End-of-Year Salary-Dividend Planning: Paperwork Is Key
Many owner-managers want to withdraw cash from their corporations throughout the year and decide at the end of the year (or shortly after) whether the withdrawals should be characterized as salary, dividends, or a mix. The flexibility is convenient in that factors such as the amount of salary needed to support the desired level of RRSP contributions and the amount of dividends needed to eliminate CNILs may not be known until the year-end calculations are complete. There are various ways to implement this approach, some of which may be common although not legally effective.
One method that is not recommended is to characterize the payment, at the time of the withdrawal, as either a salary (with appropriate source deductions) or a dividend (through a directors' resolution)--and then, when the year-end numbers are determined, make journal entries that recharacterize the payments as something other than what was initially recorded. This approach is clearly disallowed by case law. For example, in Irmen v. The Queen (2006 TCC 475), the taxpayer received payments from the corporation as salary. Later, journal entries were recorded to reverse the salary payments and instead record them as reductions of the balance of the loan from the shareholder to the corporation. The court stated that a salary cannot be converted into something else after the fact. Earlier decisions in C.G. Wood v. MNR ( 1 CTC 2312 (TCC)) and Adam v. MNR (85 DTC 667 (TCC)) support this conclusion.
The more effective way to preserve salary-dividend flexibility is to process cash withdrawals through the shareholders' loan account initially and then, near the end of the year, record an offsetting change in the loan account together with the desired salary or dividend payments. Consider two examples:
If the corporation owes money to the owner-manager, any payments throughout the year could be recorded as reductions of the loan balance; given the direction of the loan, no tax consequences should occur. At the end of the year, the salary and dividend payments would be documented, with a corresponding increase in the loan balance. (Of course, it might be desirable to instead leave the amount as a loan repayment and avoid receiving amounts that would be taxed.)
If the shareholder-employee is the debtor (that is, if he or she owes money to the corporation), payments throughout the year could be recorded as loans from the corporation. At the end of the year, salary or dividends could be documented together with a repayment of the loan. However, this approach creates an income inclusion under subsection 80.4(1) or (2) for the imputed interest benefit on the loan; if the shareholder is a non-resident, such a benefit is treated as a dividend subject to part XIII withholding. Although the extra tax is undesirable, it might be worth the value of flexibility in the salary-dividend choice.
The more common situation is to document the salary or dividend payment after the end of the year. The CRA has a policy that allows some delay in putting documents in place (CRA document no. 1991-224, April 1991) where the parties agreed, understood, or resolved at a particular time that transactions would occur in a particular manner. Thus, it seems that the CRA is prepared to allow transactions to be documented after the fact if the original intention is clear. Unfortunately, there is no CRA opinion on whether this policy applies to the salary-dividend payment issue.
In the more recent case of Maxi Maid Services Ltd. v. The Queen (2012 TCC 178), the issue was whether payments intended to be dividends but later recorded as salary were subject to source deductions. The court accepted that the corporation did not make salary payments and held that the penalty did not apply. Presumably no resolutions were created prior to each dividend payment, yet the court considered the draws to be dividends. The court also acknowledged the commercial reality that small businesses often decide at year-end how the owner-manager is to be paid. Perhaps this acknowledgment and the CRA's policy on delayed documentation form a basis for allowing owner-managers to determine the mix of salary and dividend after the year-end.
The law is that taxpayers must characterize (although not necessarily document) a payment as salary, dividend, or loan at the time it occurs and not recharacterize it later. In order to properly characterize a payment, the intention of the payment should be supportable at the time the payment occurs. For instance, if the intention is to pay a dividend on December 31, there should be some evidence (e-mails, letters, notes, etc.) in place on or before December 31 to support that intention.
Cadesky & Associates LLP, Toronto