What is corporate GRIP?
GRIP (General Rate Income Pool) is a notional account, which means it only exists on paper for doing taxes. This account describes the amount of money that a Canadian Controlled Private Corporation (CCPC) can pay out as eligible dividends to its shareholders.
Eligible dividends are taxed at a lower personal tax rate. This is meant to account for the fact these eligible dividends are paid out by a company that has already been taxed on the income at a higher corporate tax rate. It is part of how our tax system tries to achieve tax integration.
The goal of tax integration is that a dollar earned will be subjected to the same tax burden by the time it reaches an individual – whether that is done directly, or through a CCPC (such as a professional corporation). Tax integration is not perfect. With a few exceptions, if you simply take all of the money that you earn and pass it through a corporation, you usually pay slightly more tax than an individual getting paid directly. The main advantage to a corporation is tax deferral from the initial lower corporate tax rates. The initial low corporate tax rate leaves you more money in the corporation, called “retained earnings”, that you can invest and grow further.
Why does understanding GRIP matter to business owners?
It sometimes seems like accountants speak a different language with all of the bizarre terms and acronyms. I think it resembles Klingon, and we previously translated redundable dividend tax on hand (nRDOTH and eRDTOH) into English. It was a little awkward and dangerous, like walking in on a Klingon mating ritual; but we survived unscathed. You also need a strong grasp of GRIP to hold onto your bat’leth when the Klingon tax collectors come calling. Used wisely, it could trim your tax bill. If not careful, it could also remove your fingers, toes, or other appendages.
The nuances of GRIP and Refundable Dividend Tax On Hand (RDTOH) can raise or lower your overall tax bill.
- If your CCPC makes over $500K/yr in active income and generates investment income from interest, foreign dividends, or taxable capital gains. You can trigger a partial tax refund to your corporation for these types of investment income using the GRIP generated by your active income. This results in a tax savings. Using your GRIP and RDTOH to save tax on investment income was translated in detail from accountant Klingon previously.
The maneuver results in a 5% absolute reduction in tax on those forms of investment income compared to dispensing ineligible dividends. That would be a $500 tax savings for every $10K of investment income. The government is obviously unimpressed about this and moved to eliminate it with the 2018 Federal Budget. We only have until the end of our current corporate fiscal year ending in 2018 before they yank this tax cutting weapon out of our hands.
- After 2018, if your CCPC is going to have active income above the new sliding SBD threshold. Then, you will want to consider how well that translates into personal income using GRIP and eligible dividends compared to lowering your active business income by paying more salary. Understanding GRIP lays the groundwork for us to explore this important decision-making in a future post.
- For CCPCs with passive investment income, the GRIP generated by receiving eligible dividend income can increase your personal cash-flow and lower your tax burden. We will explore this in detail later in this post.
You will want to pay attention and not put this off. Let’s start with describing how GRIP is calculated and allows us to give eligible dividends.
Calculating GRIP for a CCPC such as a professional corporation
The four-page long complex GRIP calculation tax form is available on the CRA website. I found that form about as digestible as Klingon cuisine. So, I will spare your palates and give a basic translation from accountant Klingon into English below.
Basically, you have a starting balance based on your previous GRIP minus eligible dividends that you have already dispensed. You generate new GRIP that you add to your balance through active income above the SBD threshold or by receiving eligible dividends from other companies.
Next, subtract eligible dividends that you dispense from the GRIP balance, and you have your new start point for the following year.
A more detailed look at generating new GRIP:
a) Earning active business income above the small business deduction (SBD) threshold.
The default SBD threshold is $500K for most provinces, but that could now be less if you have passive investment income that counts and shrinks your active income limit. To calculate the GRIP balance created by that income over the SBD limit, multiply it by the “general rate factor” for the year. That factor is currently 0.72, and is set by the Federal Government. It is based on subtracting the average general federal/provincial corporate tax rate (about 28%) from 100%.
For example, a medical professional corporation (MPC) earns $700K net active income in Ontario with a SBD threshold of $500K. The MPC will pay the Ontario/Federal combined general tax rate on $200K of that $700K. It also generates 0.72*$200K = $144K for its GRIP account.
b) Earning investment income as eligible dividends from another company.
These dividends would usually come from holding stocks in a dividend paying publicly traded Canadian company or a fund that holds those stocks. However, it could also be an eligible dividend paid by another private company from their general rate income pool. Receiving this type of income adds dollar for dollar to the GRIP account of the receiving CCPC.
For example, if our MPC holds ETFs that pay us $25K in eligible dividends, then that adds $25K/yr to our GRIP account.
Simply add the amount generated from active business income to that from eligible dividend investment income to get the total added to the GRIP balance for the year. For the MPC in our example, that would be $169K.
When you have a positive balance in your GRIP account, you can elect to give lower taxed eligible dividends.
To give yourself an eligible dividend from your corporation, that needs to be designated in writing. That includes a letter to shareholders, notation on dividend cheque stubs, or a notation in the corporate minutes. You should do this in conjunction with your accountant because you don’t want to mess it up and incur penalties.
Let’s say with our MPC example, we paid out $100K of eligible dividends. That would leave us with 69K in our GRIP account to start with the following year.
The example of GRIP calculation for our hypothetical MPC in the above text is summarized in the flow chart below.
How can GRIP keep your money in your fist and out of the hands of the taxman?
The GRIP generated by receiving eligible dividends in your corporate investment account can allow you to pass money out of your corporation more efficiently. This is illustrated in the comparison chart below using the Ontario top marginal tax rates.
Generating GRIP using eligible dividend paying investments in a corporate portfolio can help you get the personal cash flow that you need while retaining more earnings to invest in your corporation.
Let me illustrate this idea from another more practical angle as the driver – how much money you need to take out of your corp to pay for your lifestyle :
An MPC that makes $400K net clinical income and pays the owner $150K salary has a net active income of $250K. It also has an investment portfolio that generates $50K/yr in eligible dividends. With that active and passive income level, it is below the SBD tax threshold still. They need $137K/yr (after tax) to fund their lifestyle. It would take a $50K eligible dividend from the MPC to the owner to achieve that after-tax income, and with the $50K GRIP generated by the investment portfolio, they can do that.
If instead of the eligible dividend distributing investments, they used one that made the equivalent as unrealized capital gains only (such as with a swap-based ETF), then they would not have any GRIP and would have to give ineligible dividends instead. It would take an ineligible dividend of $57300 to give the same after-tax cash flow. That is $7300 less money retained in the CCPC to invest and grow. Per year. Think of how that annual increase in invested retained earnings in the corporation account could grow over time.
For this strategy to work optimally, you do need several conditions:
- Your corporation pays out enough dividends to trigger all of your eRDTOH. This would be $2.61 for every $1 of RDTOH. In the case of eligible dividends, that means paying out $1 of eligible dividends for every $1 received from investments. By trigging refund of all of your eRDTOH, you are making the tax drag of eligible dividends in your corporation investment portfolio zero.
- There is enough cash flow inside the corporation to pay out the dividends from active income without touching your investments and investment income. If you have to use the money from the dividends from your investments, then you are simply passing the money through (the original intention of GRIP) with no change in tax burden.
- You actually require the personal cash flow from the dividends from your corporation. If you start paying out more dividends from your corp just to release the RDTOH when you don’t need the money, then you are decreasing the tax deferred growth from retained earnings in your corporation. I don’t foresee this being an issue for me personally, as we certainly have no problems spending money to support our lifestyle.
- The combined passive investment income and active business income of the CCPC does not push its income over the small business deduction threshold. If that happens, then the tax advantage switches to investments that do not increase aggregate investment income and bump more of the corporation’s active income into the higher general corporate tax zone.
Some notes on safety while weilding your bat’leth.
When thinking about tax optimization, it is important to remember its place in the hierarchy of your planning. An asset mix that suits my goals and risk tolerance would be my primary concern, with tax efficiency being a secondary consideration. Paying less tax doesn’t help much if it is due to poor portfolio performance.
When considering this strategy, you need to also bear in mind that you probably don’t want to just hold a non-diversified portfolio of Canadian dividend paying funds. Canada only represents about 4% of global markets and having a globally diversified portfolio helps to mitigate investment risk. For example, to generate 50K/yr in eligible dividends using Canadian equity ETFs yielding ~2.5%, then you would require $2M of them. If you wanted Canadian equity to be 20% of your overall portfolio, that would mean you need to have a $10M portfolio for that to work out! Plus, if you hold other income producing assets in your corporation account as part of a balanced portfolio, or realize any capital gains through re-balancing, then that could also add up and shrink your SBD threshold.
Be careful how you swing your tax bat’leth – you don’t want to cut off your nose in spite of your face. You don’t see many long-nosed Klingons walking around.
However, you will want to consider the lessons in this post if you are considering using swap-based ETFs or corporate class mutual funds in your corporation. Those products have some excellent advantages in some situations and less so in others. We will be sure to model some scenarios comparing an eligible dividend paying conventional ETF like XIU to HXT (its swap-based comparator) soon in The Sim Lab.