In my last post, I reviewed how a Canadian Controlled Private Corporation (CCPC), such as a professional corporation, can be used like a dam to regulate the flow of earned business income. This can smooth our cash flow so that we lose less money to our progressive personal tax system. Also like a dam, a corporation allows us to collect a large reservoir of capital (money) to invest and grow. But beware, if your reservoir becomes stagnant, the tax skeeters can breed. Let’s explore how to avoid that.
There are several phases to how investing through corporation works:
- Corporate Tax Deferral Advantage (on earned income)
- Growing Corporate Capital Reservoir (by investing)
- Minimizing the drag of taxes on investment growth
- Flowing money out of the corporation and into our personal accounts
This general process is outlined at a high level below and I will spend the rest of the post looking in more detail at each of these segments.
The Corporate Tax Deferral Advantage Gives Us More Money To Grow
One of the biggest advantages of the CCPC structure is tax deferral on active business income. The pool of capital left in your corporation after expenses, taxes, and dividends is called the retained earnings.
Those retained earnings have been taxed at the lower corporate rate, leaving us a larger money reservoir than if we took that income personally. A stagnant pool of water doesn’t grow anything except mosquitoes. We need to invest it to grow. The effect of the corporate tax deferral advantage invested for 6% annual growth is shown below.
Understanding Corporate Investment Taxation Is Important
I want to put this “out there” near the beginning of the post because most of us hear “taxation” and our eyes glaze over. When you combine the words “investment” and “taxation”, it’s game over. However, you will note that the above chart ignores the drag on investment returns from the taxation of investment income. We call that unfortunate reality “tax drag“.
Does Tax Drag Matter?
The tax deferral on earned income for a corporation leaves you more money to grow initially. However, in a corporate investment account, there is tax paid on the income generated by those investments. Tax drag blunts the rate of growth.
That tax drag can be minimal or it can be 1-1.5%/yr depending on how you invest and how you dispense money from your corporation. If you applied a 1.5%/yr tax drag to the investment income in the above model, it decreases the annual after-tax return to 4.5% from 6%. That flattens the growth curve as shown below. “Investment Taxation” may be boring, but I bet you could think of some exciting things to do with the money in the “orange tax drag gap”.
Fortunately, a 1.5%/yr tax drag would be an extreme example. That is easily reduced with some basic knowledge of how investment income in a corporation is taxed to guide us. So, tape your eyelids open and let’s proceed.
Corporate Investment Accounts
Corporate retained earnings are invested via a corporate investment account. This is an account at a brokerage like Questrade, Qtrade, MD Financial, or your advisor’s affiliated brokerage (if you have one). Your CCPC can have more than one corporate investment account, even at different brokerages. However, that makes tracking for tax purposes more of a pain in the butt.
Setting up a corporate investment account is a simple process and similar to opening a personal one. You fill out some forms. Instead of personal ID for a personal account, you will need to provide a copy of the face sheet from your Articles of Incorporation as your “ID”. We will go through how to do this, step by step, elsewhere.
This account is owned by the corporation. You put money into it from the corporate operational account. For clean accounting, it is also best to transfer money from the investment account back to the operational account before dispensing it to you personally. The ways to flow money out of your corporation were described in the previous post.
What can you invest in via your professional corporation?
We will focus on investing in financial products via our CCPC. By financial products, I mean stocks, bonds, GICs, or the funds that hold a basket of these products like exchange traded funds (ETFs) or mutual funds. My preferred investing approach is passive index investing using ETFs. That method gives a broad diversification, minimal hassle, and minimal loss of returns to fees. Historically, it also has the strongest record of overall performance.
In addition to passive investment income from financial products, your corporation can hold investments like the real estate and infrastructure used in your practice. For professional corporations, like a Medical Professional Corporation (MPC), there can be restrictions on holding passive real estate or alternative investments that are not directly related to your professional practice. Your professional college regulates that. Dr. Networth has described how to hold real estate in relation to a corporation elsewhere.
Entering the Potential Investment Income Tax Drag Zone
In order to discourage the use of professional corporations for tax deferral, passive investment income within a corporation is taxed upfront at a rate close to the maximum possible personal tax rate. Like the other attempts at tax integration, there is not a perfect match-up.
As you can see in the chart below, the upfront tax on investment income generally favours corporations in the provinces where individuals get hosed the most with higher personal tax rates. It is also vital to note, that this comparison is assuming top personal tax rates. If you are in a lower personal tax bracket, then the relationship could change to further favour personal investment income.
Keep Money Flowing Through Your Corporation To Combat Mosquitoes
Fortunately, this high upfront taxation is not the end of the story. If we pay money out of our corporation (which we do to live on), then tax integration lessens or negates this upfront taxation. In order to avoid this drag on investment growth in our corporate reservoir, we need to keep the money flowing. Stagnate water will allow mosquitoes to propagate. Keeping it flowing will power the “refundable taxes turbine” of our corporate dam further described below. [Editorial Note: Any resemblance between those levying these taxes and blood-sucking insects is purely coincidental.]
Tax Integration for Professional Corporation Investment Income
High tax rates are charged upfront to decrease tax deferral on the investment income generated. However, when money is passed on to personal hands, that tax needs to be refunded. Otherwise, the same investment income would be getting taxed twice (once in the corp and again personally). This is accomplished using four notional accounts (meaning they only exist on paper for the purpose of taxes).
Investment Income Type & The Associated Notional Accounts
- Eligible Refundable Dividend Tax On Hand (eRDTOH)
- General Rate Income Pool (GRIP)
Interest, Foreign Dividends, & the Taxable Half of Capital Gains:
- Non-Eligible Refundable Dividend Tax On Hand (nRDTOH)
Non-Taxable Half of Capital Gains:
- Capital Dividend Account (CDA)
In this next section, I will review how each type of investment income works through its associated notional accounts to attempt tax integration.
Eligible Dividend Income
Eligible Refundable Dividend Tax On Hand (eRDTOH)
One notional account type is the eRDTOH. This account is new for 2018 onwards and I have described the new eRDTOH rules in detail elsewhere. Dividends from investing in Canadian publically traded companies are eligible dividends and taxed favourably.
When your corp is paid an eligible dividend, then it is taxed at close to the highest personal rate (38.33%). That tax is paid to the government from a real account. However, the eligible dividend also affects two notional (on paper only) accounts: eRDTOH and GRIP.
The full amount of tax paid is noted in the eRDTOH account. When your corporation then pays you dividends, the eRDTOH is refunded to your corp when it next files its tax return.
This means that eligible dividend paying investments can pass that income through your corporation without losing anything to tax compared to if you took that money directly (100% tax efficient).
Either an eligible or ineligible dividend paid out from your corp can trigger the release of eRDTOH. However, an eligible dividend is taxed at a lower personal rate so it is preferable.
General Rate Income Pool (GRIP)
To be able to pay out eligible dividends, your corporation needs to generate a balance in its GRIP account. When your corporation receives eligible dividends, the pre-tax dividend amount is added to your corp’s GRIP account. Your CCPC can then pay out eligible dividends up to the GRIP balance.
GRIP and eRDTOH Can Improve Your Personal Cash Flow
If your CCPC has enough excess retained earnings and you need to dispense dividends each year from your corporation to meet your personal cash flow needs, then using eligible dividends can improve your personal cash flow. This is because you end up paying less personal income tax on eligible dividends compared to receiving the usual ineligible dividends from a CCPC.
Eligible Dividend Income Summary:
- Eligible dividend-paying investments are very tax efficient in a CCPC
- They may reduce your personal tax bill if you are paying yourself dividends out of your corporation’s retained business earnings annually to meet your personal cash flow needs.
- Unfortunately, their tax efficiency is lost if your investment income becomes large enough to shrink your corporation’s Small Business Deduction threshold as described later in this post.
Foreign Dividends & Interest Income
Non-Eligible Refundable Dividend Tax On Hand (nRDTOH)
When your corporation earns other investment income, it pays the 50.17% tax rate upfront. Of that high upfront tax, 30.67% is directed to the nRDTOH and 19.5% is lost as a non-refundable tax.
When your professional corp gives you ineligible dividends, the nRDTOH is refunded to your corporation. It is important to note that only ineligible dividends trigger nRDTOH release and not eligible ones.
You will also notice that with foreign dividends, some income is lost to foreign withholding tax. That may be partially refundable for countries with tax treaties with Canada. It is a small amount and is applied before the CCPC investment tax. Justin Bender did a full analysis of the impacts of foreign withholding tax for various account types. The impact is small, but slightly worse than in a personal taxable account where the withholding tax is usually fully recoverable.
Foreign Dividend & Interest Income Summary:
- Interest and foreign dividend income in a CCPC are tax inefficient compared to personal investment income. This is because some of the tax on CCPC investment income is not refunded.
- To get the refundable portion of the tax, your corp must pay out higher taxed ineligible dividends.
Capital gains only trigger tax when they are realized, meaning that the investment was sold. Further, realized capital gains only have a 50% inclusion rate. This means that half is taxed and passes through the nRDTOH tax mechanism described above. The other half avoids tax and goes into the third notional account type, the Capital Dividend Account.
The Capital Dividend Account (CDA)
This is the notional account that the non-taxable half of realized capital gains go into. This account is tracked because if you had earned the capital gain personally, rather than in a CCPC, then half would have have been tax exempt also.
The balance that you build up in your CDA can be used to dispense a tax-free capital dividend. That’s right. You can pass money from your CCPC financial capital reservoir into your personal hands tax-free.
This raises all sorts of fun tax planning possibilities because it allows you to get your hands on tax-free money to live on while regulating the taxable cash flow out of your corporation. That could be used to optimize against marginal tax brackets and Old Age Security clawbacks. I also wonder if it could be used in Ontario to live on and draw no taxable income while your kids get free tuition for University due to your low personal income.
Oh, the impure thoughts…
While Capital Dividends may be tax-free, they do come with some accounting fees – generally in the $750-$1500 range. So, you would want to make sure that you dispense capital dividends in large enough aliquots to justify that cost.
Capital Gains Summary:
- Capital gains are not taxed until realized. The larger initial capital available to invest from the corporate tax deferral advantage, coupled with the tax-deferred growth of unrealized capital gains, make this a real winner in a corporate account.
- When realized, the taxable half is slightly less efficient than in a personal account due to the tax loss in the nRDTOH mechanism.
- Together, these first two points hit home an important message. Capital gains oriented investments are awesome in a CCPC – unless you frequently realize capital gains. Don’t crystalize gains by selling unless you have a compelling reason to.
- The CDA generated through realized capital gains can be useful for tax planning.
Dividends should be paid out of your active income, if possible.
As mentioned, the RDTOH and CDA are notional accounts. All dividends that you pay yourself have to come from a real account, like your corp’s operational account. If you have to sell investments or use the investment income generated by your investments to pay out dividends, then you are sacrificing some of the growth in your portfolio to do that.
While working and accumulating financial capital for your future, you should pay dividends from your corporation’s operational account that is filled by earning active business income. Paying dividends out of the net active income of your corporation still triggers the release of RDTOH, and allows you to fully take advantage of tax-deferred growth in your corporate investment portfolio. To do that means spending less than you earn.
How big of a dividend does your corporation need to dispense to trigger RDTOH?
A dividend of $2.61 will release $1 of RDTOH. That would need to be an eligible dividend to release eRDTOH. An ineligible dividend can release either eRDTOH or nRDTOH. Personally, if I had an eRDTOH balance, I would want to dispense the lower taxed eligible dividends. I suppose that if the higher gross-up of eligible dividends resulted in an Old Age Security (OAS) clawback, that could make eligible dividends less appealing.
I am too young to bother with the math on that one, yet. It just gives me one more reason to keep emptying out that eRDTOH account while I am young and spendy. Further, I hope to so massively fatFIRE that OAS won’t play much of a role in my retirement income.
Limits On Corporate Investment Size and Income
Corporations that have more than $10MM in assets lose their small business deduction linearly until it is eliminated by $15MM. Reasonable. Wish I had that problem.
Recently, the Federal Government imported some genetically modified tax skeeters from Manitoba in its attempts to further discourage tax deferred investing via small corporations. Passive investment income, starting in 2018, will affect the small business deduction for active income in the following year. The full list of what counts as passive investment income for CCPC business tax is called adjusted aggregate investment income (AAII).
How the New Active-Passive Small Business Tax Threshold Works
For every dollar of AAII that your corporation earns above $50K/yr, the small business deduction threshold will shrink by $5 for the subsequent year. For example, if your corporation earns $75K passive income this year, then the SBD threshold will shrink by $25K times 5 = $125K. That means if you earn more than $375K active income the following year, the excess active income will get taxed at the higher general rate.
If you have “too much” AAII coupled with “too much” active income, you will pay the higher general corporate tax rate (~28% vs 12-13%) on your active business income over that amount. That blunts the corporate tax deferral advantage significantly, but doesn’t eliminate it.
What does this all mean for planning our corporation investment account and overall portfolio?
- A corporation preserves more money up front to invest. You could have 70-88% of your actively earned income (after paying 12-30% corp tax on active income) to initially invest compared to half personally.
- However, investment income in a corporate account is not tax-sheltered. A high rate of tax is charged upfront on passive investment income. It is close to the top marginal tax rate, but lower than the top bracket in provinces where you really get hosed personally.
- You can minimize the drag on income from that upfront tax by paying dividends from your corporation to trigger the release of RDTOH.
- Even with the release of RDTOH, interest income and foreign dividend income are less tax efficient in a corporate account than personally. Consider holding investments that produce larger amounts of these income types elsewhere, if possible. Unfortunately, we may need to if there is not enough space in our tax-sheltered accounts to fit our overall planned asset allocation. Asset allocation is always our number one priority.
- Eligible dividend paying investments held in a CCPC can be very tax efficient, if you pass the income through to yourself personally as eligible dividends to fund your lifestyle. Unfortunately, that efficiency is lost if the dividend income bumps your CCPC out of the small business tax rate. When building our portfolio, we may want to preferentially hold our Canadian dividend paying equities/funds in our corporation up to the SBD threshold. After that, we would need to use other strategies.
- Capital gains focused investments are very tax efficient in a corporate account. Capital gains are efficient in a personal account also. However, a corporate account is where they can really shine. Part of this is because there is more initial capital to invest. That can grow exponentially since it does not trigger tax until the capital gains are realized. Investment account growth from unrealized capital gains also does not count towards the small business active-passive income threshold. When a capital gain is realized, only half of it is taxed and counts towards the small business income threshold.
- Frequently cashing in and realizing capital gains is tax inefficient. This holds true with personal taxable investment accounts also. However, slightly more of the taxable half of a realized capital gain is lost than it would be personally due to the inefficient nature of nRDTOH. So, don’t realize capital gains unless you have a good reason to.
- If you do crystalize capital gains, then it does generate a balance in your capital dividend account. I would not sell just to do this, but the CDA does offer some tax planning opportunities.
Disclaimer: I would recommend discussing with your accountant and advisor. For incorporated professionals, a good accountant is mandatory. A financial advisor may be optional. However, if you use one, this kind of strategic planning for your portfolio is what they should be talking about to add value. Accountants and financial advisors may be experts at tax planning and financial planning respectively, but it is important to blend both to get the optimal outcome. Being an educated client helps to bridge this divide.