Retained earnings left inside an incorporated IT contractor’s corporation do not sit idle by default. Left in a corporate bank account or moved into a brokerage account under the corporation’s name, that cash starts generating interest, dividends, or capital gains, and each of those is corporate investment income subject to its own tax treatment. That treatment is meaningfully different from the tax the corporation pays on its active consulting income, and past a certain balance, the fact that the corporation is earning investment income at all can raise the tax rate on the active income the business is actually built on.
Why Corporate Investment Income Is Taxed Differently
Active business income eligible for the small business deduction is taxed at a preferential combined federal and provincial rate, roughly in the 9% to 13% range across most provinces on the first $500,000 of active income annually. Investment income earned inside the corporation does not qualify for that rate. Interest, most rental income, and taxable capital gains are subject to the corporation’s higher investment-income regime, which runs closer to 50% combined federal and provincial for many CCPCs once refundable taxes are added, before any refund mechanism applies.
The higher initial rate on investment income is partly offset by the refundable dividend tax on hand (RDTOH) mechanism, which refunds a portion of that tax to the corporation when it later pays a taxable dividend to the shareholder. The system is designed so that investment income earned inside a corporation and eventually distributed to an individual shareholder is taxed at roughly the same total rate as if the individual had earned and invested that income personally. In practice, the mechanics rarely land at an exact wash, and the timing mismatch (tax paid now, refund triggered later on a dividend that may not be paid for years) is a real cash flow consideration on its own.
The Passive Income Grind on the Small Business Deduction
The rule that catches most incorporated IT contractors by surprise is not the tax rate on the investment income itself. It is what a large investment income balance does to the small business deduction available on the corporation’s active consulting income.
Once a corporation’s adjusted aggregate investment income (AAII) for the prior taxation year exceeds $50,000, the $500,000 small business deduction limit for the current year is reduced by $5 for every $1 of AAII above that threshold. The reduction is proportional and continues until AAII reaches $150,000, at which point the small business deduction limit is reduced to zero and all of the corporation’s active income is taxed at the general corporate rate instead of the small business rate.
A corporation earning $100,000 of AAII in a year (comfortably achievable from a mid-six-figure investment portfolio generating a mix of interest and dividends) loses $250,000 of its $500,000 small business deduction limit for the following year. That is not a $100,000 tax cost. It is the loss of the preferential rate on $250,000 of active income the corporation would otherwise have taxed at roughly 9% to 13% instead of the general rate, a difference that runs into tens of thousands of dollars depending on the province.
What Counts Toward Adjusted Aggregate Investment Income
AAII is a specific, defined calculation, not a simple sum of everything in a corporate brokerage statement. It generally includes:
- Interest income from savings accounts, GICs, and bonds held by the corporation
- Taxable capital gains (net of allowable capital losses) from the sale of investments
- Most rental income, where the corporation is not carrying on an active rental business
- Portfolio dividend income from non-connected corporations (dividends from connected corporations are generally excluded)
It does not include the corporation’s active business income from consulting services, and it is calculated on the corporation’s prior taxation year, so the grind applied to the current year’s small business deduction is based on last year’s investment income, not a real-time figure. This creates a one-year lag: a corporation that builds a large investment balance this year will not feel the small business deduction reduction until the following taxation year.
RDTOH: The Refund Mechanism, Not an Exemption
Refundable Dividend Tax on Hand is a notional account the corporation tracks (separated into eligible and non-eligible RDTOH pools since 2019) that accumulates a portion of the tax paid on investment income. When the corporation pays a taxable dividend to the shareholder, a refund from the RDTOH pool is triggered, calculated as the lesser of a formula tied to dividends paid and the account balance.
RDTOH is a deferral and integration mechanism, not a way to avoid the higher rate on investment income altogether. The corporation still pays tax on the investment income at the higher rate when it is earned; the refund only arrives once (and if) a dividend is actually paid out to the shareholder. A corporation that accumulates investment income and RDTOH for years without paying dividends is not accessing the refund, and the RDTOH balance is not cash available to spend; it is a notional balance that can only produce a refund when the dividend rules are met.
Holding Companies and Associated Corporation Rules
Some incorporated contractors consider moving investments into a separate holding company, separate from the operating corporation that bills clients, as a way to isolate investment risk from operating liabilities. That structure has legitimate uses, but it does not by itself avoid the AAII grind.
Where the holding company and the operating company are associated corporations under the Income Tax Act’s associated corporation rules, they share a single $500,000 small business deduction limit between them, and the investment income earned in the holdco counts toward the AAII grind calculation applied against the group’s combined small business deduction. A holdco structure can still be worth setting up for creditor protection, succession planning, or separating investment decisions from operating decisions, but the passive income grind follows the associated group, not the individual corporation holding the investments.
Deciding Where to Hold Investment Balances
There is no universal answer to whether retained earnings should be invested inside the corporation or distributed to the shareholder to invest personally. The right answer depends on:
- The shareholder’s personal marginal tax rate and whether a large dividend to fund personal investing would push them into a higher bracket
- How close the corporation’s active income already runs to the $500,000 small business deduction threshold, since that determines how much room exists before the AAII grind starts costing real tax on active income
- The size of the investment balance being considered and the mix of interest, dividend, and capital gains income it is likely to generate
- Whether the shareholder has unused RRSP or TFSA room that would shelter personally-held investment income more efficiently than the corporate structure
A corporation with modest active income well under the $500,000 threshold and a small investment balance has little to worry about from the AAII grind. A corporation with active income already near the ceiling, growing an investment balance in the same entity, is the file where the grind becomes a real annual cost rather than a theoretical one.
What to Review Before Building a Corporate Investment Balance
Before leaving significant retained earnings inside the corporation to invest rather than distributing them, review:
- The corporation’s current and projected active income relative to the $500,000 small business deduction ceiling
- The prior year’s AAII figure and how close it already sits to the $50,000 threshold where the grind begins
- Whether an associated holding company already exists, and how its investment income factors into the combined AAII calculation
- The shareholder’s personal tax position and available RRSP or TFSA contribution room as an alternative for at least part of the balance
- Whether the corporation’s dividend history is generating RDTOH refunds, or whether the account is simply accumulating without being accessed
The year-end corporate tax planning guide covers how the AAII grind fits into the broader year-end tax estimate, and the retained earnings and retirement planning guide covers the longer-term question of how much should stay in the corporation versus flow out to the shareholder over time.