How Passive Income is Taxed in a Canadian Corporation
- Elkhanagry Accounting
- Oct 3
- 7 min read
Table of Contents
Introduction – Why the CRA Taxes Passive Income Differently
When the Canada Revenue Agency (CRA) designed the rules around how passive investment income is taxed inside a corporation, the goal was integration. Canada’s tax system is built on the principle that whether you earn income directly as an individual or through a private corporation, you should end up paying roughly the same total tax.
If passive income earned in a corporation were simply taxed at low corporate rates, business owners would gain a permanent advantage by deferring personal taxes indefinitely. That would create unfairness between incorporated and unincorporated Canadians.
To prevent this imbalance, the CRA introduced special measures: higher tax rates on corporate passive income, rules reducing access to the Small Business Deduction (SBD), and a system called the Refundable Dividend Tax on Hand (RDTOH) to keep the system fair.
What is Passive Income?
In tax terms, passive income is generally income a corporation earns from investments rather than its main operations. The Income Tax Act (ITA) uses the concept of Aggregate Investment Income (AII) to measure this. AII includes:
Income from Property
Interest from bank accounts, bonds, or GICs.
Rents and royalties, unless the corporation employs more than five full-time employees to manage them, in which case they may be considered active business income.
Taxable capital gains (only 50% of capital gains are included in income).
By contrast, active business income is revenue from the corporation’s daily operations, such as a dental clinic’s billings or a consulting firm’s fees. Active income may qualify for the small business tax rate, while passive income is deliberately taxed more heavily.
The Higher Corporate Tax Rate on Passive Income
Active business income of a Canadian-controlled private corporation (CCPC) can benefit from the small business deduction (SBD), giving access to a much lower corporate tax rate at around 12–13% depending on the province. This low rate allows businesses to retain more earnings to reinvest in growth, employees, and expansion.
However, when it comes to passive investment income, the government’s goal is not to encourage long-term tax deferral. For that reason, passive income is subject to a much higher tax rate inside a corporation, often exceeding 50% depending on the province.
This high rate acts as a neutralizer. Without it, corporations could essentially act as giant tax shelters: owners could earn millions in investments at corporate rates, leave the funds inside indefinitely, and avoid paying the higher personal tax rates that individuals normally face.
By taxing passive income heavily at the corporate level, the CRA ensures that incorporated and unincorporated Canadians end up paying similar total taxes.
This extra tax of 10.67% is called Additional refundable tax ("ART"). Take the below as an example of how Passive income is taxed:
Basic Tax Rate | 38% |
Federal Tax Abatement | (10%) |
Additional refundable tax (ART) | 10.67% |
Small Business Deduction 0% | 0% (Passive Income inelgible for SBD) |
Provincial Tax Rate | 12% |
Combined Tax Rate | 50.67% |
Refundable Part I tax (added to RDTOH) | (30.67) |
Effective Tax Rate | 20% |
The Refundable Dividend Tax on Hand (RDTOH)
At first glance, paying over 50% tax on passive income seems punitive. But not all of that tax is permanent. A portion is tracked in special accounts called the Refundable Dividend Tax on Hand (RDTOH) accounts.
There are now two separate RDTOH accounts:
Eligible RDTOH (ERDTOH): Refunded when the corporation pays eligible dividends.
Non-Eligible RDTOH (NERDTOH): Refunded when the corporation pays non-eligible dividends.
How RDTOH Builds
30.67% of aggregate investment income is added to the corporation’s NERDTOH balance.
Part IV tax (payable when the corporation receives dividends from non-connected corporations) also increases NERDTOH or ERDTOH (if an eligible dividends was received from the non-connected corporation)
How Refunds Work
When the corporation pays taxable dividends, it becomes entitled to a refund.
The refund is 38.33% of the dividends paid, limited to the balance in the relevant RDTOH account.
Example:
A CCPC earns $100,000 of passive investment income.
About $50,000 of tax is paid, of which $30,670 (30 ⅔%) is added to NERDTOH.
The corporation then pays a $100,000 taxable dividend.
It is eligible for a refund of $38,333 (38 ⅓% of dividend), but since its RDTOH balance is $30,670, the refund is capped at $30,670.
Key Takeaway: RDTOH prevents double taxation. You pay high tax up front, but recover part of it when dividends are paid, bringing total tax in line with personal investing.
The Reduced Small Business Deduction (SBD) Limit
In addition to high tax rates, the CRA uses another lever to discourage excessive passive investments in corporations: the SBD grind.
Every CCPC is normally entitled to the small business deduction on the first $500,000 of active business income.
Once passive income exceeds $50,000, the $500,000 SBD limit starts to shrink.
For every $1 of passive income above $50,000, the SBD is reduced by $5.
By the time passive income reaches $150,000, the SBD is fully eliminated.
Association Rules: This grind applies to all associated corporations. If an entrepreneur owns multiple corporations, their passive income is aggregated for this calculation.
This rule ensures that CCPCs remain focused on active business activities rather than becoming passive investment holding companies.
For example:
A medical professional corporation earns $90,000 of passive investment income in a year. That is $40,000 above the $50,000 threshold.
The small business deduction is reduced by $200,000 ($40,000 × 5).
Instead of enjoying the small business rate on $500,000 of active income, the corporation only gets it on $300,000.
This can represent tens of thousands of dollars in additional taxes each year.
Why This Matters for Business Owners
For entrepreneurs, professionals, and family-owned corporations, these rules carry major implications:
No permanent sheltering: Passive income inside a corporation doesn’t allow you to indefinitely defer taxes at low rates.
Impact on your active business: Too much passive income reduces your access to the small business tax rate, meaning you could end up paying much more on your operating profits.
Dividend planning is key: You must actively manage when and how dividends are paid to recover RDTOH efficiently and maintain integration.
Strategic Alternatives to Corporate Passive Income
Are you a business owner thinking of opening a holding company for investment purposes? It’s important to understand that while there can be valid reasons to hold investments inside a corporation — such as legal liability protection, succession planning, estate structuring, or separating business assets from personal ones — the strategy does not provide tax savings on its own. The CRA designed the rules so that passive investment income inside a corporation is taxed at high rates, reduces your Small Business Deduction (SBD), and only provides relief through RDTOH refunds when dividends are paid.
At the same time, there are other options that provide advantages corporations cannot — particularly when it comes to registered plans like the TFSA, RRSP, and FHSA.
Tax-Free Savings Account (TFSA)
The TFSA’s biggest strength is that all growth is completely tax-free. Corporations, by contrast, face immediate tax on interest, dividends, and capital gains, with only partial relief through RDTOH refunds. Even then, the shareholder still pays personal tax when dividends are received.
With the TFSA, you don’t face that complexity. Investments compound tax-free, and withdrawals are tax-free. This makes the TFSA one of the most powerful tools for high-growth investments.
Registered Retirement Savings Plan (RRSP)
Many business owners invest in a corporation because they like the idea of using pre-personal-tax dollars — investing money before it’s taxed personally. The RRSP offers a similar advantage, but in a cleaner and often more efficient way: you get an immediate deduction for contributions, reducing your taxable income today.
Like corporate investing, you’re effectively investing with pre-tax dollars. But unlike a corporation, the RRSP ensures that all growth is tax-deferred until withdrawal, and you typically withdraw in retirement when your personal tax rate may be lower. This makes the RRSP an excellent tool not just for tax deferral, but also for structured retirement savings.
First Home Savings Account (FHSA)
The FHSA is a newer option that blends the benefits of both the RRSP and TFSA. Contributions are deductible (like the RRSP), meaning you invest with pre-tax dollars, but withdrawals for a first home purchase are completely tax-free (like the TFSA).
This is something corporate investing simply doesn’t offer: the ability to invest pre-tax dollars, enjoy tax-free growth, and then withdraw funds with no tax if used for a qualifying home. For younger business owners or those planning to buy a first home, the FHSA is unmatched in terms of its tax saving potential!
Why This Matters
Corporate investments can serve a purpose — particularly for retaining wealth within a business structure — but they come with high taxes, SBD consequences, and limited flexibility. Registered plans like the TFSA, RRSP, and FHSA provide unique advantages:
TFSA: Permanent tax-free growth and withdrawals.
RRSP: Tax-deductible contributions and tax-deferred retirement savings.
FHSA: Deductible contributions and tax-free withdrawals for a first home.
These are benefits that corporate-owned investments cannot provide, and for many business owners, they make registered plans the better first choice for building long-term wealth.
Contact Us – Plan Your Passive Income Strategy
The CRA’s passive income rules can be overwhelming — between the high tax rates, the SBD grind, and the complexities of RDTOH refunds, it’s easy to miss planning opportunities. But the good news is that with the right strategy, you can minimize unnecessary tax costs and preserve more of your wealth.
At Elkhanagry Accounting, we help business owners:
Preserve access to the small business deduction.
Build tax-efficient investment strategies inside and outside corporations.
Maximize RDTOH recovery while balancing personal tax exposure.
If you’re considering building an investment portfolio inside your corporation, or you’re already feeling the effects of the SBD grind, let’s talk.
📩 Contact us today to book a consultation and ensure your corporate structure is working for you — not against you.
CRA & Income Tax Act References:
ITA s.129 (1), (3), (4) – Dividend refund mechanism & RDTOH calculation
ITA s.125(1), (5.1) – Small Business Deduction & SBD grind on passive income.
ITA s.123.3 – General corporate tax rates.
Disclaimer
This article provides general information that is current as of the posting date and is not updated, which means it may become outdated. The content is not intended to provide accounting, tax, or financial advice and should not be relied upon as such. Tax and financial situations are unique to each individual and may differ from the examples discussed in this article. For personalized advice, please consult a qualified tax professional.
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