Tax reform in 1971, based on the Carter Commission, introduced the concept that income should be taxed at the same rate regardless of whether it was earned in a corporation or personally. To accomplish this objective the Canadian Income Tax Act has various tax integration mechanisms. In effect what this means is that the Canadian personal and corporate tax system is integrated to yield the same overall tax liability regardless of the structure used to earn the income. These tax integration mechanisms has two major components.
The first relates to active corporate income, also called business income. There are two stages of taxation of corporate earned business income. For a Canadian Controlled Private Corporation (CCPC) that earns active business income that qualifies for the small business deduction (SBD) there is a low rate of corporate tax charged, about 15% in Ontario. That same income, if earned personally, would be taxed at over 50% in Ontario at top personal marginal tax rates. How is this remaining 35% of tax charged to maintain integration? Through the dividend tax credit mechanism. When a dividend is paid the shareholder pays tax at full personal marginal tax rates but receives a dividend tax credit more or less equal to the tax the corporation originally paid. So the overall tax rate is the same and tax integration is achieved.
The second tax integration mechanism relates to passive or investment income earned in a corporation. In this case the objective is to ensure that there is no tax benefit to earning investment income in a corporation by paying a lower rate of tax. This is accomplished by taxing the investment income earned at high rates, about the same as would be paid by an individual earning the income directly. However in this case part of the tax is allocated to the refundable dividend tax on hand (RDTOH) account and this amount is paid to the shareholder tax free, thereby again achieving tax integration.
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