mechanism via the refundable tax on hand account (RDTOH)

When passive investment income is earned, a higher initial corporate tax rate is applied to discourage the use of a corporation as a vehicle to earn passive income. On the other hand, the lower tax rate available to active business income aims to promote small business development. Income unrelated to the generation of passive investment income does not benefit from a lower tax rate. The additional corporate tax is tracked under the refundable dividend tax on hand (RDTOH) accounts. The tax is refunded to the corporation when taxable dividends are paid to its shareholders. The corporation must track two RDTOH accounts: an eligible and non-eligible account. The eligible RDTOH account will track taxes paid on eligible portfolio dividends only. While the mechanisms by which a refund is paid are complicated, we have provided some of the basic rules below:

• An initial credit to the RDTOH balance is 30.67% on AAII (Part I tax) plus 38.33% of all portfolio dividends earned (Part IV tax).
• A refund is received for dividends paid, though the amount of refund is limited by the balances within the non-eligible refundable dividend tax on hand account and the eligible refundable dividend tax on hand account.
• The refund percentage rate to the corporation generally equals the lesser of 38.33% of all non-eligible dividends paid in the year and the balance of the non-eligible RDTOH at the end of the year. When the non-eligible RDTOH balance has been exhausted, any excess dividend incurs a 38.33% refund from the eligible RDTOH. These are generalized rules subject to many further conditions.
• If there is a balance in the non-eligible RDTOH account when an eligible dividend is paid, then the private corporation will not be entitled to a refund. The ordering rule forces a recovery from the non-eligible RDTOH account before any recovery can be obtained from the eligible RDTOH account.

To the shareholder, it is more tax-efficient to receive an eligible dividend over a non-eligible dividend, as illustrated in Table C (assumes the individual is taxed at the highest marginal tax rates). 

Small business deduction grind

Per the 2018 federal budget, the SBD threshold limit is reduced by $5 for every $1 of passive investment income earned above $50,000, with a complete elimination of the small business limit when passive investment income reaches $150,000. This is shared across associated corporations, so care must be taken in managing the total investment income earned across all associated corporations. Generally, two corporations are considered associated if one controls the other directly or indirectly, or if both are controlled by the same person or group.

For instance, where when a private corporation earns $60,000 in passive investment income, the first $50,000 of passive investment income will be exempt and not affect the small business deduction. The excess $10,000 in passive investment income will reduce the available small business deduction limit at a rate of $5 for each $1 above $50,000. In this example, the available SBD limit would be reduced by $50,000 as a result ($5 * $10,000 = $50,000).

The SBD limit is also reduced when the aggregate taxable capital of the corporation (and its associated corporations) exceeds $10 million and is fully eliminated when it reaches $50 million.

Reducing access to the SBD is intended to target private corporations that have higher levels of retained earnings deployed to generate income from passive investments to discourage this activity. 

Capital dividend account

Certain dividends may be paid by the private corporation to its shareholders free of tax. The payment of these dividends is tracked within the private corporation in a notional account called the capital dividend account (CDA). The corporation will accumulate various tax-free amounts that must be tracked within the CDA and ensures that tax-free amounts received by the corporation remain tax-free in the hands of its shareholders when distributed. The CDA is a running balance, and the issuance of capital dividends will reduce the CDA. Common tax-free amounts that accumulate within the CDA are:

• The tax-free portion of capital gains realised by the corporation for the amount in excess of the non-deductible portion of capital losses
• Tax-free receipts of life insurance payments
• Non-taxable capital gains and capital dividend distributions from trusts
• Capital dividends received from other corporations
• 100% of the capital gains on eligible securities donated in-kind

The CDA is an important mechanism to a Canadian-controlled private corporation to ensure non-taxable accumulations within the corporation remain non-taxable to the shareholder. This ensures continuity and fairness in the tax system, as similar non-taxable treatment is available to shareholders of a private corporation who would have otherwise received these tax-free amounts as an individual had they invested directly.

Some considerations with respect to the CDA

1. Consider distributing positive CDA balances early – Generally, it is a good idea for the CCPC to pay out of the CDA balance a tax-free capital dividend to its shareholders as soon as possible to maximize the amount from the CDA, as future capital losses, if they should arise, will reduce the balance of the CDA and the capital dividend that can be paid tax-free.

2. Corporate life insurance for buy/sell agreements – A common tool used to fund buy-sell agreements is life insurance, which can be leveraged to ensure sufficient funds are available by the corporation to purchase the shares of a deceased shareholder from their estate. Where the corporation owns the insurance, it can be much more tax-efficient than the individual owning it personally, assuming that the corporation is in a lower income tax rate than the individual, as it requires less pre-tax income to pay for the insurance premiums. Additionally, where the corporation owns the policy, upon receipt of the tax-free death benefit, the amount of the proceeds over the policy’s adjusted cost basis (ACB) is credited to the corporation’s Capital Dividend Account (CDA). This allows the corporation to pay tax-free capital dividends to shareholders though the methodology is dependent on the agreement itself. Generally, it may be possible to have the corporation buy the shares from the estate or to have the surviving corporate shareholders receive funds from the corporation (via promissory note) to purchase the shares directly from the estate.

3. Strategic review of elements that give rise to a CDA balance – Carefully review property that could credit or debit the CDA balance and implement a strategy to maximize the tax-free payments. For instance, choosing to prioritize the crystallisation of property with accrued gains to ensure a positive credit to the CDA and then distributing that balance as a tax-free dividend to shareholders. Any remaining property that is in an unrealized loss position can then be crystallised which will give rise to a negative credit to the CDA which will be accounted for from that point forward.

4. Carefully consider the investment asset mix – The investment product selection is an important step in maximizing the tax efficiency of investing within a corporate structure. Investing with the view of generating long-term capital wealth, as opposed to income generation, has typically resulted in the most favorable after-tax results, provided it is deemed suitable given the investment goals.

As with most tax planning initiatives, it is imperative to understand the downstream implications of any contemplated transaction prior to its execution with a view to maximize the tax outcome.

Earning passive investment income through a private corporation: the tax-disadvantage

It is generally not tax-advantageous to earn passive investment income within a corporation, as indicated by the table below. In almost all cases, earning the various investment income characterization types (shown here are interest, capital gains and Canadian dividends) results in an overall tax cost because of under-integration of the tax rates depicted in the “Savings or (Cost)” column. The “Deferral or (Prepaid)” column compares the initial corporate taxes payable (prior to the issuance of dividends) with the taxes payable by the shareholder had they invested personally (assuming the shareholder was in the highest marginal tax bracket). In other words, a deferral means that the tax payable by an individual (taxed at the highest marginal rate) is greater than the initial corporate tax payable on the same investment income. A prepayment is the opposite, namely the tax payable by an individual is less than the initial corporate taxes payable on the investment income.

As we reviewed in our previous blog, All About Private Corporation – Taxation of Active Business Income, there is significant tax-deferral advantage when earning active business income through a corporation. Where excess capital is not needed for the short- or longer-term business needs, business owners must decide how to invest this capital.

Use of Holding Companies

Given the tax cost of investing within a corporation, there remain valid reasons to use a holding company for investment purposes. Firstly, a holding company is its own distinct legal entity separate from the activities of the operating company. A holding company may be utilised to achieve certain tax and non-tax related outcomes for the owners of a successful business and is often considered an integral part of the overall management of the financial plan, integrating both personal and business interests. Below we discuss some of the advantages and disadvantages of utilising holding companies.

Advantages

Asset protection – By funnelling excess cash not required by the operating company into the holding company, an additional layer of protection may be added to the overall ownership structure of the assets for a particular individual or group. Separating some of the assets from the operating company could help shield against claims from creditors of the operating company. This may extend to lawsuits against the operating company related to the goods or services produced for malpractice, faulty performance and other litigious claims such as gross negligence.

Tax-deferral and control on timing of dividends – Canadian small businesses benefit from a preferential tax rate relative to the highest marginal tax rates at the individual level on active business income. We previously identified this as the tax-deferral advantage. Further, dividends can pass through the operating company to a holding company, tax-free¹. These two tax attributes together offer the owners flexibility in the overall timing and issuance of payment from the holding company that will eventually be taxed in the shareholders’ hands when funds are needed, or as circumstances necessitate. 

Estate/Succession planning – In a typical estate freeze, common shares of the operating company are transferred into a holding company or trust at any value between the shares’ adjusted cost basis and the fair market value. Any capital gain triggered on the transfer would effectively crystalize the gains and would be taxable to the shareholder transferor. Provided the conditions are met, the lifetime capital gains exemption (LCGE) can be used to exempt up to $1,250,000 of capital gains (2025 limit, indexed to inflation on an annual basis starting in 2026). General qualifications for the LCGE are that 90% of the fair market value of the assets of the business are used in an active business carried on primarily in Canada immediately before the sale and that more than 50% of the fair market value of those assets must have been used in an active business in Canada during the 24 months immediately preceding the sale.

Preferred shares are often taken back in exchange at time of the estate freeze, and those shares may carry voting rights and dividend entitlements. Often, new common shares are issued to the next generation of business owners (in many cases, family members of the original owners) whose efforts in the business and any associated growth will be reflected in the market value of the shares going forward. Anytime family income sprinkling or income splitting is being considered, one must understand the implications of the tax on split income (TOSI) rules and plan accordingly.

Diversification of investments – In addition to ensuring the operating company meets the conditions for LCGE eligibility, the holding company can diversify its investments beyond the industry the operating company carries its activities. This may include investing in marketable securities such as mutual funds, exchange traded funds, stocks, bonds and real estate to name a few. In many instances, in addition to using the broader retirement planning tools available to most Canadians such as RRSPs/RRIFs, TFSAs and non-registered accounts to name a few, business owners find themselves leveraging cash within their small businesses for retirement planning purposes where those funds are not needed for business reinvestment. A holding company is often utilised for these purposes.

Purification of Operating Company for the Lifetime Capital Gains Exemption (LCGE) – This strategy aims to ensure the assets of the operating company qualify for the LCGE by transferring the ‘non-qualifying’ assets into the holding company. By transferring assets unrelated to the business to the holding company, the owners position the business to meet the conditions for LCGE eligibility. Coupled with an estate freeze - for example, the succession of the business to the new business owners (e.g. family members) - places those new shareholders in the best position to also qualify for the LCGE on their shareholdings on the future appreciation of the business that will be reflected in the value of those new common shares. It is possible that in some business sales to spread the capital gains tax bill over a number of years by utilizing the capital gains reserve.

Advantage in retaining investment income within corporation – When it is decided to invest within a corporation, we can review whether there is an advantage or disadvantage of retaining or distributing the after-tax investment income generated. A tax advantage means that it is better to retain the after-tax investment income within the corporation than distributing the after-tax income to the shareholder. On the other hand, a tax disadvantage would mean its better to issue dividends out to the shareholder than retaining the after-tax investment income within the corporation.

In most provinces across Canada, we find that there is an advantage to retain the after-tax income as it relates to earning interest income and capital gains income. With respect to earning Canadian Eligible Dividend income, there is a mixed result as illustrated in the table above. Typically, Canadian Eligible Dividends are dividends earned from a portfolio of Canadian dividend paying securities that may include stocks, exchange traded funds and mutual funds.

Disadvantages

Tax cost associated with passive investing within a corporation – As we have reviewed, there is a tax cost of earning passive investment income within a corporation on a fully integrated basis. That said, there is indeed a tax advantage of earning active business income within a Canadian small business versus individually. That advantage may be leveraged to in the form of more initial capital to be invested in passive investments. The difficulty here is ensuring those investments remain invested for a long enough period to overcome the eventual tax cost that will be incurred when those proceeds are disposed within the corporation and distributed out to the shareholder as dividends. Despite this tax cost, as noted in the advantages section, there could be valid reasons for investing within the corporate entity structure that ties into the broader financial plan.

Beware of the Tax on Split Income (TOSI) rules – A family-controlled business often blends personal and professional aspirations, where family members are drawn into the business organically. As the business grows, it invariably becomes the single largest source of financial means for the owners and their families. A good financial plan seeks ways to lower the family tax bill whilst providing for the members of the family. Income splitting or income sprinkling techniques are typically introduced, traditionally carried out by way of Trust planning or through a multi-layered corporate structure or both. Unfortunately, the Tax on Split Income (TOSI) rules were expanded in 2018 and are designed to prevent individuals from reducing their overall tax burden through income splitting techniques traditionally utilised. Absent specific exclusions or exemptions, income split into the hand of family members of the business owners are taxed at the highest marginal tax rates, negating any tax benefit that would have otherwise been achieved. It is therefore imperative that business owners work closely with a tax expert to understand the implications of the plan with the TOSI rules in mind, ensuring arrangements are put in place to qualify for the TOSI exemptions.

Loss of other tax benefits – Associated companies to the operating company must share certain tax attributes such as the SBD and will be impacted by the level of passive investment income earned for the purposes of the grind to the SBD limit. Care must be taken to ensure there is no adverse impact to the small business tax rate and associated tax benefits that are typically enjoyed by the active business.

Ongoing cost for compliance and administration– Running a multi-layered organizational ownership structure lends itself to additional regulatory and administrative compliance obligations that are mandatory. These efforts require additional resources that are to be weighed against the benefits they seek to produce.

Conclusion - Balancing Tax Efficiency with Strategic Planning

While earning active business income through a CCPC offers notable tax deferral advantages, passive investment income within a corporation often results in a tax disadvantage due to imperfect integration. Strategic use of holding companies, capital dividend accounts, and estate planning strategies can help mitigate these effects and align corporate structures with broader financial goals. Ultimately, understanding the interplay between corporate and personal tax is essential for optimizing outcomes and ensuring long-term financial sustainability.

Personal and corporate tax integration - 2025

Personal and Corporate Tax Integration