RDTOH, ERDTOH, and NERDTOH Explained: A Strategic Tax Guide for Canadian Companies
In Canada, corporations are subject to a range of taxes that can impact their business decisions, profitability, and financial planning strategies. One such tax mechanism that is significant to both public and private corporations is the Refundable Dividend Tax on Hand (RDTOH) system. The introduction of Eligible RDTOH (ERDTOH) and Non-Eligible RDTOH (NERDTOH) from the year 2019 has further refined how corporate taxation is handled, creating different pools for different types of income. This article will explore the concepts of RDTOH, ERDTOH, and NERDTOH, how they are generated, how businesses can benefit from them, and the practical steps corporations can take to optimize these tax mechanisms.
What is RDTOH?
Refundable Dividend Tax on Hand (RDTOH) is a tax mechanism designed to mitigate the double taxation of corporate income. In essence, it allows a corporation to claim a refund of taxes it has paid on certain types of income when those earnings are distributed to shareholders as dividends. The goal of the RDTOH system is to provide fairer tax treatment for corporations, particularly about investment income, by allowing the corporation to recover tax paid on earnings once they are passed on to the shareholders.
The RDTOH account accumulates refundable taxes that a corporation has paid on income that is not actively earned during business. This typically includes interest, rental income, and dividends received from other corporations. These taxes are collected in the corporation’s RDTOH account, and they can be refunded when the corporation distributes taxable dividends to its shareholders.
How is RDTOH Generated?
RDTOH is primarily generated in two ways:
1. Part I Tax on Investment Income: A corporation that earns investment income, such as interest, rental income, or income from investments in other companies, will be subject to Part I tax. This tax is refundable and added to the corporation’s RDTOH account.
o Investment income is taxed more heavily than active business income to discourage the accumulation of passive income in a corporation.
o The Part I tax paid on this income is deposited into the RDTOH account and can be refunded when taxable dividends are paid.
2. Part IV Tax on Dividends Received: A corporation that receives dividends from other corporations will also be subject to Part IV tax, which is refundable and contributes to the RDTOH pool. This tax applies when a corporation receives dividends from shares it holds in another corporation.
o The Part IV tax is refundable when the corporation pays taxable dividends to its own shareholders.
What Are ERDTOH and NERDTOH?
In 2019, a significant tax reform introduced two pools of RDTOH: Eligible RDTOH (ERDTOH) and Non-Eligible RDTOH (NERDTOH). These two pools were created to address the tax differences between eligible and non-eligible dividends.
1. Eligible RDTOH (ERDTOH):
o Eligible RDTOH arises from the tax paid on dividends received by a corporation from connected corporations that pay eligible dividends. These eligible dividends generally come from active business income that has been subject to the lower tax rate in the hands of the paying corporation.
o ERDTOH is more beneficial because the tax paid on eligible dividends can be refunded when the corporation distributes eligible dividends to its own shareholders.
2. Non-Eligible RDTOH (NERDTOH):
o Non-Eligible RDTOH arises from the tax paid on dividends received from corporations that are not connected, or from dividends that are not classified as “eligible dividends.” Typically, these dividends are from corporations that have paid tax at higher rates on their income (e.g., private corporations).
o NERDTOH is refunded when the corporation distributes non-eligible dividends to its own shareholders.
How Are ERDTOH and NERDTOH Generated?
1. Generating ERDTOH:
o When a corporation receives eligible dividends from another corporation in which it holds shares, it is subject to Part IV tax. The amount of tax paid on those dividends is credited to the ERDTOH pool. For example, a corporation that owns shares in a public corporation and receives eligible dividends from that corporation will have ERDTOH generated from the Part IV tax.
o This pool of ERDTOH can be refunded when the corporation distributes eligible dividends to its shareholders. The purpose of this is to avoid excessive taxation on intercorporate dividends.
2. Generating NERDTOH:
o NERDTOH arises when a corporation receives non-eligible dividends (dividends that are subject to a higher tax rate), typically from non-connected corporations or private corporations that pay dividends out of their income that has been subject to higher tax rates.
o Just like ERDTOH, this amount is credited to the corporation’s NERDTOH pool. The tax on these non-eligible dividends can be refunded when the corporation pays non-eligible dividends to its shareholders.
Benefits of RDTOH, ERDTOH, and NERDTOH
Corporations can leverage RDTOH, ERDTOH, and NERDTOH in various ways to maximize tax efficiency, avoid double taxation, and reduce the overall tax burden. Here are some key benefits and strategies:
1. Refund of Taxes on Investment Income:
o One of the primary benefits of RDTOH is that it allows corporations to recover taxes paid on investment income. For example, if a corporation earns passive income and pays tax on that income, it can receive a refund of that tax when it pays taxable dividends to its shareholders. This helps to prevent double taxation on the same income—once at the corporate level and again when it is distributed to shareholders.
2. Refund for Dividends Paid:
o The ability to recover taxes paid on dividends from connected corporations (through ERDTOH) or non-connected corporations (through NERDTOH) provides significant tax relief. By paying taxable dividends, the corporation can trigger a refund of the tax already paid, helping to maintain liquidity and ensure the taxes are refunded in a reasonable manner.
3. Optimizing Dividend Distributions:
o By managing RDTOH pools effectively, corporations can plan their dividend distributions to ensure that they trigger the most beneficial tax refunds. For example, a corporation with significant ERDTOH may prefer to distribute eligible dividends to its shareholders to recover the tax paid on eligible dividends.
o Similarly, a corporation with significant NERDTOH may distribute non-eligible dividends to take advantage of the tax refunds associated with those dividends.
4. Tax Planning for Private Corporations:
o Private corporations often have large amounts of passive income and investment income, which can generate RDTOH. Strategic dividend planning can allow private corporations to recover RDTOH balances efficiently by distributing taxable dividends to their shareholders.
5. Reducing the Cost of Tax on Passive Income:
o For both public and private corporations, managing RDTOH can reduce the effective tax rate on passive income, such as interest and dividends received from other corporations. By triggering the refund through the distribution of dividends, a corporation can reduce the overall tax cost of holding passive income.
Practical Tips for Utilizing RDTOH, ERDTOH, and NERDTOH
Corporations can take a number of practical steps to optimize their use of RDTOH and the two subcategories—ERDTOH and NERDTOH.
1. Track and Separate RDTOH Pools:
o It is essential to maintain accurate records of the different RDTOH pools—ERDTOH and NERDTOH—since each pool has different rules for refunds. Regularly updating these accounts and understanding the distinction between the pools will enable corporations to make more informed decisions about dividend distributions.
2. Plan Dividend Distributions:
o Careful planning of dividend distributions can optimize tax refunds. Corporations should analyze the type of RDTOH they have (eligible or non-eligible) and align their dividend strategies accordingly. For example, a corporation with significant ERDTOH might prefer to distribute eligible dividends to maximize the refund.
3. Avoid Excessive Accumulation of Passive Income:
o Excessive accumulation of passive income can result in a higher RDTOH balance that is not refunded until dividends are paid. To avoid holding large amounts of RDTOH indefinitely, corporations should manage their investment income and make timely dividend distributions.
4. Consult with Tax Advisors:
o Given the complexities of RDTOH, ERDTOH, and NERDTOH, corporations should consult with tax advisors to develop effective strategies for managing these accounts. A tax professional can provide guidance on structuring investments, dividend policies, and other tax-efficient strategies to maximize the benefits of these refundable taxes.
Conclusion
The introduction of RDTOH, ERDTOH, and NERDTOH has created a more nuanced system of corporate taxation in Canada, allowing corporations to benefit from tax refunds on passive income and dividends paid. By strategically managing these pools, corporations can recover taxes paid on investment income and dividends, reduce double taxation, and improve their overall tax efficiency. Whether for a public or private corporation, understanding how these refundable tax pools work and how to take advantage of them is critical for sound corporate financial planning.
With careful management and a solid understanding of the tax rules governing RDTOH, ERDTOH, and NERDTOH, businesses can effectively optimize their tax position, ensuring that they fully benefit from the available refunds while reducing unnecessary tax burdens.
This article is only for the purpose of education and awareness. Please consult a professional before adopting the right strategy.
Author
Raman Nagpal
B.Com, CA, CMA, DISA.
