(Disclaimer: I am not an accountant nor a tax pro, etc., etc.)
Yes, a Canadian corporation can function as a partial income tax shelter. This is possible since a corporation can retain earnings (profits) indefinitely, and corporate income tax rates are generally less than personal income tax rates. Details:
If you own and run your business through a corporation, you can choose to take income from your corporation in one of two ways: as salary, or as dividends.
Salary constitutes an expense of the corporation, i.e. it gets deducted from revenue in calculating corporate taxable income. No corporate income tax is due on money paid out as salary. However, personal income taxes and other deductions (e.g. CPP) would apply to salary at regular rates, the same as for a regular employee.
Dividends are paid by the corporation to shareholders out of after-tax profits. i.e. the corporation first pays income tax on taxable income for the fiscal year, and resulting net income could be used to pay dividends (or not).
At the personal level, dividends are taxed less than salary to account for tax the corporation paid. The net effect of corporate + personal tax is about the same as for salary (leaving out deductions like CPP.)
The key point: Dividends don't have to be paid out in the year the money was earned. The corporation can carry profits forward (retained earnings) as long as it wants and choose to issue dividends (or not) in later years.
Given that, here's how would the partial income tax shelter works:
- Earn revenue for your corporation, doing whatever real business it does.* (see far below)
- Do not pay out all corporate revenue as salary. Leave all or most in the company.
- Revenue remaining in the company at the end of the year is subject to corporate income tax, likely at the corporate small business rate. e.g. Ontario, 2010: 15.5%. This rate is significantly less than the top personal income tax rate.
- Do not pay out those retained earnings as dividends. Leave all or most in the company.
- The company would invest retained earnings to generate a return.
- Next year, the company will owe tax on income generated by the invested retained earnings. (Note: The tax man will want to see most of the company's income being active business income – perhaps not a problem if it continues doing real business as in step 1.)
At some point, for you to personally realize income from the corporation, you can have the corporation declare a dividend. You'll then have to pay personal income taxes on the income, at the dividend rates. But for as long as the money was invested inside the corporation, it was subject only to lesser corporate tax rates, not higher personal income tax rates. Hence the "partial" aspect of this kind of tax shelter.
Or, if you're lucky enough to find a buyer for your corporation, you could qualify for the Lifetime Capital Gains Exemption on proceeds up to $750,000 when you sell a qualified small business corporation. This is the best exit strategy; unfortunately, not an easy one where the business has no valuable assets (e.g. a client base, or intellectual property.)
* The major sticking-point: You need to have real business revenue! A regular employee (of another company) can't funnel his personally-earned employment income into a corporation just to take advantage of this mechanism. Sorry. :-/