Introduction – the tax implications of financing
Businesses that have moved beyond the start-up phase and need to consider how to implement continuing expansion must ultimately determine the method of financing that will yield the greatest total return. Since the after-tax return is the pivotal concern tax plays a vital role in decision making.
Financing can be categorized in broad terms as either debt financing, equity financing or leasing. The cost to the business of all types of financing is influenced by the tax treatment to both the borrower and the lender.
Tax Treatment of Debt Financing
Debt financing is generally thought of as those means of borrowing that do not involve the lender taking an ownership stake in the business. While this is not entirely wrong, it is perhaps better thought of as those means of financing that do not involve the lender taking voting interest in the management of the business. The basic accounting formula, the sum total value of the business assets being equal to the ownership claims on those assets by the creditors and the equity stakeholders, demonstrates this quite well.
The important insight to take away from this distinction is that debt, like equity, provides a means of putting assets into the business and paying profits out to investors. And where there are alternative options for paying profits to investors, there is opportunity for tax planning.
Debt financing can come in a variety of forms. It can be as simple as a bond issued at a discount, paid back in full on the date of maturity. Alternatively, corporate bond holders could receive a regular payment of interest at the beginning or end of a regular interval until the date of maturity at which time the principle amount of the loan is returned. It is also possible to issue bonds at a premium.
Where regular interest payments are made, those amounts are deductible against the business income of the corporation as current expenses in the period when they occur. There are some limitations to this that arise in specific circumstances. Where borrowing costs are incurred for the purchase of idle (or vacant) land, such as where the land is held for later resale or development, the interest expense is deductible only up to the amount of revenue generated by the property. Similarly, where the business is financing the construction of a building, the interest expense incurred during the construction period is not allowable as a current expense. However, in both of these situations the expense is not entirely lost. While these assets are not generating revenue the interest expense is recognized as an expense relating to the acquisition of capital and is added to the cost base of the assets and will ultimately reduce any future capital gain.
Where interest expense is incurred in the acquisition of depreciable property, the taxpayer has the choice between recognizing the expense as current expense as it is incurred and filing an election to have the cost of borrowing imputed into the adjusted cost base of the property. This means that the expense is incorporated into the capital cost allowance of the property. Making this election will mean that less than the full amount of the expense will be recognized in the period in which it is paid. A business will typically want to take advantage of this election where it does not expect to generate a profit for an extended period into the future. As capital cost allowance cannot be used to create business losses, by making this election the corporation is able to avoid the 20 year limitation on carry-forward of losses.
Where a debt security that is issued at a discount, the tax treatment will depend on the amount of the discount. Where the discount is 3 percent or less, the full amount of the discount is deductible against business income. Where the discount is greater than 3 percent then the deductibility of this amount is treated similar to a capital loss; only one half is deductible.
Where a debt security is issued at a premium, the premium is not taxable, unless the issuing corporation is in the business of lending money.
Whether the debt is secured or unsecured against real or personal property will not have an impact on the tax treatment of the interest expense. However, different expenses incidental to borrowing costs may arise depending on the type of borrowing. Secured borrowing for example, where a mortgage or lien is registered on land or personal property, may require legal expenses related to the registration of the lien or appraisal fees to verify the value of the asset. These expenses would normally be recognized as a part of the acquisition cost of the asset being acquired but in some instances these expenses are allowed as current expense recognized over a five year period in equal proportions each year.
Often it is the case that institutional lenders such as banks require the directors or officers of the company to have purchased life insurance agreements as a term of the lending agreement. While, these costs are not normally allowed as expenses against business income, the Income Tax Act makes an exception under these circumstances and allows the full deduction of the premiums paid in the period they are paid.
Tax Treatment of Equity Financing
Generally speaking, the cost of servicing equity to the corporation is the same as the cost of servicing debt financing; a payment is made to the equity shareholders, commonly referred to as a dividend. In practice however, there are a variety of ways to return value to equity shareholders. A corporation may choose to alter its debt to equity ratio by borrowing funds to repurchase the shares of equity previously issued by the corporation. Additionally, the corporation may choose to retain profits inside the corporation, either allocating this amount to the shareholders equity accounts or the retained earnings account. The important distinction between the debt and equity is that servicing costs are deductible against business income when servicing debt. Dividend payments are not deductible and because of this, debt finance offers a tax advantage to the corporation, relative to equity finance, when returning money to investors.
The non-deductibility of dividends will hold true regardless of whether the equity is common shares or preferred shares. However, there is an additional set of tax considerations for the corporation when servicing preferred share equity. An additional tax arising under Part VI.1 of the Income Tax Act must be paid by the corporation on preferred share dividends paid on the amount of the dividend that exceeds $500,000.
There are new tax considerations to take into account when it comes to equity investment. For more than 2 years Finance Minister Bill Morneau has been revising proposals on changes to the tax treatment of private companies in Canada. The liberal government, in the most recent budget, implemented a new tax treatment on corporate income arising from investments held by the corporation; retained earning that are held in the form of investment securities (commonly referred to as “passive income”).
Prior to the change, passive income was taxed at approximately the top marginal rate for an individual (depending on what province the corporate taxpayer was located in). This tax contributed to the ‘Refundable Dividend Tax On Hand’ (RDTOH) account balance, an account which is refunded to the corporation upon the distribution of a dividend to shareholders. The corporation can of course pay out as much in dividends as it would please, however the amount that of refund the corporate received is limited to the balance in the account balance; once the balance reaches zero no further refunds are received.
The new rules create two separate accounts, an eligible and a non-eligible RDTOH account. The eligible account measures refundable tax paid on passive income, while the ineligible account measures the refundable tax paid on active business income. When a corporate designates a dividend as either eligible or ineligible, the shareholder received a corresponding tax credit. The old rules allowed a corporation to receive a refund from the RDTOH account created by passive income when paying an eligible dividend sourced from business income taxed at the higher general rate. Because the small business tax rate applies to active business income up to $500,000, and the higher general rate is applied to business income in excess of this amount, shareholders received a larger credit when the corporation designates an eligible divided. With the change, a business paying an ineligible dividend can only receive a refund from the eligible RDTOH account when there is no remaining balance in the ineligible RDTOH account.
The budget for 2018 also amended the calculation of the small business deduction. Generally speaking, it is still the case that the small business deduction applies to the first $500,000 of active business income. However, the new rules reduce this amount as a corporation accrues passive income in excess of $50,000.
Tax Implications of Leasing
Leasing presents an alternative means of financing the assets in the business process. Unlike the other forms of financing the business, leasing will not result in the corporation taking on the legal title to the property being leased unless a purchase option is exercised at the end of the lease. The impact this will have on tax consequences primarily relates to timing of income and expense recognition. A business that chooses to purchase its own assets will have acquired either a depreciable property or a non-depreciable property. Where the business has acquired a non-depreciable property, the business will eventually realize a capital gain or loss on disposition, but until then there will be no tax consequences. Had the business chosen to lease this property, the regular lease payment would be deductible during the years of use. A depreciable property would give rise to capital cost allowance should the business acquire its own assets. This typically results in a larger claimable amount of expense in the early years relative to the leasing costs.
Recent changes to the tax treatment of leases on equipment allow for the leasing company to elect to claim capital cost allowance and an imputed interest expense instead of the leasing expense. This requires an agreement be reached with the resident taxpayer who owns the property being leased and the joint filing of the election.
Tax Treatment for Investors
The tax treatment for investors will impact the decision making of the corporate managers in two ways. Either an investor is also a manager of the business or the investor is not. Where the investor is also a manager of the business, the need to consider the tax consequences of how profit is returned to the investor is self-evident. Where the investor(s) are not also involved in the operation of the business, the tax consequences on the business will impact in a derivative way; the tax is ‘capitalized’ into the cost of borrowing.
Tax capitalization refers to how the price of an asset will change due to varying tax implications. For example, an investor looking to purchase a corporate bond would be willing to pay a higher price for a bond with an identical yield to another bond, if the tax rate applied to it was lower because the after tax rate of return on the investment would be equal. Historically in the United States, the interest income earned from municipal bonds has been tax deductible. This has allowed municipalities to issue bonds to raise funds to finance government services at a lower cost of borrowing. . Thus, finding ways to lower the tax burden to investors on investment income can also lower the cost of borrowing for the corporation.
While interest payments made by a corporation on a bond are deductible expenses against the income of the corporation, a recipient of the interest payment must include the whole amount of the interest as income in the individual’s return. By comparison, should the corporation be paying out to the investor on account of equity, dividend payments are not deductible expenses against the corporate income. The recipient of the dividend will receive some amount of tax relief in the form of the dividend tax credit. The amount of this relief will depend on the type of dividend declared by the paying corporation.
The purpose of the dividend tax credit is to eliminate, the extent possible, the occurrence of double taxation on the income generated by the business. Due to the difference in rate structure applied to individuals and corporations, double taxation is never completely avoided.
Double taxation is a concern that is particularly important where the investors are also the managers of the business. By shifting the distribution of profits from equity towards debt, the investor avoids the double taxation that would occur if the final pay out was by way of a dividend.
Investors who do not also have the second role as manager of the corporation do not need to be concerned with the specifics of double taxation. Those investors will ultimately make the decision between equity and debt securities based on their own after-tax return, independent of the tax implications for the corporation.
Two areas where equity issues can provide investors with preferable tax treatments are timing of the tax obligation and the opportunity for capital gains.
While it is possible to experience a capital gain by selling a bond for more than it originally cost, the market for buying or selling common shares is typically more volatile. Of course, the great benefit of being able to provide a capital gain instead of a dividend payment is the tax treatment; capital gains are only one half taxable.
The other benefit of equity returns is the timing of the tax obligation. Equity investors can choose when to realize their capital gain/loss. By comparison, a bond will almost certainly have a fixed maturity date and a fixed date for payment of interest, leaving investors with considerably less control over the time of income recognition. An Equity investor that also holds a role in management may be able to control the timing of dividend payments, providing an even greater level of control over the tax implications of investment.
These benefits that are available to equity investors means the bond investors will demand a relatively higher regular interest payment, compared to the dividend stream, to forgo the tax benefits of equity investment. Managers recognizing this implication for investors can save their business significant borrowing costs.
Tax Tips for Your Business
Taxation law is complex to say the least. This complexity is never more prevalent than where the cross-section of business income and investment income occurs. Slight changes in decisions can trigger drastic changes to the consequences faced by corporation’s financial stakeholders. Consulting an expert Toronto tax lawyer is imperative to successful tax planning so that decisions of managers can be fully informed.
Where business have large expansion on the horizon, taking the time to slowly consider each possible means of financing that undertaking will pay off in the long term and the near term. Where managers are also investors, careful analysis of the tax consequences of these considerations should be even more paramount. A general retainer of a Toronto tax lawyer who can provide tax advice or information on an on-going basis in these situations can pay for itself and then some.