Corporate Class Swap ETF Tax Calculator

The newly restructured corporate class total return index ETFs (TRI ETFs) from Horizon can offer some tax advantages. This interacts with their fees which are sometimes higher or lower than conventional ETFs. This post describes how my online Corp Class Swap ETF comparator works to simulate the advantage or disadvantage of these ETFs in a TFSA, RRSP, corporate (CCPC) account, or a personal taxable account.

Some of you may want to simply play with it.

To do that click the link in the first paragraph or the icon found in the right sidebar (or bottom) of any page on the blog. For those wondering about the math running in the background, read on. There are ~150 000 pieces of data or calculations behind the scenes. This is a technical document that explains them, but it is also a good refresher about dealing with a number of investment taxation issues.

Thank you to the blog readers and Physician Financial Independence (Canada) Facebook Group that helped me find bugs and improve the interface. If you spot more, please let me know!

Inputs

Select your province for the tax calculators. For those using a corporate account, indicate that you are incorporated. The corporate income and account options will then appear.

Note: A personal taxable account is still the default in the Baseline Comparison tab. You need to change that manually to look at a corporate investment account. It helps to change this to “Corp” account type on the baseline tab right away. That will enable the flags for the passive income limit and release of the refundable corp investment taxes (RDTOH) described below.

Corporate Income

Enter your net corporate income (your revenue minus overhead costs, including salaries paid and payroll costs). A ballpark number is fine. If you already have a bunch of corporate investments producing aggregate investment income, then enter the annual amount here also. This data is used to calculate your basic corp tax rate on both passive and active income and the active-passive income limit.

There is a major decrease in corporate tax deferral if you are above the passive income limit and it shrinks your small business deduction. If you are already past the point where you get any small business deduction (SBD), then you have nothing further to lose. If further passive income shrinks your SBD faster than a dip in a cold lake, the corporate class ETFs have a major advantage compared to conventional income-generating ones.

The left column shows the baseline using a swap ETF (no added passive income). The two to the right factor in the added income of conventional ETF comparators. This will change when you select different ETFs in the baseline comparator tab.

Retained Earnings and Corporate Dividends

The money left after the corporation pays its expenses and taxes are the retained earnings. These can be paid out as dividends to the owners, in addition to their salary. Alternatively, they can be used to invest within the corporation.

The CCPC issued dividends can be eligible dividends or ineligible dividends. Eligible dividends are taxed at a lower personal rate because some of the tax has already been paid by the company. To give eligible dividends, the CCPC must have some GRIP.

The corporation generates GRIP from business income taxed at the higher general corporate rate or if it gets passive income from eligible dividend-paying investments. It sounds confusing, but the calculator deals with this automatically.

Enter the amount of the dividends that you would pay to help meet your personal spending.

The calculator will then automatically try to dispense dividends to minimize the overall personal and corporate tax drag. The biggest drag generally results from not paying enough eligible dividends to release the eRDTOH (38% refundable corp tax on eligible dividend investment income). Not dispensing enough ineligible dividends to release the nRDTOH (30.67% refundable part of the corp tax on investment income) is the next biggest tax drag. If there is still GRIP left after these have been released, then more eligible dividends will be prioritized since they are more lightly taxed in personal hands.

Not dispensing enough dividends to release RDTOH causes major tax drag in a corporate investment account.

This will flag as red in the bottom part of this section. That will change if you alter the ETFs, amount to invest, or switch to a non-corp account in the Baseline Comparison Tab. You can also clear those flags by dispensing more dividends. However, realize that it means you would also pay more personal tax and lose some of the corporate tax deferral advantage. Not requiring you to move out excess money from the corp to release more RDTOH is another area where the corporate class swap ETFs shine.

Personal Income

This field forms the basis for tax calculations when comparing the ETFs in a taxable account. This data should be for the owner of the taxable account. Enter the total for regular income and other investment income if you have a personal taxable account. If incorporated, dividends from the corporation section are automatically added to the income appropriately.

Selecting Investments To Compare

The top section of the Baseline Comparison Tab has three variables to set up the comparison. Enter the amount to invest that will be used to generate the investment income. Select which corp class swap ETF to compare and it will automatically select comparator ETFs. Select account type (TFSA, RRSP, Taxable, Corp). The table showing the “risk premium” for using the swap ETF will automatically recalculate.

How the risk premium is calculated.

The risk premium is the annual drag on returns from fees and taxes of the corp class swap ETF compared to a matched conventional ETF. A positive number favors the swap. For example, a risk premium of +0.5% means that the drag of fees and taxes of the conventional ETF is 0.5%/yr worse than the swap version. This calculation assumes that the capital gains of the swap ETF equals that of the conventional one plus its income (which gets functionally converted to a capital gain by the synthetic swap structure).

Fee and tax drag in a TFSA, RRSP, or Personal Taxable Account

The MER is the management fee plus sales tax. Foreign withholding taxes (FWT) are collected on dividends from foreign equities. These are lost in a TFSA, recoverable in an RRSP that holds stocks directly, but are fully recoverable in a personal taxable account when you file your income taxes. FWT is fully described elsewhere. This also makes the calculator useful for comparing the Canadian-listed vs US-listed ETFs in an RRSP or TFSA where it may matter.

The money left after fees and FWT is then paid out and taxed at the appropriate personal or corporate tax rate.

Fee and tax drag in a corporate investment account.

The MER is the same as other accounts. FWT may also apply and is assumed to be 50% recoverable when the corporation files its taxes. The remainder of the tax drag during the accumulation phase in a CCPC depends on the tax rate, release of RDTOH, if the passive ccpc income limit is exceeded, and if there are enough dividends being dispensed to attenuate the impact of that.

It is complicated, but the calculator handles this automatically to minimize the tax drag.

RDTOH and tax drag.

The RDTOH is refunded and deducted from the tax drag if sufficient dividends are dispensed. The net drag from tax on corporate investment income is shown as part of the net Canadian tax drag. Eligible dividend income received by a CCPC can be passed through very efficiently and the GRIP sometimes results in a net personal/corp tax savings. If this advantage applies, it is bundled in with the active-passive corp effects line of the table.

Corporations over the passive income limit.

The increased drag from tax on active income for corporations over the passive income limit is accounted for. If possible, it is reduced by dispensing eligible dividends and the personal tax savings of that factored in. I fully describe that process (with pictures) in an older post comparing HBB and ZDB in a corporate account. Since, I wrote that post the tax integration was broken in Ontario and New Brunswick making a tax reduction loophole for some situations. That anomaly is accounted for. The net effects of the active-passive corp tax and personal tax are reported in the active-passive corp effects line.

Outputs: Base Comparison

The table in this tab shows the cost breakdown over one year at baseline as outlined above. It also provides some additional information to consider.

Below is a screenshot for $10K invested in bond ETFs for an Alberta CCPC over the passive income limit, but dispensing out adequate dividends. It shows the fee and tax drag described above. Plus, some basic information about the index tracked.

Diversification of the index held.

One of the criticisms of the Horizon TRI ETFs is that they are less diversified than some other options. Diversification helps to reduce specific investment risk. Some indexes track more individual holdings than others. However, the incremental benefit of diversification becomes much less when you have a larger number of holdings. The difference between 1000 and 1500 holdings is negligible – but the market sectors covered by those holdings also matters.

Limited exposure to some aspects of the market.

The corporate class ETFs only track the main large-cap stocks (like the TSX 60 or S&P 500) and some Canadian sectors (like banks or REITs). I used conventional ETFs that match these indexes. However, there may be more diversified ones that have intermediate and small-cap stocks.

For example, I use XIU to compare with HXT. Both cover the TSX 60. However, those are only the 60 largest Canadian stocks. Some would argue that something like VCN is much more diversified, covering more of the large plus some smaller cap Canadian equities using 200 holdings. I did not include that as an option because it would be apples to oranges and my assumption of having the same overall capital growth between ETFs may not be true.

In fact, it is a different risk. For example, the small-cap component of the Canadian market has lagged while in other parts of the world it has increased returns over long time-frames. Ben Felix touches on this in his video about swap ETFs done just prior to the recent legislative attack on them.

Unreleased RDOTH or Small Business Deduction Shrinkage

If the conventional ETFs produce income that causes inefficiency due to RDTOH not being released or the passive income limits, then these are flagged. As mentioned previously, this increases the conventional ETF tax drag substantially.

Yes, you can go back to the income tab and decrease the corporate net income (usually by paying more salary) or increase the dividends dispensed. That will clear the flags and make the risk premium of the swap ETF less. However, that does not reduce the overall tax drag in real life. You are just paying more personal tax now by moving more money out of your corporation (loss of tax deferral).

Outputs: Growth

This tab will take the after-tax annual total return and project it over a 35 year period. You can adjust the capital gain portion of the total return with a slider on this tab. It is set at 5%/yr as the default. That is at the upper end of reasonable for equity. Consider adjusting it lower if you want to account for a lower expected return (such as for bonds). While the growth rate accounts for the annual tax drag from income, the investment values are shown in pre-tax dollars.

The capital gains are not realized each year. You would realize those gains and pay tax on them as you sell holdings to rebalance (should be a rare event) or to draw money.

Below is a screenshot for the previously described Alberta corporation holding bonds. The annual capital growth was set to a low 1%/yr.

Changes in RDTOH release or exceeding the passive income limit over time.

There are two factors that this calculator does not account for with the corporate account. Whether enough dividends are dispensed to release RDTOH and if the passive income is below the threshold makes a large difference in tax-drag. This issue is likely to strike those with high incomes or high savings rates.

The simulator uses the baseline status for the whole time period.

All of the RDTOH may be released and income may be below the threshold at baseline. However, that may actually change over time. Depending on the annual contributions and growth, at some point, the income of conventional ETFs may cause further inefficiency. That is not accounted for and would favor the corporate class swap ETFs by delaying or avoiding the issue.

Outputs: Drawdown

In addition to the tax advantage of less annual tax drag, the other area where the tax deferral of the corporate class structure can be advantageous is during the drawdown phase. When you start to live off of your portfolio.

You can select how many years into the simulation to start drawdown. It will use the pre-tax investment value for that year as the base for you to draw money from. For simplicity, we would draw a percentage of the portfolio each year.

Adjustable Withdrawal Rate

The default is set at the much-touted 4%/yr. However, the “safe withdrawal rate” for Canadians may be different based on length of retirement and portfolio mix. Ben Felix wrote about it here. The drawdown tab of my Corp vs RRSP vs TFSA Calculator also automatically adjusts for it. For this calculator, I made it manually adjustable with a slider.

Adjustable Drawdown Income Tax Bracket

The overall income level during drawdown may also have an impact. If you are in a lower tax bracket at drawdown than accumulation, then the tax-deferral advantage of capital gains may be increased. So, I made the income level adjustable and there are tax calculators running in the background. Top marginal rates are displayed.

Adjustable Capital Gains Inclusion Rate

Capital gains are given favorable tax treatment for a reason. The amount included and tax is currently half of the gain. However, it has historically ranged from 50% to 75% in Canada. It seems a likely target for tax-strapped governments to raise this again in the near future. That would attenuate the benefit of the swap structure somewhat. So, I made that adjustable.

Detailed Description of Income Drawn

How income is drawn and taxed depends on the account type. All income from a TFSA is tax-free and all income taken from the RRSP is taxed as regular income.

For a corporate or personal taxable account, dividend or interest income is passed through first. If more money is required to make up the withdrawal amount, then that amount of ETF is sold. The appropriate tax on the realized capital gains is applied based on the inclusion rate set.

The excluded capital gain and the remaining money is a tax-free return of capital. For a corporation, the analogous process is applied to flow the money into personal hands. This is illustrated in the diagram below.

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Don’t worry. That confusing algorithm runs in the background. The results for the above inputs are displayed simply like this:

Outputs: Liquidation

This tab shows the after-tax value if the portfolio were liquidated at any given point in time. That would trigger and tax all unrealized capital gains (of which there would be more in the swap ETFs). To change the capital gains inclusion rate, you need to do so in the Drawdown tab.

The liquidation value is unchanged for a TFSA or RRSP because they are tax-sheltered.

For a personal taxable account, the capital gains are added to the baseline earned income, and the investment income from the ETF for that year. It then performs a personal income tax calculation.

For a corporate account, the capital gains are realized and the included half taxed at the corporate rate. It is assumed that enough dividends are dispensed to realize all of the RDTOH.

Moving money out of the RRSP or Corp accounts does trigger other personal income taxes. The Drawdown tab is meant to inform on that aspect.

Bugs and Feedback

As you can probably tell, if you made it this far, there is a tonne going on in the background of this calculator. If you find something that does not make sense, looks broken, or should be improved – please send let me know.

I have found a number of intriguing possibilities for the usage of these ETFs by applying the calculator to my own situation. I will share this in future posts. In the interim, try it for yourself because the potential benefit of these products changes with different inputs.

I am also working on a calculator that will better compare a full portfolio over time and also assess the potential damage from different legislative doomsday scenarios.