The impending increase in taxation of capital gains realized in a Canadian Controlled Private Corporation (CCPC) has many incorporated business owners wondering whether to realize capital gains before the June 25, 2024, tax hike. Same with those who advise them. It is a complicated problem spanning tax and financial planning. I did a deep dive on the relevant variables elsewhere. The optimal strategy is very situation-specific and not always intuitive. So, I built a capital gains harvest simulator with detailed annual calculations running in the background to model it.
This is the first in a series of cases comparing different strategies using my simulator. I will also explain what I see as the mechanisms underlying the results. This will hopefully help advisors develop their intuition about cases they encounter. As a corporation owner, you may identify with aspects of your own situation. This is not meant to be specific financial advice. Consult with your advisors. Refer them here if needed. Other opinions, thoughts, and commentary are also welcomed. This is on the cutting edge of planning strategy. It is not understood by many, but is an area for planning to make a difference. Particularly, with the window before the impending tax legislation (not finalized as of this writing).
I am trying to be transparent. So, in this first case, there are details about the strategies, optimal compensation, and return assumptions. I will skip them in future cases and reference this one. If you don’t care about those details, you can skip to the comparison of how the strategies perform. Also, if you don’t want to the details of what is happening under the surface, you can skip to the executive summary.
About the Strategies & Assumptions
Comparison of the Strategy Results
Capital Gain Tax Harvest Strategies
What is the capital gains harvest strategy?
This is not the same as capital surplus stripping (now mauled by the GAAR tiger).
The strategy uses a capital gains harvest before June 25, 2024. That means selling and rebuying assets to crystallize the capital gain before the change. It means the capital gain is taxed this year at a lower rate. A tax savings, but also loss of tax deferral on the gain. A special election to give a tax-free capital dividend is used. The net effect is some corporate tax this year. But, also more personal after-tax money.
Dividends can be paid out from any corporate bank account, and the investments left the same.
Harvest & Spend
This strategy dispenses a capital dividend. The excess personal cash is used to live off of. This means that the corporation can pay out less salary and dividends to fund personal spending. The eventual result is more retained earnings left in the corporation.
Excess personal cash is added to the TFSA each year ($7K) and the remainder is invested via a personal taxable account. Dividends are paid from the corporation to efficiently empty RDTOH and GRIP. If there is a gap between that income and spending needs, then money is spent from the personal account. If there is still a gap in after-tax personal cash, salary from the corporation is used to bridge it. The TFSA is preserved.
Harvest & Invest
The harvest strategy and capital dividend are the same as with the spend strategy. However, instead of reducing salary and dividends from the corporation, the excess personal cash is invested. Preferably attributable to a lower-income spouse. This decompresses more from the corporation, but also loses more corporate tax-deferral.
Excess personal cash is used in the same way as the spend strategy. However, salary is used to make up a consumption requirement before the personal taxable account is tapped. The TFSA and personal investment accounts are preserved. More is paid out of the corporation using salary.
No Harvest
Basically, do nothing. The model assumes that the money will eventually come out at the proposed increased capital gains rate. It maintains the current level of corporate tax deferral. It also maintains the current level of legislative tax risk. That is good if future governments change the rules to tax corporations favorably. It is bad if they target incorporated business owners further.
Optimal Corporate Compensation
Dynamic Salary & Dividend Algorithm
All strategies in this simulation use an algorithm of optimal salary and dividend mix. This was detailed in Ep 13 of The Money Scope Podcast. Personal protective equipment and a screen protector to contain brain matter are advised. My Corp Salary & Dividend Optimizer also runs the algorithm in the background. The basic premise is to use enough dividends to release notional accounts (if efficient) followed by salary to make up the rest. Any RRSP room generated by salary is used. Some nuances kick in with income splitting and low income or consumption levels.
How Salary & Dividend Mix Changes Over Time
What this looks like for the 20-year simulated period without doing a capital gains harvest is shown below. Mostly salary to start with. Proportionately more dividends and less salary as corporate passive income increases. There is a big shift when the passive income limit shrinks the small business deduction threshold and bumps more corporate income to the general rate. At that point, more eligible dividends to clear out the GRIP generated are often used.
Dynamic Salary vs Max RRSP vs Dividends-Only
Ben Felix and Braden Warwick recently compared this type of dynamic salary algorithm vs prioritizing salary to maximize IPP vs dividends-only in a recent white paper. At high consumption levels, a dynamic salary and RRSP-focused strategy are very similar over the study period. As are the final results. With using an RRSP rather than an IPP, the RRSP-focused strategy was 0.16% ahead at $192K/yr spending levels. Below that, there was more of a difference in compensation strategies, with the dynamic strategy outperforming (6-10% more assets using a dynamic strategy). That is table A2 in their appendix using an all-equity portfolio.
Below is a similar analysis using DIY investing and RRSPs and the $500K corporate pre-owner-salary income with $150K/yr personal consumption. The yellow dividend-only and green dynamic salary/dividend mix are overlapped and the RRSP-focused strategy trails slightly. Ontario is a special case where dividend-only takes maximal advantage of the current favorable GRIP anomaly. The odds of that not being closed over 35 years are low. Not to mention the risk of “keeping it all in the corp” as an easy political tax target. In other provinces with normal integration, dynamic salary wins.
Portfolio & Return Assumptions
For the simulation, I am using an 80% stock, 20% bond portfolio with no attempt at asset location optimization. The detailed allocation and return mix is below. I account for foreign withholding tax (FWT) and Canadian taxes in all account types annually. US-listed ETFs are used when appropriate to avoid a layer of non-recoverable FWT. All returns are adjusted into “real dollars” using 2.1% inflation. Contributions to the Canada Pension Plan (CPP) are hard to peg a value on, but shouldn’t be ignored. I arbitrarily treated CPP like an account with contributions earning a 2% real return. That is close to the predicted IRR when taking CPP at age 65 and living to age 85.
Meet Our Corporation Owner
This first case is an incorporated Ontario business owner who earns $500K/yr net active income in their corporation. That is before paying an optimal salary and the CPP that goes with it. Their business is eligible for the small business deduction.
They spend $150K/yr on lifestyle. Reasonable, given how disciplined and hard they worked to get where they are. They have maximized their RRSP and TFSA to date. Plus, they’ve retained about $500K in the corporation over the years, invested that, and grown their corporate portfolio to $1MM. They are sitting on a $500K unrealized capital gain. We’ll exclude the existing RRSP and TFSA from the analysis, but track new additions to those accounts. That way differences from the current maneuver will be more readily apparent.
They are single and have no kids.
How The Harvest Unfolds Over 6 Years
Part of why this strategy breaks people’s brains is because it unfolds over several years. In this case, it unfolds over about six years. I will hone in on what that looks like and summarize it in the chart below. They harvest the $500K capital gain before June 25th, 2024. Later that same year, they pay out a $250K capital dividend. The option of using that capital dividend to spend personally and ultimately retain more money in the corporation is shown below.
Year Zero (Age 40): The Harvest
In year zero, their corporation also pays them a $46K non-eligible dividend and $6K eligible dividend to get the RDTOH from their usual investment income refunded to the corporation. With that and the capital dividend, they have $143K to invest in a personal taxable account.
Year One (Age 41): Clearing nRDTOH
The capital gain also generated extra nRDTOH on the taxable half. In year one, they use non-eligible dividends to release that. That, plus drawing $18K from their personal investment provides enough after-tax cash in year 1. They could have used more non-eligible dividends in year zero to clear the RDTOH out faster. However, I carried it to the next year to simplify the model since different corporations have different fiscal year-ends.
The other thing that happened with realizing the capital gain in year zero was it generated $250K of passive income. That eliminates the small business deduction for the corporation’s active income for year one. With using non-eligible dividends only, all of that corporate income is taxed at the general corporate rate. But wait, in Ontario, the Federal passive income tax grab was not mirrored. So, the provincial SBD applies for a combined tax rate of 18.2%. Plus, that generates GRIP as if the corporation had paid the usual 26.5% general corporate rate.
Year Two (Age 43): Clearing The GRIP
That GRIP allows the corporation to pay out more favorable eligible dividends to fund personal consumption in year two. The net effect of corporate plus personal tax on that income flowed through is 2-6% less than with salary. That is boxed in red on the screenshot below from my corporate tax integration tables.
So, a capital gains harvest gives a little extra bonus for moving money out of a corporation in Ontario. That was the intent of the passive income limits – although the Federal government meant for it to be a big stick rather than a small carrot.
It is not a benefit if you don’t use it promptly. In year two mostly eligible dividends are used to take advantage of the GRIP generated. Before its value is eroded by inflation. Otherwise, the passive income limit shrinkage of the SBD means a higher corporate tax rate without being offset by using the personal tax reduction of eligible dividend income. A small amount of non-eligible dividends are also used to keep the nRDTOH from the corporation’s investment income flowing.
Years Three to Six (Age 44-46): Spending Your Personal Investment Money
In year three, a small amount of non-eligible and eligible dividends are used to keep the corporate investment income efficient with RDTOH refunds. Meanwhile, the extra money invested from year zero has been largely untouched. It has accrued a small capital gain. Way below the $250K/yr personal capital gains threshold. That is sold as required and used to make up the personal spending shortfall over the next couple of years. Gradually, more salary is used to make up the shortfall and contribute to the RRSP room generated from that as well. By year 6 or 7, the corporate compensation plan is back to normal.
Net Effect On Tax Deferral & Efficiency
The previous section showed how the corporation uses a shifting mix of salary and dividends to efficiently process a capital gains harvest. However, what does that look like from a tax standpoint? The analysis below is the sum of personal tax deferral (unrealized capital gains and RRSP) and corporate tax deferral (unrealized capital gains & partially taxed business income). The annual tax drag is the sum of personal and corporate taxes paid in a given year divided by the total active and passive income.
There is a loss of tax deferral upfront using a harvest due to realizing the gain and paying the embedded tax liability. However, if the extra personal cash from the harvest is used to reduce taxable income paid by the corporation in later years, there is a larger boost in tax-deferred retained earnings in the corporation. Looking at that another way, there is an upfront tax bump from realizing the gain. Followed by a lower tax drag spread over several years.
Portfolio Value & Composition
After-Tax Portfolio Value
The chart below shows the portfolio after-tax value. That means all corporate assets are liquidated and distributed as efficiently as possible using a mix of capital dividends, eligible dividends, and non-eligible dividends as appropriate. An RRSP is liquidated and taxed as regular income. Personal cash accounts realize capital gains and that tax bill is deducted. A TFSA is tax-free.
Most of us would not voluntarily liquidate our portfolio. We would draw it down more gradually and tax efficiently. Unfortunately, that tab of my simulator pushed it over what I could convert to a webpage. However, a deduction of taxes to somewhat emulate a more gradual drawdown is shown below. It doesn’t change the comparative results between strategies in this case. The initial tax efficiency increase, while resetting the corporate capital gains tax liability. That carries forward and compounds over the 20-year study period. That one $500K harvest translated into $105K more after-tax money.
Portfolio Composition & Diversification Against Future Tax Changes
One of the reasons why many corporate owners have been caught flat-footed by the proposed tax changes is that they have their portfolios concentrated in their corporation. Fortunately, the business owner in this scenario was using their RRSP and TFSA as well as their corporation. That spread out their tax risk. Plus, the TFSA and RRSP provide tax-sheltered growth while corporate investment income is taxed each year. Still, we can look at the changes from doing the harvest to see how it affects that account mix.
Harvest & Spend Account Changes
Using a capital gains harvest initially results in moving more money out of the corporation. If that excess money is used to reduce future taxable income paid out of the corporation (the harvest & spend strategy), then there is ultimately more corporate money. That comes at the expense of a slightly smaller RRSP. From a numbers standpoint, it is still a win. At 20 years, it translates to $200K more in the corp, but $155K less in an RRSP. However, that boost of value held in the corporation does mean more money is exposed to future changes in corporate taxation.
Harvest & Invest Personally Account Changes
While not the numerically optimal strategy in this scenario, using the excess money from the capital dividend to invest personally (the blue line in the charts) increases the diversification of future tax risk. Less partially taxed money is in the corporation, less fully tax-deferred money is in the RRSP, and more money is left to grow in the personal account. At 20 years, they would have $53K less after-tax money in the corporation than if they hadn’t done a harvest, $100K less in their RRSP, and $163K more in their personal cash account. Overall, they now have much less exposure to future tax rate hikes.
Compensation Mix Changes Over Time
Another way to visualize the reason behind the difference in RRSP size is to look at the salary paid over time. CPP contributions are also affected by salary. I have not focused on them, but they are accounted for in the model and CPP provides further diversification. CPP is also ideally suited to mitigate longevity risk and inflation risk. The capital gains harvest caused a pause in salary. Salary use resumes, but is eventually truncated again in this scenario as the corporation becomes large enough to trigger the passive income limits and shift to more eligible dividends. You can see the blue area under the curve below corresponding to salary.
Size May Matter
One concern with doing a capital gains harvest is the time required to work through the RDTOH, and GRIP (if over the passive income limits) that is generated. That timeframe would increase due to several factors. A larger capital gain obviously creates more CDA to work through. However, that does not pose an issue if the capital dividend is paid immediately and invested personally.
A higher corporate passive income requires more taxable dividends to be paid out at baseline to keep the RDTOH flowing. So, adding a pile of nRDTOH from the taxable portion of a capital gain could add to that temporarily. Lower personal spending needs mean fewer dividends required to fund consumption each year and longer to work through the RDTOH.
If you generate massive notional accounts to work through, then two issues may arise. One is that RDTOH and GRIP are tracked in nominal dollars. So, their economic value erodes with inflation. That occurs very slowly with GRIP, but could be substantial with RDTOH. The second is that using more dividends decreases the salary required. That means less RRSP and CPP. The impact may be minimal if you are near or in retirement and planning to stop your salary anyway.
A larger capital gains harvest means a bigger opportunity to move money around. However, that must be put into the context of the rest of your financial plan over time. In this scenario, there was a moderate-sized portfolio, a capital gain large enough to make it worthwhile, but small enough and with enough consumption to work through the notional accounts over a few years. There is no simple rule of thumb. That is why I created this model with many modifiable inputs and detailed outputs to examine the results.
Case 1: Executive Summary
This was an Ontario corporation owner with $500K/yr of income and $150K/yr personal spending. There was no spouse or external income source to fund consumption. The corporate portfolio was $1MM with a $500K capital gain. They have a long career before retirement still. In this case, doing a capital gains harvest prior to the June 25th inclusion rate increase resulted in more after-tax portfolio value.
Harvest & Spend Won. But Keeps More In Corp.
Where the portfolio value was stored depended on what was done with money paid out using the CDA. If it was used for consumption and to decrease taxable income paid out of the corp (Harvest & Spend: Green Lines). That boosted the amount of retained earnings in the corporation over several years. The tax liability of the capital gain was also reset. This compounded over the 20-year period into $138K more money than without a harvest. The corporation held $200K more, but the RRSP $155K less. So, there is more concentration of funds and future corporate tax-risk.
Harvest & Invest Personally. Beats Not Harvesting. Spreads Out Tax Risk.
While not the numerically optimal strategy in this scenario, using the excess money from the capital dividend to invest personally (Harvest & Spend: Blue Lines) increases the diversification of future tax risk. The tax liability of the capital gain was realized at the lower current rate and reset. Since the excess money was invested personally, there was more investment outside of the corporation and less tax baked into the personal account. There was also slightly less in the RRSP. At 20 years, they would have $53K less after-tax money in the corporation than if they hadn’t done a harvest, $100K less in their RRSP, and $163K more in their personal cash account compared to not harvesting before the June 25, 2024 changes.
Other Considerations
The proposed legislation has not been passed. If there are changes to it, that could change things. For example, if corporations are given the same $250K threshold as personal, then harvesting enough to justify accounting fees but not exceeding $250K would make more sense.
The size of the harvest and how long it takes to clear the RDTOH could make a difference. At this level of corporate passive income and personal spending, it was not an issue. Investing the money from the CDA personally helps to keep it growing and maintaining its buying power until used. Leaving the money in the corporation and not using the CDA right away would mean that its economic value would erode with inflation. The tax savings represented by GRIP erode slowly, but a pile of nRDTOH to work through over a long period could have meaningful effects from inflation. It is not always favorable. However, in Ontario with our model portfolio, more spending and harvest scenarios were above water than below at 20 years.
Results will also vary depending on tax integration for the province, portfolio mix, and how efficiently excess personal cash can be deployed. Those issues will be explored in further cases. In the meantime, you can also play with the simulator used to develop this case.
Question that comes to my mind when looking at this and other scenarios (ie generally how to pay oneself, fhsa use even), how much is RRSP space worth? Not just by running the numbers. Seems the most politically secure investment vehicle.
Hey Tim,
I totally agree. That has been a concern of mine for years. We have actually slowly harvested strategically for years to spread out our tax-vulnerability. Partly for that reason – an RRSP is tax-sheltered and politically a no-go for any politician. An RRSP also is pre-tax though. So, if future personal tax rates rise greatly, there is still some tax-risk. We also have some mostly after-tax personal investments as well to mitigate that.
Trying to be mathematically optimal based on a few tax-nuances has been part of what has caught some people – for example, using only dividends and keeping everything in a corporation. A small tax change makes a difference and there is value to spreading out your money to different account types. Personally, we have used the harvest and invest approach over the years for that reason. Also comes in handy to have different account types to draw from. Not a number-value, but very important for planning and mitigating risks.
Mark
Hi Mark,
Thank you so much for this. I have been harvesting modest gains over the years mostly when donating appreciated securities or adjusting asset allocation. This case study closely approximates my situation with some nuances (retired so no active business income and no need for RRSP contributions). The harvest (before June 24) and spend looks like the way to go. The nRDTOH will be large, but can split with spouse and also spread out over 2024 and 2025 tax years. Looking forward to the next scenarios.
Thanks Raj. The donation of appreciated stock is a great way to go. We do that from our largest gain each year. Being able to dividend split is a big plus because one of the pitfalls is if the nRDTOH takes too long to work through. Still playing with and figuring out lots of nuances.
Mark
Hi Mark,
You are putting out so much info that my head hurts. It is hard to make sense of everything, even after plotting the graphs. In the long run (20 years), there is no significant difference for me according to your calculators, no matter what I do.
After speaking with my accountant, paying out the CDA is a non-brainier in order to get rid of the mortgage with the current interest rates. Half of my after tax capital gains will take care of that. The absence of mortgage payments will make up for the loss of income I would have gotten from the corp due to the extra tax deferral without the harvest.
For the other half, I am leaning towards harvest in order to diversify against future tax risk and a possible move outside of Canada. If we get another decade of a fiscally irresponsible government that attacks small business owners, you never know.
Also, I want to let you know that I love the money scope episodes. An interesting nugget of information was that it is not worth it to take out salary just for the sake of making RRSP room. I am in that situation. I have been good at clearing RDTOH, but I have not yet touched on GRIP. I have way to much GRIP to clear, probably until retirement. What a puzzle!
Thanks Mai,
It is definitely information overload. I am mainly doing that because there are a lot of people who dismiss the idea without really knowing what is going on under the surface. It is also important for those advising for specific situations. That will be very important for the financial and tax advisor visitors here. After I unpack some detailed cases, I am hoping to put together some broad statements. I didn’t want to do that right off the bat because I am exploring nuances and I want to make sure that my intuition is correct.
The cases of having a really good use for the personal money (unfilled TFSA, mortgage to pay, or a low-income spouse that can invest) are really a no-brainer in my mind also. There are also people for whom it makes little difference either way. My gut says people trying to realize too large of a gain with too low of consumption – but I am not sure yet. Those with a small gain where it isn’t worth doing a capital dividend shouldn’t sweat any of this stuff.
It is more the people who have maxed their accounts & paid off their mortgage that spend a good chunk of change each year and have a moderately sized capital gain that could have a dilemma. Even then, the argument for tax diversification is a strong one in my opinion. With potentially a small gain using a harvest.
That nugget about not paying salary more than needed just to get RRSP room was a good one. I was actually just about to publish a post about it here when the budget dropped and threw me down a rabbit hole. The basic issue is that it is only 18% tax deferral on the salary paid out (RRSP is 100% pre-tax but you only get 18% of salary as room). So, a lot of extra tax now overall compared to leaving it in the corp. There are a lot of people on either extreme (dividend only and salary maxing RRSP) that should probably do a dynamic salary and dividend mix.
Mark
Hi Mark – thank you as always for the analysis. Creating these test cases that captures the decision tree many of us are working through is especially useful.
In your “After Tax Portfolio Value (first few years)” chart, there is an inflection at age 41 when non-eligible dividends are paid to clear the nRDTOH. Can you clarify why this inflection exists?
Hey Prab,
I am deciphering too, but think that I am getting better at it. What I see happening is that as you move out the non-eligible dividends in year one (age 41) you have two things happening at once. You have to pay less out of the corporation (since dividends have a lower personal tax rate compared to the salary used in the “no harvest”) to get your $150K of spending money. So, more kept in the corp due to that. Plus, the corp also gets the nRDTOH refunded from the tax that was collected in the year zero (age 40). Bumping the amount in the corp up even more at age 41. By using a capital dividend in year zero (age 40), you pay out less to live on but there is also bunch of tax collected up front on the taxable half of the capital gain in the corp (attenuating the benefit until the nRDTOH is released). If you were paying enough dividends to release the nRDTOH in year zero just to live on (small cap gain and more spending), you’d see that separation right away. So, it may spread out more quickly in real life depending on how you pay yourself with dividends anyway, have a smaller gain or spend more. The opposite also applies.
Mark
Hmm… not an easy problem to solve, but there are some issues with the graphs. I understand the intent to show the changing mix of distribution out of the corp to the personal side, but the continuous nature of the graph could be mis-interpreted as a variable over time distribution. In addition, I think what you’re trying to achieve is area = distribution in the year.
While less illustrative, it would be more accurate to show perhaps distinct bar graphs for each year to show the overall distribution in the year for Cap gains/NERDTOH etc vs the continuous line (unless you were to reprocess the lines to be representative of distribution over time in the year (*i.e. AUC…).
Hey Stevie. I had to make some choices about how to display the data. That would be more accurate to use a bar graph with each year rather than a continuous variable. However, the other challenge is that the corporation’s fiscal year end and personal calendar tax year may not line up. So, there could be spread across years. So, I went with the stacked area graph to visualize the big idea of how compensation changes and it displayed more attractively than how my par graphs do with so many data points. You can hover over a year to get the detailed breakdown. It was a compromise, but I’ll have to re-think it perhaps.
Mark
I’m not sure if this is clear in some of the discussions, but I think one of the core assumptions is that, if you have personal investments, one should be selling them off to live off of, instead of taking money out of the corp. That is most tax efficient way to go about things. Do I have that right?
Hey Stevie,
That is actually why I made a harvest & spend and a harvest & invest option to compare. Usually, it is more efficient to spend down any personal money first (harvest & spend). However, the “invest” option will preserve that personally invested money and draw from the corp instead. There are some cases when that may work out better. Generally, when personal tax drag is lower than corporate – that can mostly happen at really low personal tax rates. Like a very low income spouse investing. Or a high income spouse meaning the corp owner draws really low income and invests personally. Those are the times I have been able to find. The simulator will look at which partner has the lowest taxable income at baseline and try to invest attributable to them as much as possible. When I built the simulator, I put both options because I wasn’t sure how it would play out. There are so many variable situations that people may have.
Mark
Was wondering, does the capital gains inclusion rate, mean that in the future the CDA % will also drop? i.e. gains are currently taxed at 50% of gains and 50% is into the CDA. In the future, the CDA will only receive 33%?
Hey Stevie,
That is correct. In the future, it will be 66.67% taxable and 33.33% will go to the CDA balance. Main exception – donation of appreciated stock to a registered charity should stay at 100% to CDA.
Mark