Tax AOs Salary vs. Dividends vs Bonus in CPA Canada PEP and CFE Exams

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The structure of Canadian taxes is meant to charge the same level of income tax regardless of if it is earned through a salary or dividend on the individual and corporation level. This is known as integration. However, this is not a perfect model and there can potentially be a benefit to receiving one form of remuneration compared to another.

When assessing salary vs dividend AOs, CPA candidates should write a balanced qualitative analysis and demonstrate understanding on various tax topics. Several examples are provided below that can be used in determining your recommended structure.

Salary

Pros:

  • Will provide a deduction in the calculation of corporate tax, therefore reducing the taxable income.
  • You will receive payments from the CPP program later in life when you retire. This is an effective and stable form of pension planning.
  • Generates earned income, which will create RRSP room. This will allow you to put funds aside for your retirement and receive a tax deduction in the year of contribution that will reduce your personal tax liability. Funds invested will compound tax-free while in the RRSP plan.
  • Generates earned income for child care deduction purposes. This allows you to deduct childcare costs if you have children and meet the specific criteria. Being paid a dividend will not allow the same cost deductions.
  • Allows you to qualify to claim non-deductible work expenses such as uniforms, home computers, etc. This is known as the Canada Employment Credit (CEC) and is a non-refundable tax credit designed to help employees.
  • Creates more predictive and steady income. From a personal standpoint this can make obtaining loans, mortgages, etc. easier as the bank can assess your ability to comply with payment criteria. From a company perspective this is beneficial for planning monthly outflows.
  • Deducting salaries payments from corporate taxable income can be used in tax planning to decrease income below the $500k small business limit to achieve a lower tax rate.
  • Less tax planning works as taxes taken off automatically with a payroll/accounting system.

Cons:

  • Included in employment income in the year received and taxed personally using increasing tax brackets.
  • Requires payments into the CPP program (employer and employee portions). This could result in reduced net cash flow available due to CPP costs associated off of each salary payment.
  • Reduces the financial results of a company as the salary payment represents an on-going expense. This could impact the company’s ability to obtain financing.
  • Penalties are incurred for late payments for submitting income tax, CPP, EI, etc. for salary amounts.
  • Need to determine a reasonable salary; otherwise amounts cannot be deductible and tax filings may be increased or may need to be amended for prior years.

Dividends

Pros:

  • Capital gains produce amounts for a capital dividend account (CDA) balance. This can be paid out as a tax-free dividend.
  • Generally, create less tax at the personal level. This will depend on numerous factors, including: whether the dividend is eligible or other-than-eligible, personal tax bracket, tax rates and tax credits.
  • Interest and capital gain income earned from investments will be considered property income. This will be subject to additional refundable tax (ART), creating an RDTOH balance. In that case, by paying a dividend, the company will receive a dividend refund for paying the general corporate tax rate.
  • Opportunity for income splitting can be achieved with two or more shareholders (i.e. husband and wife). Be mindful of new TOSI rules and discuss the implications if it applies.
  • Net profit is not reduced by dividends, and they are not considered a business expense. Therefore, showing more favorable results which could be preferable when viewed by potential lenders or investors.
  • Dividends can be declared at any time, allowing the owner to optimize their tax situation.
  • Provides greater flexibility as dividends can be paid out based on how the business is performing.
  • Dividends reduce an individual’s CNIL (cumulative net investment loss). When claiming the lifetime capital gains exemption (LCFE), CNIL will diminish the amount available. Receiving dividends as payments will reduce the existing CNIL balance and will increase the LCE available in the future.

Cons:

  • Dividends are not deductible like salary payments, thus increasing taxable income for the company. However, dividends will be paid out of after-tax profits and be eligible for a dividend tax credit which, assuming integration is working, will offset the higher corporate rate of tax paid. Therefore, they reduce cash flow and do not decrease corporate income taxes.
  • Does not generate RRSP contribution room and pensionable earnings for CPP.
  • Issued and paid based on share ownership. This can become challenging to allocate different amounts of income to various shareholders.

Bonus

Pros:

  • Bonuses declared at year-end create the opportunity for a personal tax deferral since the amount does not need to be paid for 6 months.
  • Can often be directly deposited in RRSP, reducing the amount of taxes paid compared to receiving the bonus directly.
  • The owner can set a bonus amount once the company’s earnings have been determined, ensuring the company maintains positive income. This also provides flexibility in the amount of bonus to be paid out.
  • A CCPC can declare a bonus to reduce corporate profits, thus resulting in a lower tax rate.

Cons:

  • If a bonus is declared and not paid right away, cash flow issues later could create difficulty in actual payment of bonus.
  • Paying a bonus (like salary) comes with a higher cost, as employer and employee portions of CPP must be factored in.
  • Personal tax rate on bonus is significantly higher than salary for example.

Conclusion

In CPA cases, recommending between paying out a salary, dividend or bonus is not a decision of exclusively picking one over the other. You should should recommend a variation between these alternatives that’s most optimal. For example, you can recommend the user to choose salary large enough to qualify for the maximum CPP benefits and RRSP room, to ensure effective retirement planning. Any excess beyond this amount can then be paid out in the form of a dividend. Deciding which combination will result in the least net taxes will be dependent on several other factors.