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1 Lecture 10: Investment Income and Private Corporations, Basic rules for Partners and
Partnerships, and Personal Services Businesses

1.1 Recommended Exercises and Self-study Problems

 Refundable Part I and Part IV Tax
 Exercises 13-3 to 13-5
 Self-study Problem 13-6 (Parts A, B, and C)
 Note: for purposes of this course, you are not responsible for material relating to foreign
taxes as it pertains to refundable taxes.
 Partnerships
 Exercises 18-1 to 18-6
 Self-study Problems 18-3 and 18-4

2 Refundable Part I Tax on Investment Income [13-23 to 13-42] and [13-48 to 13-66]
 Additional Refundable Tax (ART) is a refundable tax on the investment income of a CCPC
 It is equal to 10 and 2/3 percent of the lesser of:
 The corporation’s “aggregate investment income” for the year; and
 The amount, if any, by which the corporation’s taxable income exceeds the amount
eligible for the small business deduction.
 Aggregate investment income is investment income included in taxable income– see definition
in CTP 13-23 to 13-27
 ART makes it less attractive to keep investment income within the corporate structure in
order to defer taxes (due to lower corporate tax rate) since ART raises the corporate tax rate
 Integration and ART:
 With the addition of the ART on the investment income of a CCPC, the investment income
ends up being taxed at combined federal/provincial rates over 50 percent
 See example at 13-50 to 13-53
 Solution: when the corporation distributes a dividend, a portion of a corporation’s federal
tax is refunded
 The refund is the lesser of: 38 and 1/3 percent of taxable dividends paid; and the
RDTOH closing balance (discussed below)
 See examples at 13-60 to 13-62 and 13-63 to 13-66

3 Refundable Part IV Tax [13-67 to 13-74]

 Part IV tax is assessed on Canadian dividends received by a private corporation (regardless of
whether Canadian controlled or not) from certain other corporations.
 “Subject Corporations” are treated as private corporations
 See definition of “Subject Corporation” in CTP 13-70.
 Tax is assessed at a rate of 38 and 1/3 percent. Note: without Part IV tax, private corporations
could earn Canadian dividend income tax-free
 Any Part IV tax paid can be refunded (since it adds to RDTOH)
 Applies to portfolio dividends and some dividends from connected corporations

This edition of the notes was updated by Priya Shah [p_shah@yorku.ca].

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3.1 Portfolio Dividends [13-75 to 13-80]
 Under general rules for inter-corporate Canadian dividends, the dividend would be deductible
in the calculation of the corporation’s taxable income
 Potential for significant deferral of taxes until the corporation pays out dividends to
individual shareholders.
 Part IV Tax – When a private corporation receives a Canadian dividend on shares that are being
held as a portfolio investment, the corporation pays Part IV tax of 38 and 1/3 percent of the
dividend received. This tax is refundable since any Part IV tax paid adds to RDTOH
 38 and 1/3 percent tax rate chosen to make it unattractive to use the corporation to defer taxes

3.2 Dividends from Connected Corporations [13-81 to 13-91]

 Connected corporation (See CTP 13-75):
 A controlled corporation, or
 A corporation in which more than 10% of voting shares AND more than 10% of the
FMV of all the issued shares are owned.
 When a private corporation receives a dividend from a connected private corporation that has
received a dividend refund as a result of paying the dividend, the recipient corporation pays
Part IV tax equal to its share (i.e., it’s % of shared owned) of the dividend refund received by
the “paying” corporation. Any Part IV tax paid adds to RDTOH and is refundable
 Read CTP 13-85 to 13-86 to see how this Part IV tax maintains integration when dealing with
connected corporations.

4 Refundable Dividend Tax on Hand (RDTOH) [13-118 to 13-130]

 Tracking mechanism to keep track of amounts of taxes that have been paid that are eligible
for a refund.
 Beginning January 1, 2019, and thereafter, there will be 2 RDTOH accounts: eligible RDTOH
and non-eligible RDTOH. For non-eligible RDTOH only the payment of a non-eligible
dividend will lead to a dividend refund. These complex changes are covered in ADMS 4562.
 Each RDTOH balance is calculated as follows:
 Opening RDTOH balance (closing prior year balance)
 - dividend refund from preceding year
 + refundable portion of Part I tax paid (only for non-eligible RDTOH calculation)
 + part IV tax on dividends received
 Keeps track of the various types of refundable taxes:
 Refundable portion of Part I tax paid; least of:
 30 and 2/3 percent of aggregate investment income
 30 and 2/3 percent of the amount, if any, by which taxable income exceeds the
amount eligible for the small business deduction
 Part I tax payable
 Part IV tax on dividends received (portfolio dividends and connected corporations)
 The dividend refund in a given year is limited to the balance in the relevant RDTOH account.
 The dividend refund for the year will be equal to the lesser of the balance in the RDTOH
account at the end of the year, and 38 and 1/3 percent of the dividends paid for the year.

This edition of the notes was updated by Priya Shah [p_shah@yorku.ca].

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5 Personal Services Business (PSB) [12-121 to 12-127]

 There is a strong incentive (lower tax rate, hence tax deferral) to have income directed into a
corporation that qualifies for the small business deduction.
 See CTP 12-123 for definition of “personal services business” (PSB). A PSB exists when:
 An incorporated employee or any person related to the incorporated employee is a specified
shareholder (owns at least 10% interest in the company) of the corporation and would be
regarded as an officer/employee of the entity for which the services are performed.
 2 exceptions(i.e., companies that meet one of these exceptions are not PSBs):
 Corporation employs more than 5 full time employees throughout year
 The amount paid/payable to the corporation in the year for the services is
received/receivable by it from a corporation with which it was associated in the year.
 PSBs are not eligible for the small business deduction.
 PSBs are not eligible for the general rate reduction.
 PSBs are subject to an additional tax of 5%, resulting in an overall federal rate of 33%, which
is equal to the maximum individual federal rate. Since a PSB is essentially incorporated
“employment income”, the PSB is taxed at the top personal tax rate
 The only deductions permitted by the corporation are:
 Salaries, wages, benefits, other remuneration paid in the year to the individual performing
the services
 Other expenses that would normally be deductible against employment income
 Therefore it is not beneficial from a tax perspective to be classified as a PSB.

6 Partnerships: Flow-through Entities

 Partnerships are often referred to as flow through entities because the income earned by the
partnership can be flowed through to investors who have an interest in the partnership
 See 18-4

7 Partners and Partnerships

 A partnership is an automatic flow through

 For example, if a partnership earns $100,000 and there are 10 partners (10% each), each
partner earns and must pay tax on $10,000. Note: partners can decide to share
income/losses in any manner that they wish (i.e., they do not have to equally share in the
income/losses of the partnership)
 Further, each type of income flowed through maintains its character (e.g., business
income, interest income, etc.)
 See CTP 18-1 to 18-5

This edition of the notes was updated by Priya Shah [p_shah@yorku.ca].

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 There are basically three types of partnerships:

 general partnerships (which have no limited liability protection)
 limited partnerships (used for investments in tax shelters, oil & gas and real estate) and
 limited liability partnerships (referred to as LLPs and used by accounting and law firms)
 The last two types of partnerships are formed under provincial legislation and provide some
limited liability protection for partners
 The limited liability protection is different in each case and has tax consequences
 See CTP 18-16 to 18-23

7.1 Allocations to Partners and Partner Expenses [ITA 96] [18-37 to 18-62]

 The partnership computes its Division B net income as if it were a taxpayer (even though it is
not a taxpayer)
 Each partner is allocated a % of this Division B net income of the partnership and must pay tax
on this income (whether or not they receive it)
 The income is added to the ACB of the partner’s “partnership interest”. The partnership interest
is a capital property and it represents the partner’s ownership interest in the partnership
 When partners actually take money out of the partnership it is called a “draw” or “drawing”
(because it is generally a withdrawal of cash)
 Draws are not taxed because the income is taxed as it is earned
 Instead, the draw reduces the ACB of the partner’s partnership interest
 Most deductions are claimed at the partnership level
 This includes discretionary deductions (such as CCA and reserves)
 The partnership must decide on the amount and will usually claim the maximum amount
of CCA
 There are a few items computed at the “partner” level rather than by the entire “partnership”
Here is a list of the five most common items:
 Dividends from taxable Canadian corporations earned in the partnership are allocated
(and it keeps its form) to the partners
 they are grossed up and have dividend tax credits in the hands of individual partners
or
 are eligible for ITA 112 deduction in the hands of a corporate partner
 Business-related expenses which are paid by the partner rather than the partnership can
be deducted as a business expense (and are eligible for a GST/HST rebate)
 Common examples are auto expenses, promotion, meals & entertainment, etc.
 Losses (non capital losses, net capital losses, etc.) incurred in the partnership are
allocated (and keep their form) to the partners
 Charitable donations made by the partnership (e.g. if the XYZ partnership contributes to
the United Way). A 10% partner would be able to claim a donation = 10% of the amount
donated
 an individual partner would get a credit under ITA 118.1 for his/her 10% share of
the donation

This edition of the notes was updated by Priya Shah [p_shah@yorku.ca].

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 a corporate partner would get a deduction under ITA 110.1(1)(a) for its 10%
share of the donation
 Federal political contributions made by the partnership. The partners would be able to
claim a political tax credit under ITA 127(3) for their % share of the political
contribution. Note: corporations and unions are no longer allowed to make federal
political contributions
 Note: for charitable donations and federal political contributions
 the ACB of a partner’s partnership interest is reduced by the partner’s % share of
any charitable donation or political donation made by the partnership
 It is useful to think of this as a “non-cash” draw
 Instead of cash, the partner gets a donation to claim on the partner’s tax
return

7.2 Partnership Interest [18-63 to 18-67]

 ACB of partnership interest (= partner's equity in a partnership for tax purposes)
 In an uncomplicated situation, the ACB of a partnership interest is
 partner’s initial cost + partner’s share of income of the partnership - partner’s share of
losses of the partnership - drawings by the partner
 But there are complications requiring extra adjustments for certain tax-free amounts to
maintain integration (so that income earned tax-free to the partnership can be received tax- free
by the partner). That is, the ACB is increased:
 for the full amount of a capital gain (CG) (and similarly decreased for the full amount of
a capital loss, CL)
 for tax-free capital dividends and the tax-free profit when life insurance proceeds are
received (life insurance proceeds minus the ACB of the policy; note: the ACB is zero for
simple life insurance, hence life insurance proceeds are typically received tax free)

7.2.1 ITA 53 Rules (ACB of partnership interest) [18-75 to 18-83]

 When these complications are added, we get the technical ITA 53 rules for calculating the
ACB of partnership interest
 = Original cost of the partnership interest
 plus ITA 53(1)(e) adjustments:
 Income computed on the basis that:
 CG and CL are computed on a 100% basis
 non-taxable capital dividends and life insurance proceeds are included
 Capital contributions
 Other (not covered in this course)
 minus ITA 53(2)(c) and (o) adjustments:
 Losses computed on the same basis as above
 Drawings (including partner salaries)
 Other (investment tax credits, foreign tax credits, charitable and political donations
allocated)

This edition of the notes was updated by Priya Shah [p_shah@yorku.ca].

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7.2.2 If the ACB of a partnership interest is negative at any point/ Interest Expense

 there is no immediate CG (ITA 40(3)(a)) unless

 the interest has been disposed of
 it is a residual interest in a partnership (e.g. the interest of a retired partner) or
 the partner is a limited partner of a limited partnership (not an LLP)
 How could the ACB of a partnership interest be negative?
 Answer
 If the partner’s share of losses and/or draws exceeds contributions and/or income
 Is interest expense incurred to purchase a partnership interest deductible?
 Answer
 Yes, as long as the partnership is earning income from business or property, all other
conditions in ITA 20(1)(c) are met and no other provision of the Act applies to stop
the deduction

7.2.3 Admission of new partner and withdrawal of a partner [18-68 to 18-74]

 See example in CTP 18-70 to 18-74

 If a new partner is admitted to the partnership, the price paid by the new partner to acquire
his/her partnership interest is the initial adjusted cost base (ACB) of his/her partnership interest.
The new partner may buy out an existing partner’s partnership interest or he/she may
contribute assets to the partnership
 If a partner leaves the partnership, the partner typically will sell his/her partnership interest (to
a new partner or to the partnership) in return for proceeds of disposition (P of D). If the P of D
exceeds the (former) partner’s ACB of his/her partnership interest the (former) partner will
have a capital gain. If the P of D is less than the (former) partner’s ACB of his/her partnership
interest the (former) partner will have a capital loss

7.3 Partnerships and Tax Planning

 There are complications to using partnerships for tax planning. Here are some reasons:
 Partnerships with an individual as a partner must have a December 31 year-end
 Certain corporate partners are not able to defer income earned through a partnership.
This is discussed in ADMS 4562
 The CRA has the power to reallocate partnership income:
 if the allocation was made to defer or reduce income tax payable [ITA 103(1)] or
 if it is to make an allocation between non-arm’s length partners (e.g. spouses or
siblings) more reasonable [ITA 103(1.1)]
 Attribution rules:
 The attribution rules obviously apply to property income (e.g., interest, dividend,
rental income) and capital gains (in the case of spouses) earned through a
partnership

This edition of the notes was updated by Priya Shah [p_shah@yorku.ca].

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 But business income earned through a partnership is deemed to be property income
for the purposes of the attribution rules if the partner is a limited partner or not
actively engaged in the business [ITA 96(1.8)]
 This deeming rule was introduced when it became popular to loan spouses and
minors money to invest in partnerships that owned nursing homes and hotels

Review Problem

Burt and Sam Jones are brothers and professional accountants. They operate a partnership that specializes
in doing accounting and tax work for small to medium sized manufacturing companies. The partnership
agreement calls for them to share the partnership profits equally. The partnership has a fiscal year that
ends on December 31.

For the year ending December 31, 2019, they have prepared the following Income Statement for the
partnership:

Burt and Sam Jones

Partnership Income Statement
Year Ending December 31, 2019

Assume that neither partner has Taxable Income that will be taxed federally at 33 percent.

This edition of the notes was updated by Priya Shah [p_shah@yorku.ca].

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Required: Calculate the minimum amount of Net Business Income from the partnership to be recorded in
the tax returns of each of the brothers for 2019. Also indicate other amounts that would be allocated to the
brothers by the partnership, as well as any credits against federal Tax Payable that would result from these
allocations.

Solution:

The calculation of net business income is as follows:

Net Income As Per Income Statement $25,000

Additions:
Charitable Donations $63,000
Drawings by Partners 298,000 361,000
$386,000
Deductions:
Eligible Dividends ($32,000)
Capital Gain (52,000) ($84,000)
Net Business Income $302,000

The Net Business Income would be allocated equally (50%) to each of the brothers.

Other allocations would be as follows:

Donations
For tax credit purposes, each brother would be allocated $31,500 in charitable donations. This would
entitle each of them to a federal credit of $9,107 [(15%)($200) + (29%)($31,500 - $200)] assuming this is
their only charitable donation.

Dividends
Each of the brothers would be allocated $16,000 [(50%)($32,000)] of eligible dividends. For inclusion in
the tax returns, this would be grossed up to $22,080 [(138%)($16,000)]. They would each be entitled to a
federal dividend tax credit of $3,316 [(6/11)(38%)($16,000)].

Taxable Capital Gains

Each brother would be allocated a taxable capital gain of $13,000 [(50%)(1/2)($52,000)].

This edition of the notes was updated by Priya Shah [p_shah@yorku.ca].