Corporate Class Bond ETF (HBB) in a Private Corporation

Canadian Controlled Private Corporations (CCPCs), such as professional corporations, can be great tax-deferred investment vehicles. Further, capital gains flow very tax-efficiently through a corporation. In contrast, corporations are generally less tax-efficient for interest income. Also, high levels of passive income becomes increasingly inefficient in some situations.

A corporate class bond ETF functionally converts interest to an unrealized capital gain when functioning as intended. That seems like a silver bullet if you must hold bonds as part of your corporate investment portfolio.

Is it? Or are you needlessly buying more expensive ammo to risk shooting yourself in the foot?

None of this is specific investing advice. My goal with the next few posts is to give you my perspective on the potential risks and benefits of using corporate class ETFs in a corporation. Add that to the other due diligence that you need for making your own investment decisions. There are nuances to tax situations. So, consult your tax planning professional.

How efficiently a corporation deals with investment income depends on several factors. Two of the main factors are the type of income and whether you pay enough dividends to release refundable corporate taxes. Plus, if the investment income bumps you over the corporate passive income limits, then that worsens the overall taxes. Except in Ontario and New Brunswick, where imperfect tax integration may favor going over the passive income limits. Regardless of province, if your corporation gets bumped over the passive income limits and you don’t spend enough personally to make use of extra eligible dividends, it is a huge tax bump.

To account for the above, for each of the model comparisons that I do, I will show the efficiency of the corporate class ETF vs conventional ETF in a few different corporate and personal compensation scenarios.

Efficient CCPC

The corporation is dispensing enough dividends from its retained earnings (active income minus taxes) to also release all refundable dividend tax on hand (RDTOH) generated by investment income. These are dividends you would normally pay to fund personal consumption. Not extra dividends, dispensed solely to release RDTOH refunds.

Trapped RDTOH

Someone with low personal spending and/or high CCPC passive income may find themselves in a situation where RDTOH is temporarily trapped until they need the money personally. Passive income is taxed at the high CCPC rate upfront (~50% or 38% for eligible dividends). The corporation gets some of that refunded as RDTOH when dividends are paid out and personal taxes are paid on them. If you don’t need the money and personal taxes are high, then the RDTOH is collected and not refunded until some time in the future when you do. That is an upfront tax drag.

Over Passive Income Limit & Using The Eligible DIvidends

corporation taxes

When the CCPC exceeds the active-passive income threshold, then the SBD threshold shrinks from $500K at a rate of $5 for every $1 of passive income. That takes effect the following tax year. Active income above that level is taxed at the higher general corporate tax rate. Usually about a 12-15% bump. So, at a 5:1 clip, that is functionally it is a 60-75% tax increase. As mentioned, ON and NB have a middle tax rate because only the Federal tax gets bumped. For example, in ON the bump is only 6%*5=30%.

To help preserve tax integration, the CCPC income taxed at the higher Federal general corporate tax rate also generates some GRIP. That allows the corporation to give some eligible dividends. So, if you do need dividends personally to live on, then those eligible dividends are taxed at about 8-10% of a lower personal rate. That means increased corporate tax and some personal tax savings. The net effect of the passive income SBD shrinkage tax is still a significant tax increase in most provinces, except ON and NB.

Over Passive Income Limit & Not Enough DIvidends

This is the same situation as above, except that you are not paying out enough dividends to take advantage of the extra GRIP generated by the bump up to general corporate tax rates. That functionally means an extra 60-75% corporate tax triggered by the investment income. If you choose to leave it all in the corporation, then it is a big tax drag. You’ve paid the taxes upfront.

It is important to remember that if your CCPC exceeds the passive limits this year, the SBD threshold shrinkage is the following year. You could choose to work/earn less or spend/invest more personally the following year instead. So, this worst-case scenario is someone who is over the limit and doesn’t make an income or spending adjustment.

For the conventional ETF, I used ZDB from BMO ETFs. It holds discount bonds. Discount bonds should be more tax-efficient than regular bonds. More of the return is a capital gain rather than interest. If not comfortable with the extra complexity and risk of the corporate class bond index ETF (HBB), then ZDB would be my conventional ETF of choice to hold bonds in a corporate account.

The main role of bonds in a portfolio is to decrease volatility. That utility should be similar between comparable discount or regular bond index funds. However, the discount bond fund should have a better total after-tax return. HBB also tracks the total return of a broad bond index. However, the corporate class structure functionally changes the income to capital gains when working as intended. That means both tax deferral and reduction.

HBB vs ZDB Fees & Projected Returns

The current weighted yield to maturity for ZDB is 4.68%, and the coupon is 1.97%. I modeled that as 1.87% interest (net of the 0.1% MER) and a 2.71% capital gain and applied tax at the top Ontario & BC tax rates. When capital gains actually get distributed varies depending on the turnover of bonds in the ETF, but I will just pass them all through for this illustration. You would expect there to be constant turnover as bonds mature. For Horizons’ HBB, the underlying bond index yield to maturity is 4.41%. The management plus swap fees can be up to 0.25%.

The actual total returns of bond funds would also change with the prevailing interest rates. A larger capital gain if rates drop and a loss if they rise. For the simulation, I used no change. Interest rates are unpredictable and would impact both ETFs similarly anyway.

The table below details how I calculated the fee and tax drag of the conventional vs corporate class bond ETFs. This is the annual drag on growth from the fees and taxes paid each year. Importantly, there would be a tax liability accruing in the corporate class fund from the unrealized capital gains. Those unrealized gains are from the income being added to the net asset value of the ETF shares. When sold, then the capital gains tax would be due. It is tax deferral and most people would not sell shares until they need to use the money. I will show the complete flow-through of all income separately.

Fee & Tax Drag in a CCPC Below Passive Income Limits

The drag on the corporate class ETF is only its fees until it is sold. For HBB, that is 0.25%/yr. For an efficiently running CCPC, the conventional ZDB ETF has a 0.75%/yr drag from fees plus the taxes on interest and capital gains from the discount bonds held. The actual distribution each year would vary, but this is an estimate. That is a slight advantage of 0.50%/yr growth for the corporate class ETF. That advantage is much larger if the corporation becomes inefficient. If that inefficiency is due to more RDTOH being collected than the refunds from dividends used for normal living, then it is 1.48%.

Fee & Tax Drag in a CCPC Above Passive Income Limits

A CCPC that is over the active-passive income threshold has another layer of tax. The net of the extra corporate taxes paid and personal savings from using the eligible dividends (from the GRIP generated) is a 0.55% advantage favoring HBB in British Columbia. It is a punitive tax hike but is largely attenuated by tax integration when the money flows all the way through to owners.

Tax integration for the general corporate tax rate in BC is pretty good (0.3% inefficiency). In other provinces, the difference could be much higher. For example, in Alberta, general corporate income plus the eligible dividends from the GRIP has a 1.82% inefficiency. That translates to a 0.77%/yr advantage for HBB in Alberta.

If unable to use that extra GRIP generated to pay eligible instead of non-eligible dividends to fund personal consumption, the difference is massive. A 3.08% advantage to HHB in BC (2.41% in AB) because investment income over the passive income limit triggers punitive taxes. In that situation, you should be seriously discussing how to decompress money out of the corporation with your tax planning advisors. Preferably, way before this happens.

ON & NB vs Other Provinces

In Ontario and New Brunswick, exceeding the passive income limits can be a net tax savings if all of the money flows through. The net effect is a 2.17% increased tax efficiency for the flow-trough of active income via a corporation in Ontario. That translates to a -0.35%/yr tax drag for ZDB as long as the extra eligible dividends generated by the bump of corporate active income to the general corporate tax rate are used. When added to the fee and tax drag on the passive income, the net is a 0.38%/yr drag. That is minimally worse than HBB.

The impact of the tax integration anomaly is much higher in New Brunswick. It actually translates into an overall growth boost! For either province, if unable to use the GRIP generated by passing out eligible dividends to spend personally, the tax penalty is not attenuated and HBB is much more efficient.

The above model was buying and holding the ETFs. However, as the corporate class ETF is held, the capital gain tax liability grows. In contrast, the conventional ETF results in tax every year on the distributions instead. Most people would not sell their corporate-class ETFs every year. Just when they need the money. However, it is also important to consider the after-tax cash in hand after everything has been sold.

Efficient Corporation Below The Passive Limits

This model uses the highest marginal tax rates for current and future years. If you were deferring tax from a high current bracket to a lower future one, the tax deferral of corporate class ETFs would provide an extra advantage. Or disadvantage if your future tax rate is higher. Capital gains could also be harvested to reduce the current taxes relative to salary or regular dividends (effectively boosting tax deferral).

Tax integration and the low tax rate on capital gains mean that they do offer an advantage compared to regular investment income. Even if a capital dividend is not used, HBB has a slight (0.07%) advantage. However, if taking advantage of the capital dividends to reduce salary or non-eligible dividends required to fund personal consumption – the difference is huge. For example 1.7% to 2.4% in the above model.

Corporations Above The Passive Income Threshold

When a corporation is over the passive income limits, selling and realizing capital gains will worsen that by generating some taxable income. However, only half of the capital gain is taxed. So, it is less impactful than receiving a higher interest payment. If able to use the CDA built from the capital gain, then it really minimizes the impact. In fact, it is better than using the GRIP generated from the bump to the general corporate tax rate.

So, in a province like BC where tax integration is pretty good, HBB has a 0.60% advantage flowing all of the income through relative to a conventional ETF. If the corporation is not able to use the excess GRIP from the passive income shrinkage of the SBD threshold, then it is a massive 3.1% advantage. If unable to give capital dividends, HBB can trail. However, a large corporation over the passive income limits would likely have enough capital gains each year to make it cost-effective. Even with accounting fees for the capital dividend special election. This holds up in Ontario as well. Despite the weird tax integration issues.

HBB Benefit in an Efficient CCPC

Similar to the comparison in a personal taxable account, the corp class fund has a tax deferral advantage. It is small to moderate at ~0.5%/yr in my model for an efficiently running corporation. Whether that tax deferral ultimately translates into further tax savings depends on your current vs future tax rate. If your future tax rate is lower, as most people would expect in retirement, then tax deferral is also more savings. If it is the same, the advantage of the corp class bond ETF was minuscule compared to ZDB. Less than 0.1% if income is just all flowed through. There is uncertainty about future tax rates. So, that is not a slam dunk either.

If able to take advantage of using capital dividends instead of regular salary or dividends, that is boosted to strongly favor HBB. If the future tax rate is eventually lower.

Corporate Class Fund Tax Risk in a CCPC

There is also risk and uncertainty about the net income in Horizons’ corporate class structure, as it currently burns through its net loss pool. I will model that risk for corporately held ETFs in a future post. Similar to what I did with tax berg drills for personal accounts. The results will likely be similar for an efficiently running private corporation. However, the tax savings of corporate class ETFs are much more profound for a CCPC that is having problems with too much passive income.

That may mean more leeway before the income taxes in the corp class ETFs are worse than the punitive taxation of the CCPC. It is also likely that Horizons would see an income problem coming and take action. Perhaps, switching back to a conventional structure on a tax-deferred basis. However, that does require faith in their management. If using these funds, I would keep an eye on the counter-party risk. Horizons may need to realize income to manage that. It is currently low for HBB.

I would also consider whether to realize the capital gains and switch to a conventional ETF if their loss pool gets shallow. The resulting capital gain could be passed out very efficiently from the corporation into my personal hands using a capital dividend. That may even help my corporate tax deferral by replacing some regularly taxed income. However, in provinces outside ON & NB, that could also mean a detrimental bump over the passive income threshold for a year.

HBB For The Passive Income Werewolf

Horizons bond etf

If a corporation has too much passive income relative to what is being paid out, it can become inefficient. The RDTOH could get functionally trapped if you don’t need dividends for personal cash flow and the personal tax rate is higher than the corporate refund. No income or just half a capital gain makes corporate-class ETFs shine in that situation.

If a corporation gets bumped over the passive income limit, then HBB can side-step that. Or preferably delay/avoid it in advance if you see that problem coming.

In most provinces, that is a large advantage for HBB. In Ontario, it is only helpful if you can’t use extra eligible dividends or can use capital dividends harvested from HBB. Exceeding the passive limit and paying out the extra eligible dividends is a big net tax advantage in New Brunswick. That could make an income-spewing conventional ETF good. As long as you move money out of the corporation with the eligible dividends generated. The Ontario and New Brunswick anomaly could change on a whim if those provincial governments change to follow suit on the Federal tax hikes of 2018.

Silver Bullet or Expensive Ammo?

Like a silver bullet, HBB comes with a higher cost. All bullets can be dangerous. Similarly, HBB is tax efficient while working as intended. In an efficiently functioning corporation, it is a moderate advantage. However, if there is a misfire, like net income within Horizons’ mutual fund corporation, the embedded ETF taxes can get bad. Quickly. If trapped RDTOH or the CCPC passive income limits attract the tax werewolf, the cost and risk of a silver bullet may still be worth it to some people. Otherwise, a conventional discount bond ETF is a good straight-forward alternative.

Nothing in this post should be considered specific financial advice. I have tried to make an accurate attempt at useful modeling. However, this is complex stuff. If you find an error, please let me know so that I can check and correct it as needed. There are nuances to taxes for corporate and personal situations. Consult your tax professional as appropriate.

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