Dividend Payment Trap: ERDTOH Converted to NERDTOH

Changes to the taxation of investment income in 2018 replaced the single refundable dividend tax on hand (RDTOH) account with two accounts: eligible refundable dividend tax on hand (ERDTOH) and non-eligible refundable dividend tax on hand (NERDTOH). Where, in the same taxation year, a corporation pays eligible dividends to one corporation and non-eligible dividends to a second corporation, a portion of the opening ERDTOH account balance in the payer corporation may be converted to a NERDTOH account balance in a payee corporation. This results in overtaxation when the dividend is ultimately received by a personal taxpayer. 

Consider the following example:

  • Opco is a private corporation. Holdco owns all of Opco’s common shares and Investco owns all of Opco’s preferred shares. Holdco and Investco are related to Opco.
  • Before the payment of dividends, Opco had a general-rate income pool (GRIP) of $100,000, an ERDTOH account balance of $38,333, and a NERDTOH account balance of $100,000.
  • During its taxation year, Opco paid an eligible dividend of $100,000 to Holdco. It also redeemed preferred shares held by Investco, resulting in a non-eligible deemed dividend of $500,000.

Under subsection 129(1), the eligible dividend paid by Opco entitles Opco to a refund of the entire ERDTOH account balance. In turn, the deemed dividend triggers a refund of the entire NERDTOH account balance.

The part IV income tax that Holdco and Investco have to pay is determined on the basis of the aggregate dividends that Opco paid and the total dividend refund that it received during its taxation year. Specifically, the part IV tax payable by Holdco and Investco amounts to 16 and 56, respectively, of Opco’s total dividend refund, since those are the proportions of Opco’s total dividends that the two corporations received ($100,000/$600,000 and $500,000/$600,000). The total dividend refund is $138,333 ($100,000 + $38,333). Calculating the 16 and 56 fractions of $138,333 results in part IV tax amounts of $23,055 for Holdco and $115,278 for Investco.

The next step involves determining the type of RDTOH account to which the part IV income tax paid should be added. Under subsection 129(4), all the part IV tax that Holdco paid should be added to its ERDTOH account, because the tax is payable as a result of a dividend received from a payer corporation that obtained an ERDTOH dividend refund. However, no amount may be added to Investco’s ERDTOH account, because the dividend Investco received did not entitle Opco to receive an ERDTOH dividend refund. Thus, the entire amount of part IV income tax that Investco paid is added to its NERDTOH account.

As a result, the only non-zero RDTOH balances in the corporate group after the dividends are an ERDTOH balance of $23,055 for Holdco and a NERDTOH balance of $115,278 for Investco. Thus, at the corporate group level, the effect of the dividend payments is to move $15,278 from ERDTOH to NERDTOH, which increases the amount of tax to be paid by the ultimate shareholder.

This result could have been avoided if the redemption of preferred shares had been made in the following taxation year or if the total dividends paid had not exceeded 38.33 percent of Opco’s total NERDTOH and ERDTOH account balances.

In policy terms, the problem results from the fact that paragraph 186(1)(b) does not establish any link between the type of RDTOH account that generated Opco’s dividend refund and the type of dividend that Holdco and Investco received.

This type of problem currently comes up more frequently because of the transitional measures accompanying the 2018 changes. However, the problem will continue to occur in the future for companies that have both ERDTOH and NERDTOH account balances.

Marie-Pier Maheux
Groupe RDL Québec inc., Quebec City

Canadian Tax Focus
Volume 11, Number 1, February 2021
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