Quebec private corporation owners face some extra challenges if they do not meet the extra requirements for the PQ provincial small business deduction (SBD). So, this case will use two corporations. One with access to only the Federal SBD and another with access to both the Federal and PQ SBD. The proposed capital gains tax hike that hits CCPCs harder than individual investors adds another layer. Should a Quebec small corporation owner harvest a large corporate capital gain before the tax change? Is it a chance to move more money out of the corporation to invest personally? Salary and RRSP usage are especially useful for Quebec small corporation owners, but are potentially shrunken by realizing a capital gain and paying out dividends.
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.
What is a Capital Gains Harvest?
I detailed how a capital gains harvest works and the investment assumptions in the first case. Basically, a harvest is realizing a capital gain in the corporation, paying out a capital dividend, and investing that personally. Next, non-eligible dividends are used to clear out the RDTOH from the taxable half (soon to be two-thirds) of the capital gain. That process may all happen in one year, if it is a small gain or a lot of money is usually paid out of the corporation to fund personal consumption. A larger capital gain or low consumption level could take several to flow through.
After getting that lump of personal cash, it is either spent (harvest & spend) or kept invested in a personal taxable account (harvest & invest). If spent, that allows the corporation to pay out less salary or dividends to fund personal consumption. Paying out less salary and taxable dividends, means retaining more investments in the corporation.
In today’s case at a high personal income level, the personal investing strategy trails. So, I will focus on the “harvest & spend” strategy. Investing is more attractive if it can be done very efficiently. Like using RRSP, FHSA, RESP, or TFSA space. Or risk-free tax-free investing by paying off personal debt.
The other factor that may arise with a large capital gain is exceeding the corp passive income limits. In Quebec, this adds an interesting wrinkle. There could be a transient decrease in corporate tax deferral. However, for corporations without access to the PQ small business deduction (SBD), there is also a potential increase in tax efficiency in moving the money out. This is due to getting Federal GRIP and being able to pay out eligible dividends.
Assumptions & Disclaimer
I am trying to be transparent. Details about the strategies, optimal compensation, and return assumptions were described previously. I will focus on the strategy results for this specific scenario. Also, if you don’t want the details of what is happening under the surface, you can skip to the executive summary.
None of this is specific tax or investing advice. It is just food for thought for you to discuss with your advisors. Also, the nuances could change if the proposed legislation changes. Do not do anything rash.
Comparison of the Strategy Results
Scenario Description
This case is a 40-year-old incorporated physician in Quebec. They are single with no other income from outside of their corporation. They have no unused RRSP or TFSA room but will use whatever is generated moving forward during the 20-year study period. Their corporation earns $500K/yr before paying the owner’s salary. They spend $150K/yr on personal consumption using a dynamic mix of salary and dividends. How that changes over time will be shown in this scenario.
Their investment accounts have an 80:20 stock:bond mix of globally diversified ETFs with no fees and no advisor fee. The mix and projected income mix is detailed here. They currently have a $1MM portfolio with $500K as an unrealized capital gain.
I will run the scenarios both with access to the PQ SBD & No PQ SBD access for comparison.
Optimal Corp Compensation in PQ
Due to Quebec’s special requirements for the provincial SBD, it is possible for a corporation to have the Federal SBD rate (9%) and the Quebec general corporate tax rate (11.5%). So, the corporation’s active income is taxed at 20.5%. To make matters worse, GRIP (the corporation’s ability to pay out lower taxed eligible dividends) is calculated off of the Federal tax rate. So, they still pay the higher non-eligible dividend tax rate even though they didn’t benefit from the low corporate SBD rate. That is generally nasty, but still offers some tax deferral compared to personal taxable investing.
Quebec also has its own version of the Canada Pension Plan (CPP) called the Quebec Pension Plan (QPP). They are similar, but not identical. I used CPP and enhanced CPP contributions for the simulation. Differences should be minor and not change the big messages.
Passive Income Limits May Offer a Brief Reprieve. Or Not.
Ironically, getting bumped over the Federal SBD by having too much passive income less of a punishment. In fact, if they pass the money through as eligible dividends, it is a reprieve from the usual punishing mixed rate. The tax integration of active income flowed through at the blended SBD/General Rate vs the General Corp Rate is shown below.
So, a corporation that has a high passive income and passes the money out to spend loses a little bit of tax deferral, but there is less net tax on the money flowing through. Flowing money through at either the hybrid Federal-SBD-only rate or the general corporate tax rate are still much higher tax rates than using salary.
Unfortunately, using enough eligible dividends that salary requirements (and RRSP room) are reduced counteracts the potential reprieve except at very high levels of personal spending.
Optimal Compensation Algorithm For Quebec
For a Quebec CCPC that has both the Federal and provincial SBD, the usual compensation algorithm applies. Dividends to get corporate refunds from (RDTOH) and eligible dividends to use any GRIP generated from active income at the general corporate tax rate. That is followed by salary to bridge any gap between the dividends paid and the personal money required to spend.
However, for a CCPC that only gets the Federal SBD, salary and RRSP usage becomes more valuable than usual. Dividends to empty eRDTOH and nRDTOH still provide the largest benefits. However, salary to avoid corporate taxation at the unfavorable 20.5% rate plus tax-sheltered RRSP room may be more valuable than using eligible dividends to empty isolated GRIP.
Over a short time the ~8-15% savings of using GRIP to pay eligible instead of non-eligible dividends is greater than the ~6% savings from using salary instead of the unfavorable Fed-SBD-only tax integration. However, the RRSP offers fully tax-deferred and tax-sheltered growth. Plus, it diversifies tax-risk to a less politically vulnerable account type. The numerical difference was tiny, <0.2% on either side depending on the scenario (data not shown). So, I gave the edge to using salary/RRSP in my algorithm.
The chart below compares the “Dynamic Salary Algorithm” vs “Salary to Max RRSP” vs “Dividends-Only”. The first slide uses $500K/yr income and $150K/yr consumption to match the scenario in this post. It shows the dynamic strategy and salary-focused salary to be identical and better than dividends-only. There is no need to shrink salary to release RDTOH using dividends at that spending level. You spend enough to use some dividends and enough salary to max out RRSPs.
In contrast, the second slide shows a lower level of consumption $125K/yr) where RDTOH trapping becomes an issue in their mid-50s and the dynamic strategy is superior.
How Pay Mix Changes
Short-Term Pay Changes: Harvest/Spend Approach With No PQ SBD
With no access to the provincial SBD, the time to work through a harvest and spend strategy is shorter than usual. About 3 years for the salary and dividend mix to get back to baseline in the example. There may be minimal change for a scenario using a smaller capital gain or higher spending rate. First, a large capital dividend is paid out and invested personally. The following year, mostly non-eligible dividends are used to clear out the nRDTOH. Then, the personally invested money is used to fund consumption supplemented by dividends and salary according to the previously described algorithm.
The large investment income from the taxable half of the capital gains plus only using dividends in the second year means that all corporate active income in that second year is taxed at the Federal & PQ general corporate tax rate. That generates GRIP (the ability to pay out eligible dividends). However, the value of that erodes slowly due to inflation and the algorithm prioritizes using salary and RRSPs. So, that GRIP sits unused until the future when a switch to dividends is made. The timing of that requires more situation-specific accountant and planner advice, but it is likely to be close to or in retirement.
Harvest & Spending With Access To The Quebec SBD
The short-term compensation strategy changes are similar to the above. However, with access to both parts of the SBD, the corporation is not in the provincial penalty box. So, using the GRIP generated from exceeding the passive income limits to pay out some tax-efficient eligible dividends usually makes sense. Even though, it means forgoing some salary and the RRSP & QPP contributions that go with that. The process takes about five years to work through in the current scenario and looks very similar to other provinces.
How Does That Fit Into The Big Picture?
Below is a comparison of how a dynamic compensation strategy to optimize salary and dividend mix unfolds over a longer time frame. Regardless of strategy, the corporation starts hitting the passive income limits in their early to mid-50s.
Without access to the PQ SBD, the incorporated business owner continues to pay salary and uses their RRSP. The GRIP generated from getting bumped over the passive income limits accrues, but can be used in retirement or if the corporation is liquidated. If the corporation has access to both parts of the SBD, then it switches over to a dividend-only strategy and efficiently uses that GRIP rather than trying to build the RRSP further.
Portfolio Value & Composition
Liquidated After-Tax Portfolio Value (No PQ SBD Access)
Understanding the moving parts is great, but what is the long-term outcome when using the different approaches? The difference in after-tax total portfolio value (liquidated) in the first few years is shown below. There is an initial tax hit due to realizing the capital gains. However, that tax liability is at the lower current inclusion rate and most of the corporate tax is refunded as RDTOH.
Without access to the Quebec SBD, that tax deferral is not made up for. Paying some dividends to get the RDTOH refund and a reduced salary below the max RRSP contribution level means a smaller RRSP. That decreased tax deferral and tax-sheltered growth causes the capital gain harvest strategies to underperform further in the long run in this scenario. That may not be the case with a small enough gain or large enough personal spending level that the salary required stays above the level required to max out an RRSP.
Liquidated After-Tax Portfolio Value (With Federal & PQ SBD Access)
Similarly, there is a bump in portfolio value when there is normal access to the SBD. It is a significantly bigger bump because the GRIP generated from triggering the passive income limit is used more efficiently. That also comes into play later in the study period. The corporation remains relatively efficient even though it passes the passive income threshold in the owner’s early 50s.
Portfolio Value & Composition at Year 20 (Liquidated)
You can also see the difference between the strategies by where the value is held at the end of the study period. With the “harvest & spend” strategy, less salary is paid out of the corporation. That boosts how much money is in the corporation and decreases the RRSP contribution room. This is reflected as a larger corporation and smaller RRSP, even after the embedded taxes are accounted for. This applies whether there is access to the provincial SBD or not.
Also note that with no provincial access to the SBD, the portfolio values are almost identical at 20 years regardless of the strategy used (first slide). Both capital gains harvesting strategies significantly trailed doing nothing.
There is a small advantage to harvesting and spending when there is normal access to the provincial SBD, driven primarily by having a larger corporate account (second slide).
Portfolio Value & Composition With Gradual Drawdown
Few people would deliberately liquidate all of their holdings. More likely, they will gradually draw them down during retirement. That can impact the results. A corporation has partial tax deferral and an RRSP has complete tax deferral until the money is paid out into personal hands.
So, when you draw down the portfolio more slowly (to avoid deferring to a high future tax rate), harvesting a capital gain in the corporation at the expense of less RRSP room has a negative impact. For corporations without access to the PQ SBD, that is easily enough to negate most of the benefit of harvesting a capital gain (first slide below). However, corporations that have normal access to the Federal and Quebec small business deductions, the advantage of a capital gain harvest in this scenario was large enough to overcome the tax deferral (second slide below).
Sensitivity To Drawdown Tax Rate Changes
In this scenario, taxes are deferred from the marginal tax rates on the income required to fund $150K of after-tax spending. If the future spending rate is lower, future marginal tax rates would be too. That accentuates the impact of tax deferral.
In the case of a Quebec small corporation without access to the provincial SBD, the disadvantage from harvesting capital gains early is only magnified at lower future tax rates. There is a lot of lost tax deferral from harvesting early. The loss of some RRSP room with its tax deferral also contributes.
For a CCPC with normal access to the Quebec SBD, the added tax deferral on retained earnings in the corporation is enough to counteract having a smaller RRSP. That preserves the benefit of doing a capital gains harvest before June 25th. That added tax deferral is accentuated at lower drawdown tax rates. See below.
Executive Summary
In this case with a Quebec CCPC owner earning $500K/yr and spending $150K/yr, harvesting a $500K capital gain prior to the June 25, 2024 inclusion rate increase yields dramatically different results depending on whether they can access the Quebec small business deduction or not.
Without access to the provincial SBD, the tax savings of the lower current inclusion rate does not make for the lost tax deferral from realizing a capital gain early. Even when the capital dividend account is used to transiently decrease taxable income paid out. The loss of RRSP room accrual from less salary used compounds that.
With normal access to both the Federal & Quebec SBD, the increased deferral of tax on retained corporation earnings through using a capital dividend to decrease personal taxable income was more efficient. It made up for the loss of tax deferral due to realizing the capital gain early. Even with a smaller RRSP. In contrast, if the capital dividend was invested in a personal taxable account instead of spending it (and keeping more money in the corporation), it was worse than doing nothing. In this scenario, personal tax levels were high, and corporate investing was more tax-efficient.
Processing The Harvest
For incorporated owners with only access to the Federal SBD, there is a higher corporate tax rate. Unfortunately, that higher provincial corporate tax is not attenuated by being able to use eligible dividends personally. This makes salary and RRSP usage even more valuable than usual when considering the optimal salary/dividend mix. So, when realizing a large capital gain that bumps the corporation over the passive income rules, inefficiency develops. The corporation loses some tax deferral getting bumped to the full general corporate tax rate. The GRIP generated from that sits in the corporation until used in retirement.
With access to both the Federal and Quebec SBD, an incorporated business owner flows income through the corporation without that penalty. This also applies to realizing large capital gains. The capital gain takes a couple of years longer to work through, but it is tax efficient. That is because the eligible dividends generated by getting bumped over the passive income limit are used right away.
No Quebec SBD Access: Massive Capital Gains Harvesting Not Very Beneficial
Without access to the provincial SBD, the lower use of salary for a few years while flowing dividends out instead takes a toll. In that situation, the tax integration for salary is much better than corporate dividends. The RRSP also allows for full tax deferral and tax-sheltered growth. There is an initial tax savings due to realizing the capital gain at the lower inclusion rate before June 25th. However, over the 20 year time period, that advantage was slowly lost. The larger RRSP from not harvesting grows a bit faster. Plus, the value of the unused GRIP generated by exceeding passive income limits slowly erodes due to inflation.
No Quebec SBD Access: Moderate Capital Gains Harvest May Still Be Beneficial
This scenario used a large $500K capital gain ($250K taxable income). With a smaller gain and/or more personal spending, the salary and RRSP room may not be affected. For example, if I repeat the scenario using a $500K portfolio with a $100K capital gain to harvest, it avoids some issues.
Enough salary is still required each year to get maximum RRSP room. Further, the passive income limits are not seriously exceeded, avoiding trapped GRIP. Overall, there was $6K more after-tax money from harvesting that $100K capital gain. The RRSP is the same size, but there is an extra $6K in the corporation. The increased retained earnings are due to paying out less taxable income to meet personal spending requirements. This is summarized in the slides below.
Normal Federal & Quebec SBD Access:
A Quebec CCPC is much more tax efficient when it has access to both the Federal and provincial small business deduction rates. That carries over into the benefits of realizing a capital gain and flowing that money out of the corporation. Because tax integration is more normal, the impact of going over the passive income limit for a year is lessened. The corporation can attenuate the impact of the higher corporate tax rate by paying out lower-taxed eligible dividends. That also keeps the corporation more tax efficient when it hits the passive income limits due to a large portfolio later on in life.
At the high personal tax bracket used in this scenario, using a capital dividend to fund personal spending was marginally optimal. It allowed for less salary and taxable dividends for several years. Less taxable compensation paid out of the corporation meant more retained earnings to invest in the corporation. Roughly $160K more in after-tax corporate value from harvesting the $500K capital gain used in this example. However, that came at the expense of a $150K smaller RRSP.
While numerically optimal in this case, more of the portfolio was in the corporation and less in the RRSP. Having more money spread into an RRSP may be less vulnerable to corporate tax changes. Having money in multiple account types may also give other tax planning opportunities.
The Optimal Strategy is Situation-Specific
In this post, I modeled how harvesting a capital gain and using the capital dividend account could work. Comparing two Quebec small corporations with different access to the provincial SBD had different results. The size of the gain and spending level also make a difference. So do a variety of other factors.
The optimal strategy could also change if there are efficient personal options for investing the excess cash from harvesting a gain and paying a capital dividend. For example, topping up an RRSP or TFSA. Paying down debt is tax-free. If at a very low personal income level, personal investing can be very tax-efficient. So, it is important to consider options and discuss with those who advise you for your specific situation.
Hopefully, this article gives some ideas for discussion. An online version of my simulator is also linked below. It has modifiable inputs and may give further ideas for discussion.
