Time for Capital Gains Harvesting From Your Corporation?

Conventional wisdom is to avoid realizing capital gains in order to defer taxation as long as possible. However, there are some times when harvesting the capital gains in a corporate investment account could actually defer tax even more. It can also be useful for early retirees or those with a low-income year, but this article will focus on the Canadian small corporation owner. Learn about how this works and whether it is something that you should consider discussing with your accountant.

What is capital gains harvesting?

Capital gains harvesting is selling a holding (like a stock, mutual fund, or ETF) that has an unrealized capital gain and then immediately re-buying it. That has two effects. First, it makes the capital gain taxable. Second, it then resets the adjusted cost base (ACB) of your holding. That means that future capital gains/losses would be compared against this new price as the benchmark.

capital gain tax harvesting

Capital gains harvesting is not to be confused with capital surplus stripping. That is a boutique tax law maneuver. This maneuver is basically the inverse of tax-loss harvesting or capital loss harvesting that is commonly described. In fact, it also sometimes referred to as tax-gains harvesting. Tax-loss harvesting is realizing a capital loss now. In the U.S., that can be used as a deduction against income. In Canada, it could be useful to be offset some capital gains from previous or future years to reduce or defer taxes.

One important difference between capital gains harvesting and tax loss harvesting is that you do not need to worry about the “superficial loss” rule. In tax-loss harvesting, you cannot have bought the identical holding (in another account) or re-buy the identical holding within a 30-day window on either side of selling and realizing the loss. That is considered a superficial loss and cannot be deducted against other capital gains. Conversely, there is no such thing as a “superficial gain”.

The reason why the “superficial rule” does not apply to gains is that realizing a capital gain makes tax due now. It is to the government’s advantage. If it makes tax due now, then why the heck would you do it?!?

When would a capital gains harvest be useful?

There are a couple of reasons why you may want to trigger and pay taxes now rather than later.

The speculative harvest.

A gains harvest can be a bet that the tax rate is going to rise drastically in the very near future. Better to pay less tax now compared to pay much more next year. It is a gamble, that the tax hike will occur, and that it will be large enough to justify the smaller pile of capital left to compound over time.

Capital gains are currently taxed with a 50% inclusion rate. That means only half the capital gain is taxed. The capital gains inclusion rate is taxation by design. It is meant to encourage the risking of capital required to innovate and grow the economy, and to account for inflation eroding the “buying power” of capital appreciation.

Raising the capital gains inclusion rate has been bandied around by our cash-strapped government for several years. The NDP had raising the inclusion rate to 75% as part of their election platform. A move to 75% from 50% equates to a 50% tax hike! The expenditures dealing with Covid-19 have surely stoked the governmental thirst for revenue from unsavory types – like savers and investors. Usually, when governments announce a new tax measure, it is effective from the day of announcement forward (even if the bill is passed later). The Federal throne speech looms imminently and a budget soon thereafter…

This is a speculative reason to capital gains harvest and the topic of a future post. It could apply to either a personal taxable investment account or a corporate investing account.

Capital gains harvesting as corporate tax planning.

There is also a mathematically sound tax planning reason for capital gains harvesting. It applies to those using a small corporation, like a Canadian Controlled Private Corporation (CCPC) or Medical Professional Corporation (MPC). While the harvest results in more corporate tax paid now, that can be more than offset by personal tax savings.

When we flow cash from our corporation into our personal hands, we pay personal tax on the dividends or salary. The amount we dispense to ourselves from our CCPC is usually driven by how much after-tax cash flow we need to fund our lifestyles (and usually our RRSP & TFSA if we are trying to optimize!). In essence, we work backward from how much after-tax money we need to live on to determine how much money we must pay ourselves from our corporation. We also need to avoid mental accounting and consider both the corporate and our personal taxes together.

Reducing our personal tax rate means that we can pay out less from the corporation to achieve our cash flow goal. That translates into more tax-deferred money left in the corporation to invest and grow. It maximizes the corporate tax-deferral advantage.

The above, simplified, description of the taxes is an optimal situation. There are a number of nuances that effect how efficiently this works. To fully understand how a capital gains harvest in a corporation can result in net tax savings, we need to review how capital gains are taxed in a CCPC in more detail.

CCPC capital gains taxation: inclusion rate, refundable tax, and capital dividends.

Capital gains inclusion rate

When we sell a holding for more than we paid for it, that gain in value is taxed as a capital gain. Only part of that capital gain is subject to tax. That is the “included part” and the proportion is referred to as the inclusion rate.

For example, my CCPC bought $1K of shares in Apple in 2011. Yeah, I wish! They are now worth $101K. That is a capital gain of $100K. I sell all of those shares and realize that gain. The capital gains inclusion rate is 50%. So, $50K is taxable (included) and $50K is tax-free (excluded).

Tax on the included amount

The included amount is taxed at the corporate rate of 50.17%. Some of that tax is refunded to the corporation via RDTOH when the corporation pays out enough ineligible dividends. Further, personal tax is then due on the ineligible dividend.

The excluded amount build the capital dividend account (CDA)

The excluded amount is added, dollar for dollar, to the CCPC’s capital dividend account. The capital dividend account (CDA) is a notional account. That means it just exists on paper for accounting purposes to keep track of whether a CCPC can pay a capital dividend or not. If there is a positive CDA balance (meaning there are accrued capital gains in excess of accrued capital losses), then the corporation can elect to dispense a capital dividend. There is no personal tax on a capital dividend.

Movement of a $100K realized capital gain from a corporation into personal hands is illustrated in the diagram below.

corporation capital dividend tax

The astute will notice that the total tax paid (28.857%) is higher than if you were to realize a capital gain personally (26.765%). As in other areas of tax integration, a corporation on its own is not an efficient way to flow earnings. What can make this very efficient is if a corporation is already dispensing more than enough dividends to release the RDTOH (yellow in the chart) from its active business income as part of the usual payment to shareholders. In that case, the use of a capital dividend could reduce the amount of excess ineligible dividends paid from active income required for the shareholder/owner to have the same after-tax personal income.

Factors affecting the efficiency of tax gain harvesting in a CCPC.

Sufficient cashflow out of the corporation.

For capital gains harvesting to be efficient, you must have enough money flowing out of your corporation. That could be to fund your regular spending or it could be a one-off-big-withdrawal-year to top up a TFSA, put a lump sum in an RESP, fund a home renovation, or even buy a motorhome.

If you are not flowing enough money out of your corporation, then realizing capital gains within the corporation is not tax efficient. You are paying tax on the gains now, but not able to offset that with personal tax savings.

Sufficient dividends to release Refundable Dividend Tax On Hand (RDTOH)

When a corporation receives investment income, it is taxed upfront at ~50%. When you pay out ineligible dividends, the RDTOH of 30.67% is refunded to the corporation. So, if you are not still paying out enough dividends to release the RDTOH, then adding more investment income via the taxable half of realized capital gains worsens efficiency. Instead of a 9.5% tax drag on realized capital gains, it is a 25% tax drag in the corporation. Approximately $2.61 of dividends paid out are required to release each dollar of RDTOH.

If you pay out more ineligible dividends just to release the RDTOH, then you pay personal tax on those dividends. That decreases the tax drag in the corp by 15.6%, but the personal tax rate incurred (20-48%) is much higher than that for incomes over about $50K/yr. So, it is usually not advisable to dispense extra dividends simply to get the RDTOH if you don’t actually have a personal use for the money.

Have a large enough capital gain to offset accounting costs.

To dispense a capital dividend requires a special election and paperwork. Some accountants will include that in their overall fees for managing the corporation’s taxes. Others will charge a special fee. That fee could be a flat rate. Alternatively, it could be based on the time required to review the investments and do the paperwork. That can vary greatly based on how complex the investment portfolio is and how organized your records are. Generally, something in the $300-900 range is what I have heard of. It would be great for readers to add their experience to the comments section of this post.

So, you would need to be able to dispense a large enough capital dividend to save enough tax to offset that cost. That would be larger for those facing large accounting fees or in low personal tax brackets.

The capital gains inclusion rate.

The efficiency of a capital gains harvest from corporate investments is driven by the ability to give tax-free capital dividends. As the inclusion rate rises, this opportunity decreases as the excluded gain (that adds to the capital dividend account) shrinks. Currently, it is 50%. However, an increase in the inclusion rate to 75% would cut the amount of a gain going to a CDA and eligible for a capital dividend in half! This may limit the utility in the future if tax rates rise.

Exceeding the active-passive income threshold.

The included half of the capital gain counts towards aggregate investment income for the corporation. If that exceeds $50K per year when added to other investment income, then it will shrink the amount of active business income that the corporation is allowed the lower small business tax rate for at a rate of $5 for every $1 over $50K for the following fiscal year.

corporation investment income tax

The corporate income above the active-passive threshold is taxed at the higher general rate. However, that also generates GRIP which softens the tax-blow by allowing more eligible dividends instead of the higher-taxed ineligible ones. That may even be a net advantage in Ontario and New Brunswick where tax integration got broken by the rule change (until they fix it). One could also increase the salary paid out to decrease the corporate active income as a strategy to come back below the threshold. That is particularly effective if the extra salary can be offset with RRSP contributions/deductions. A third strategy to attenuate this problem would be to spread out the capital gains harvest across two corporate fiscal years. A number of other strategies could be used if the active-passive income threshold is going to become a recurring problem.

Is it time for you to consider a capital gains tax harvest from your corporation?

The answer will be different for everyone depending on:

  • How much investment income your corporation has normally. More income means more RDTOH collected that requires ineligible dividends to release. This also relates to the next bullet.
  • How much personal cash you can utilize for lifestyle needs or to top up your tax-sheltered accounts. If you start to trap RDTOH in your corporate account by decreasing the ineligible dividends dispensed, it is less efficient. If you require excess ineligible dividends to meet your after-tax cash needs, then offsetting that with capital dividends from a capital gains harvest can be efficient.
  • How much capital gains you have to harvest. Is it worth the hassle and accounting fees?
  • Whether it will bump you over the passive income threshold and whether you can attenuate the effects of that.
  • Whether you think the capital gains inclusion rate will rise in the near future. If that happens, then this may be a narrowing window of opportunity.

Given all of these variables, I recommend consulting with your accountant or financial advisor if you are considering this. I am neither a financial advisor nor an accountant. However, I have also made a capital gains harvest tax simulator (click the image above to link to it) that you can try for educational and entertainment purposes. You should probably get out more if you find it really entertaining…

I will use it to do some illustrative cases in future posts. The only tax harvesting example that I was able to find on the internet was from a CPMB post last year and some more examples to understand this should be helpful. The simulator has multiple tax calculators running, tries to optimally distribute dividends, and even has some flags with possible solutions when the capital gains harvesting is sub-optimal. As usual, please let me know if you find a bug, error, or are otherwise able to break it.

18 comments

  1. Another brilliant piece-your ability to explain complex topics with diagrams and plain language is truly amazing !
    Well done and thank you , I keep mentioning your blog to anyone who has a CCPC .
    Lyndon

    1. Thanks Lyndon. I had been meaning to write this one for a while, but life got busy and it took me a while to thoroughly go through the math. There was also little written about it on the internet. So, I had to start from the ground up.
      -LD

  2. Another great article Loonie MD!

    I was thinking of ways to take advantage of it with 10-15 years to go before retirement.

    If the funds aren’t spent then there aren’t many options. After maxing out a TFSA or RRSP and putting it in a personal brokerage account with likely a lot of new taxes directed at these accounts by you know who won’t be very advantageous.

    If the Central Banks are planning to hyperinflate the economies over the next decade with $Trillions in QE then perhaps the only option is buying some physical gold or silver with the proceeds and hiding it away.

    Non dividend paying stocks like BRK.B or a GLD ETF is another option but then the capitals gains will have to be declared.

    For some reason I predict the phrase ” pay their fair share” will be used a lot at the Throne Speech. LOL

    1. Thanks Monterey. I have the same feeling about where taxes are heading. The interesting part will be how much they will alter behaviour. There seems to have been an attitude shift that the government should provide for anyone who hasn’t prepared and those who do prepare and save should pay for it. We will certainly just work less in our family if working becomes a minimal after-tax return for the time/effort. We are fortunate to have that flexibility. We certainly are in unchartered waters in terms of monetary and fiscal policy. Interesting times. I still think that the best inflation hedge is stocks, but I did add some gold miners into my mix earlier this spring.
      -LD

  3. Great to see you posting again!

    There’s a gem from one of your earlier posts/comments that I saved: “Capital losses from only the current year can be applied against capital gains (nasty and means you made need to plan around capital loss tax selling to not “waste” losses).”

    Am I correct to say that capital loss selling should also always be done in a capital gains selling (but not necessarily CDA harvesting) year?

    Cheers, TM

    1. Hey Tooth Mechanic. Capital loss selling I get for a personal taxable acccount. For a corporate account, I am not sure that it is as useful. I do suppose that if you aren’t going to capital gains harvest, then selling to offset capital gains in the same year would have some use. However, I spend enough that having my CDA account in the black is quite useful to me.
      -LD

    2. Do *not* trigger a capital loss in a year where you are trying to harvest a capital gain. I’m harvesting capital gains this year and my accountant warned me that any losses will be deducted against the gain I’m trying to harvest.

      1. That is excellent advice. My accountant advised the same. Technically a loss shouldn’t count after your corp has officially elected and dispensed a capital dividend. However, you don’t want to raise eyebrows with CRA – could be a hassle. Those losses would still carry forward so that for the next capital dividend you would have to overcome them with gains before getting a positive CDA balance again.
        -LD

      2. Could you explain why this is the case? I have bought some dividend stocks and some are in red and some in black and I thought it would be better tax wise to move them to TFSA. I thought if I sell stocks at loss and some at gains and then the capital loss would offset the capital gains? Or only works in a personal account?

        Also can someone recommend an accountant who can give this sort of advice for someone with CCPC (Law Corporation)? We are based in Kelowna and Vancouver. Thank you.
        Thanks so much Loonie doctor for an excellent article.

        1. Hey Diane,

          You are correct that selling some gains and some losses would offset each other in a corp account. What the comment above was referring to is that you don’t want to have a negative balance in your capital dividend account around the time you give a capital dividend. Technically, you could have a positive balance, give the CDA with the appropriately filed election via your accountant, and then take a loss later. However, there is some risk that CRA will hassle you about it if in the same tax year. There would be also be two specific considerations when thinking about doing this to offset gains/losses to re-buy the holdings in a TFSA (or RRSP).

          1) Realizing some net capital gains now is not necessarily bad if you have enough to justify flowing out a capital dividend instead of a regular one (what I was writing about in this article). Generally a gain over $50K (depending on how much your accountant charges to do the paperwork) is a rule of thumb my accountant has used with me. If the capital gains tax rises in the next Federal budget (a distinct possibility), then it is even better. If it is a small capital gain and not worth a capital dividend, then cancelling out gains/losses is probably better in that case.

          2) If you sell something at capital loss in a corp or taxable account and then re-buy it in a tax-sheltered account in under 30 days, then technically you could lose that loss as a write-off against the gain. The issue is that you control both accounts. With a personal taxable account, it is a definite problem. With a corporate account, it is more grey-zone (as far as I have been able to figure out). It seems like it would be a hassle for CRA to go after it, but who knows. The issue is that you realize the loss in the taxed account, but it is a superficial loss and therefore not deductible now. Normally what happens with a superficial loss is that the adjusted cost base (what you compare the gain against in the future) is moved up so that eventually when you sell – it offsets the gain then. Basically, it defers the benefit of the loss to the future. Problem is there is no tax on the gain in a TFSA or RRSP. So, you lose the deduction now and don’t get it later. A way around that problem is to re-buy something very similar (but not identical) in the TFSA/RRSP.

          That is my non-accountant opinion 🙂 Unfortunately, I don’t really know any accountants in BC. Any accountant who deals frequently with CCPCs should know this stuff. However, I have also been shocked at how many colleagues have giant capital dividend balances that they have never paid out and have been getting hosed with high regular income/dividends! So, it is a good idea to have an understanding to ask about it if not brought up.
          -LD

  4. Good article! I think there is one more potential benefit – income splitting via the capital dividend. Correct me if I’m wrong but if your spouse has shares in your MPC then the capital dividend can be issued to him/her. Given how restrictive TOSI rules are — you can’t effectively income split until age 65 — this quasi-loophole is a great way of getting cash out of your MPC and into your spouse’s hands. I’m probably oversimplifying things so talk to your accountant.

  5. New physician recently incorporated here. I just finished reading every single one of your post from the beginning! Brilliant. I have learned a lot and I will keep following. Thank you for what you are doing.

    A suggestion for a new post would be a tutorial on how to read the important informations on an ETF you are looking to buy. Like what important information you should be looking at and where to find it. I feel it is difficult to find what I need with all the information out there (e.g. finding the dividende yield of an ETF, the return in the last years, the diversification of the ETF, etc.)
    Maybe it’s a basic question, but I would find that informative 🙂

    Thank you!

  6. LN.
    Thanks for publishing this article
    It’s a debate any intelligent investors in Canada must be having with their accountant
    The golden rule of compounding is to never mess with it. (Roughly quoting Charlie Munger)

    I’ve been strongly resisting the urge as I’m trying to maximize retirement nest egg more than minimize tax.

    The government is going to have to increase GST. Raising capital gains is not likely to produce much income and more likely to hurt the 99% who need to sell stocks for living expenses than the 1% who may choose to simply not sell. I also think that people with serious capital are simply going to move to more friendly jurisdictions
    This hurts all Canadians

    1. Hey Joe. I am having a similar debate. I am currently writing a post about harvesting from a personal taxable account. It is one of those rare situations where there is a reasonable chance the tax will jump imminently. We also had a lower-than-usual income this past year. So, we did harvest some gains both personally and from my wife’s account. A raise in capital gains tax will hurt savers and those depending on their investments to fund their retirement. However, I think that politically they will spin it as only rich people can afford to save and invest. A bad message since it enables lack of responsibility and will ultimately increase dependence on the government for bail-outs. However, they used it when cutting the TFSA limits even though it is the best tax-shelter for a low-income Canadian. Politics in Canada has really become all about appealing to dominant voter blocks than doing the best thing long-term for a while now. By taking some of our money off the table now, we also plan to lay low income and spending-wise as the taxes rise.
      -LD

  7. Thanks so much for this in-depth article, LD! The calculator is especially helpful. I’m wondering how the projections/ calculations could change with dual-physicians MPC able to income-split from within their joint corp? Presumably may need some serious excel spreadsheet skills to sort that out 😉 Also, for the calculator, could you direct us to the relevant lines / sections of our T2 corp tax return to find the proper amounts for our annual eligible corp dividends and corp interest / passive income, etc? Thanks again.

    1. Hi IW,
      If the corp is shared, then you could try this. For the salary and dividends paid out, just cut in half (to be like for one of the couple to simulate the income splitting). Also reduce the gross corp income by the amount of one salary – that should be make the corp active income ok. Cut the capital gain in half (since it would also be split). I think that might work.

      I don’t delve into the depths of my T2 because my account gives a nice financial statement. You can also usually get a sense from you brokerage statement. It should be on schedule 7 of the T2 corp tax filing though.
      -LD

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