Canada has one of the highest levels of income taxes in the industrialized world. The reasons include our harsh climate, large and scarcely populated territory leading to the need for huge infrastructure expenditures and a semi-socialist economy based on the active involvement of the government in the economy. One area where our tax burden is more or less comparable to the rest of the world and even better in certain segments is small business.

The government recognizes the role of small businesses as a driving force in the economic development and stimulates their growth by giving them preferential treatment. This has led to the creation of a strong small business sector and a large self-employed population. An interesting phenomenon is a growing number of employed individuals who choose to change their employment status and become independent contractors. Taxation is the main reason and here is how small businesses are taxed in BC.

First, money earned by Canadian Controlled Private Corporations is divided into active and passive income. Active business income is income from operations, as opposed to income from investments. Active income under $400,000 per year qualifies for the small business rate of only 13.5%. Income between $400,000 and $500,000 is taxed at 22%, and anything above $500,000 is taxed at 30%. In comparison, the highest personal marginal tax rate is 43%. This difference in tax rates motivates business owners to keep as much of their active income inside the company rather than draw the money out and be taxed at the higher personal rate.

Passive income is what a corporation earns in a form of return on corporate investments as opposed to income from operations. This passive income is taxed at a very high rate of 45.7% which is even higher than the highest personal marginal tax rate. The idea behind this draconic rate is to discourage business owners from leaving their money inside the company to take advantage of the low tax rates on active income.

There are two ways to get this money out: pay yourself a bonus and be taxed at whatever your personal rate is, or pay yourself a dividend. The dividend tax rate depends on where the money for the dividends is coming from. Active business income under $400,000 forms the so called General Rate Income Pool (GRIP). Dividends paid from this pool are taxed at 31.6% and other dividends are taxed at 18.5%.

This system has led to significant amounts of access cash accumulated in private corporations, and now these investments are earning return which is taxed at a very high rate. One way around it is to keep corporate investments inside a tax exempt life insurance contract. There are other ways, and this is perhaps the most interesting part of corporate tax planning, because proper planning can lead to amazing savings. One advice though - don’t attempt to do it on your own. And please note that the rates above may have changed by the time you are reading this.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.