How to extract cash from a corporation

Consider these options to avoid unexpected tax results

By: Wilmot George JANUARY 2021

Building a profitable and sustainable business requires time, patience, and hard work. During the start-up years, owners of Canadian-controlled private corporations often forgo payment of salary, dividends, or other remuneration in favour of reinvesting in the business. At some point, however, personal living costs require cash flow from the corporation.

Business owners have various options for extracting cash flow from a corporation, each with pros and cons depending on the circumstances. Tax-free payments may be the primary objective, or, perhaps, the creation of RRSP contribution room. Maybe the payment is being made to reduce taxation at higher general corporate tax rates, or maybe a loan to a shareholder makes sense.

Whatever the reason, simply withdrawing money from a corporation’s bank account for personal use without properly characterizing the payment can lead to unexpected tax results.

The table below lists common options for extracting cash flow from a corporation and some key considerations.

Table: Options to extract cash from a corporation

Type of payment	Considerations
Salary and bonus payments	Payment must be reasonable for work performed1 Fully taxable at employee’s marginal tax rate Employees can include owner-manager, family members or others2 Tax-deductible to the corporation, which can help reduce taxation at general corporate tax rates Creates RRSP contribution room Payroll taxes normally apply (e.g., CPP/QPP contributions, employment insurance (EI) premiums3) Compared to taxable dividends, less impact to income-sensitive old age security (OAS) benefits Not subject to tax on split income (TOSI) Required for individual pension plan (IPP) and retirement compensation arrangement (RCA) strategies4
Taxable dividend	Must be a shareholder to receive dividends but need not work for the business Taxed more efficiently than salary; tax rate depends on the characteristics of the dividend (i.e., eligible, or non-eligible) Non-deductible to the corporation Payments to family members who do not contribute to the business may be subject to taxation at the top marginal rate due to TOSI rules Dividends paid to minors normally subject to TOSI resulting in taxation at the top marginal rate No payroll taxes (e.g., CPP/QPP contributions, EI premiums)5 Compared to salary, can result in a larger reduction to OAS benefits because of the dividend gross-up mechanism Compared to salary, allows for a larger charitable donation tax credit because of the dividend gross-up mechanism
Capital dividend	Tax-free payment from corporation’s notional capital dividend account (CDA) where account has a positive balance Positive CDA balance normally results from realized net capital gains (non-taxable portion) and tax-free life insurance payments (net of adjusted cost base) Reduces the corporation’s CDA balance CDA balance is also reduced by realized capital losses; for this reason, owners may choose to immediately pay capital dividends when available before capital losses are realized
Return of capital (ROC)	Payments that are less than a corporation’s paid-up capital (PUC) can be paid to shareholders as a ROC Tax-free provided PUC is reduced by the amount of the payment PUC is essentially capital contributed to a corporation in exchange for shares, normally when the corporation is established; the amount can change over time with transactions Non-deductible to the corporation
Repayment of shareholder loan	Tax-free payment to shareholder in settlement of any outstanding loan to the corporation Non-deductible to the corporation
Loan to shareholder	Fully taxable to shareholder unless the payment is for certain employment purposes6 or repaid within one year after the end of the corporation’s taxation year Non-deductible to the corporation If the loan falls into one of the above exceptions but is made at no or low interest, a taxable deemed interest benefit applies7 Where the loan is included in the shareholder’s income but subsequently repaid, shareholder is allowed a deduction from income for the year of repayment

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Determining an appropriate cash flow mix

Determining an appropriate cash flow mix can be complex. Owners should consult with their tax advisors to review the corporation’s structure and tax attributes, as the best approach can differ from corporation to corporation. When determining a strategy, shareholders should consider the following questions:

• Is one form of cash flow more costly than another when all taxes (corporate and personal) are considered?
• Is a corporate tax deduction required to reduce or avoid taxation at general corporate tax rates (as opposed to the small business rate)?
• Are tax-free payment options available?
• Who is receiving the payment, and can/should capital dividends be reserved for the owner-manager?
• Is there a desire for RRSP contribution room and/or CPP or QPP benefits?
• Will the payment trigger payroll taxes and/or onerous remittance or tax-filing obligations?
• Is there a plan to establish an IPP or RCA at some point?
• What impact will the payment have on income-sensitive benefits (e.g., OAS)?
• If the payment is for income-splitting purposes, will punitive TOSI or attribution rules apply?

Can your client take a payment without formalizing it?

When personal cash flow needs arise, a business owner may be tempted to withdraw money from the corporation’s bank account without formalizing the payment as indicated above. With a solely owned business, no one would prevent the owner-manager from doing so.

However, the Income Tax Act (ITA) discourages such activity, as amounts withdrawn from a corporation are normally subject to personal taxation, except for defined options for extracting tax-free cash flow.

Specifically, section 15(1) of the ITA indicates that where a benefit, including cash, is conferred on a shareholder by a corporation, the benefit is included in the shareholder’s income for that year. If the benefit is not reported as income, the CRA can reassess, resulting in double taxation and potential gross negligence penalties payable by the shareholder.

Consider the following example.

Earlier this year, Angela, owner-manager of ABC Inc., withdrew $10,000 from her corporation’s bank account for a personal trip. No formal declaration of payment was made, and Angela has no intention to repay the amount to the corporation.

 As per the ITA, Angela is required to include the $10,000 withdrawal in her income for the year. Failure to do so can result in a gross negligence penalty of 50% of the understated tax payable. Making matters worse, the $10,000 withdrawal is not deductible to the corporation, resulting in double taxation.

While “benefit” isn’t defined in the ITA, it normally includes any type of payment or advantage to a shareholder not in the normal course of business and can include personal use of company assets, such as equipment or vehicles. Given the punitive penalties that can result from shareholder benefits and appropriations, these situations should be avoided.

Wilmot George, CFP, TEP, CLU, CHS, is vice-president, Tax, Retirement and Estate Planning at CI Investments. Wilmot can be contacted at wgeorge@ci.com.

Notes:

1 A corporation can normally deduct unlimited salary paid to its owner-manager on the principle that its profits are due to the owner’s work

2 Provided amounts paid align with services provided

3 Employment insurance premiums do not apply to salaries paid to owner-managers who own 40% or more of the voting shares of the corporation

4 Contributions to individual pension plans and retirement compensation arrangements are normally based on T4 income

5 No CPP/QPP contributions mean no related retirement benefit

6 To purchase a home, shares of the corporation or a motor vehicle for employment purposes

7 Equal to the difference between the CRA’s prescribed rate and the rate paid