Using a Corporate Capital Gain to Fund a TFSA

Purposefully realizing a capital gain in a Canadian Controlled Private Corporation (CCPC) and strategically using the capital dividend account (CDA) is a strategy that I’ve arbitrarily called capital gains harvesting. Capital gains harvesting is like the inverse of tax loss harvesting. You sell and then rebuy an asset to crystallize the gain without missing market exposure. It is counter-intuitive because that does lose some tax deferral on the capital gain in the corporation. However, it may gain back more than that by efficiently moving cash from the corporation out for personal use. One of the best uses for excess personal cash is investing through a Tax-Free Savings Account (TFSA).

Unfortunately, many CCPC owners have underutilized their TFSAs. They may have been advised that the cost of paying tax to fund the TFSA is too high and to leave as much as possible invested in their corporations instead. I have been advising against that for years. One reason is the risk of unfavorable tax changes to corporations. We are seeing that materialize yet again with the 2024 Federal Budget. It isn’t too late. In fact, the impending rise in capital gains taxes on June 25, 2024 makes the utility of harvesting a capital gain to fund a TFSA stronger in the near term. However, it may remain a good catch-up strategy after that as well, depending on your situation.

Disclaimer: I am not an accountant or financial advisor. This post illustrates concepts and ideas to discuss with your accountants and advisors. Seek advice from those professionals as required for your specific situation. There are often nuances and other factors to consider beyond the general points made in this article.

Harvesting Corporate Capital Gains

Whether harvesting a capital gain in a corporate account is a good idea depends on multiple factors. The big variables are capital gains tax deferral, corporate tax deferral, and how efficiently you can use excess personal cash. The first two variables dominate cases when there isn’t an obvious need for extra personal cash. For example, it may be beneficial in Ontario due to some tax wrinkles, but not in British Columbia unless you spend a lot. A good use for personal cash underpins the success of the slam dunks – like catching up on an underfunded TFSA.

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Capital Gains Tax Deferral

In general, realizing capital gains earlier than you normally would is not advisable. Tax is triggered when the gain is realized. Not only does that mean tax due now, but also the loss of future growth on the money that was used to pay the bill. That loss of tax deferral on capital gains is why realizing a personal capital gain early is not a slam dunk.

Even with the known impending tax increase. There is a break-even point after which the benefits of capital gains tax deferral are greater than the tax savings from beating the tax hike. If you were planning on selling in the next 6-10 years, then beating the tax hike may work out. If you don’t compromise on price. The breakeven is also longer with slower-growing investments. I made a personal capital gains harvest simulator with adjustable inputs to illustrate.

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Capital Dividends to Preserve Corporate Tax Deferral

That tax deferral loss from realizing gains early applies to corporations too. However, corporations add another layer due to partial tax deferral on business income. We lose that when we pay money out of the corporation to fund personal spending. There is a low corporate tax rate upfront. Then, we pay the rest of the tax personally on the dividends.

While realizing a capital gain in the corporation results in more corporate tax, it also allows you to use a tax-free capital dividend. You would normally pay taxes at the end of the corporate fiscal year and then do the election for a capital dividend. It takes time.

However, once done, using that capital dividend to get money into your personal hands requires much less paid out of the corporation than regular dividends or salary. Particularly, if you are above the lowest tax brackets. This is illustrated below at the top Ontario marginal rates. In this case, harvesting and fully processing a capital gain preserves corporate retained earnings by 36-53%. That is well beyond the loss of tax deferral from paying ~10% net corporate tax on the capital gain.

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Efficiently Move Money Out To Invest Personally

In the previous cases in different provinces that I used to illustrate the concept, the focus was on using the capital dividend to retain more in the corporation. A boost to corporate retained earnings. The outcome of that depends heavily on how much you spend personally. A large capital gain taking too many years to process by paying out dividends and releasing refundable taxes to the corporation attenuated the benefits. That could tip the scales either way, depending on tax integration nuances plus secondary salary and RRSP effects.

In contrast, for the capital gains tax harvest slam dunks, the harvest is more about preserving rather than boosting tax deferral. You have a personal use for the excess cash. Using a capital dividend and some non-eligible dividends avoids using extra salary or dividends to fund that. Funding a personal after-tax registered account is a great way to deploy extra personal cash.

TFSA vs Corporation

There are other accounts beyond a corporation that Canadian professionals and business owners should be using. The same registered accounts as everyone else. One of the most valuable accounts in the long run is a TFSA. When I say TFSA, I mean using it as an investment account. Not wasting its value by using it as a high-interest-savings-account-TFSA, like the banks often promote. The power of a TFSA comes from investment growth.

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More Tax Up Front. More Growth Long-Term

In contrast to a corporation, which is tax-exposed, a TFSA offers tax-free growth. The catch is that a TFSA requires after-tax personal cash to contribute to it. For corporate owners, that means getting money into personal hands and paying the personal tax due. There is an upfront tax cost. However, in under 10 years with reasonable returns in a diversified portfolio, the tax-free growth can more than make up for that. That break-even is almost immediate when using a tax-free capital dividend because there is less upfront tax.

Another important point is that the time horizon for a TFSA to grow is much longer than most people realize. For those with other pots of money to draw down first, it may be our lifespan. Hopefully, that is many years after retirement. Even if accessing a TFSA during retirement, that would happen over the course of years. Not all on the first day of retirement.

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How a corporation could win. Maybe.

A less diversified strategy focused on eligible dividends or capital gains could put a corporation ahead of TFSA longer. However, that has the risk of trailing broader markets (like Canada has recently) or changes to capital gains taxes (here we are). If the government has no qualms about breaking tax integration, eligible dividend taxation could change someday too. If you’ve been avoiding your TFSA, hopefully, this opens your eyes. Diversification is a cornerstone of risk management.

Harvesting to Fill Up a TFSA vs Do Nothing

Using a capital gains harvest to fund unused TFSA room is very effective on multiple fronts. Before June 25th, there are extra tax savings by removing the tax liability on the capital gain at the current lower inclusion rate. It shifts that money out to a TFSA with minimal extra tax.

That TFSA will grow faster than a corporation moving forward because it is tax-sheltered and there is no tax on the exit. In contrast to harvesting capital gains in a corporation when you don’t need the money, the benefit holds across provinces and at different consumption levels when the harvest is to fill a TFSA.

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Sample Case Parameters

I will illustrate some interesting points with a sample case. I use the same portfolio and return assumptions as in my previous simulations. They are 40 years old and have a $500K corporate portfolio with a $200K unrealized capital gain. However, they will only realize enough of that gain to fill up their TFSA and pay the taxes triggered to move that money out. That will be under $135K of realized capital gain even at the highest tax brackets. They have $95K of unused TFSA room because they were told not to bother with it when they have a corporation. A dynamic optimal mix of salary and dividends is used to pay themselves over time.

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Harvesting The Capital Gain

How much of the capital gain to realize and flow through depends on their tax rate, as well as the TFSA room to fill. A slightly larger capital gain harvest is required at higher tax brackets to leave $95K for the TFSA. I have added a field to estimate that in my corporate capital gain harvest simulator. It will auto-populate in the Corp Input Tab if unused contribution TFSA room is entered into the personal inputs tab.

For this case, the corporate owner makes $350K/yr in their corporation before paying themselves. They need $75K/yr from the corporation (after-tax) to fund personal spending. In that case, they want to harvest a $126K capital gain. About 40% of their portfolio value is an unrealized gain. So, they sell $315K of their corporate portfolio and immediately rebuy the holdings ($126K divided by 40% = $315K). That $126K realized capital gain will yield the extra $95K of personal money required to top up their TFSA after the corporate and personal taxes are accounted for. I will use an Ontario corporation for the main example, but show data for some other provinces at the end as well.

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Processing The Harvested Capital Gain

The corporation pays out an extra non-eligible dividend and capital dividend in the first year to flow the harvested gain into their hands. It is small enough and their corporate active income low enough that the passive income limits don’t come into play. They are back to their usual pay mix the following year.

There is also an interesting downstream effect. Because they shifted money out of their corporation, it takes longer for their corporation to develop excess passive income. That requires a shift to dividends-only in their mid-50s to keep the corporation efficient, but it is delayed by a year.

Even a corporation with a higher income that does trigger passive income limits can process the capital gain efficiently. Since the extra money is used to fund a TFSA, there are still plenty of salary and dividend requirements to fund normal spending. For example, a corporation with $500K income and still only $75K personal spending has only a one-year small decrease in salary usage a couple of years out.

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After-Tax Portfolio Value Increase

When you look at the difference between the after-tax value of their total portfolio from doing the harvest vs not – there is an immediate savings due to beating the inclusion rate increase. However, the advantage of having shifted that money efficiently to a TFSA from the corporation increases each year afterward. That is because the corporate account has tax drag and a tax liability to get the money out. In contrast, the TFSA grows tax-free and comes out tax-free.

You can see that advantage takes off further in their mid-50s. They managed to delay corporate bloat by shifting money to their TFSA to grow there instead. Corporate bloat occurs because the corporate portfolio generates more passive income than the personal dividends required to live on. There is a high up-front tax on corporate investment income. The corporation doesn’t get an RDTOH refund until they pay out extra taxable dividends to release it. Unpleasant tax drag until the gas is released.

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More Favorable Portfolio Composition

The portfolio composition is more diversified across account types. That mitigates tax-risk and gives more options for drawdown optimization.

The tax-free exit for TFSA withdrawals could come in handy during retirement. Dividends from a corporation are grossed up and that increased taxable income is what OAS clawback is based on. TFSA withdrawals do not result in OAS clawback. Withdrawals from an RRSP/RRIF may result in clawback, but at least the income isn’t grossed up. Shifting money to a TFSA from a corporation also has the added benefit of diversifying against future tax changes.

The extra salary in this simulation from shifting passive income out of the corporation also resulted in a slightly larger RRSP. Having a portfolio spread out from the corporation into an RRSP and TFSA is less vulnerable to further tax attacks on corporations.

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Other Provinces, Income & Spending Levels

When the cash was used to fund a TFSA, a capital gains harvest was advantageous at all income and consumption levels tested. Funding the $95K of TFSA room led to $10-$43K more after-tax dollars at 20 years in this test scenario in Ontario. It was greatest for those with the highest income relative to spending (savings rate). That is because it has the added benefit of delaying corporate bloat in that situation. On top of the tax savings and tax-free growth in the TFSA.

The benefits also held up in provinces with tighter tax integration, like BC. Actually, it was a little larger due to less favorable corporate treatment when exceeding the passive income limits than in Ontario. The capital gains harvest to fund a TFSA even held up in Quebec for a corporation without access to the provincial small business deduction. I show Ontario, BC, and PQ for a range of income and spending levels below.

Yeah, I basically just wanted to show some 3D charts. They’re cool. The main message is that all of the land is above water. Meaning an after-tax advantage to harvesting a capital gain from a corporation to fund a TFSA at various corporate income and personal spending levels.

Summary: Harvesting To Fund a TFSA

The proposed unfavorable tax increase for capital gains in Canadian Controlled Private Corporations is the most recent example of the legislative tax risk for corporate investing. Further, a corporation uses a tax-exposed investment account. Unfortunately, many corporate owners have not fully used their TFSAs. That is often because they were advised not to, but to keep everything in the corporation instead. In addition to the legislative risk, that also misses out on long-term tax-free investing. Fortunately, a capital gains harvest is a way for those incorporated business owners to catch up.

Prior to June 25th, 2024, there is an immediate advantage due to the tax savings from beating the inclusion rate increase. Even if that is missed, the tax-efficient shift of money out of the corporation and into a TFSA continues to outperform corporate investing moving forward.

There may even be other advantages to shifting money to the TFSA using this strategy when you consider long-term optimal corporate salary and dividend compensation. Growth in a TFSA is pleasant. Corporate bloat, not so much. Plus, having more money invested in TFSAs and RRSPs is less likely to be targeted by governments strapped for cash. Too many voters use them.

Unlike situations when there is not a great personal need for extra cash, harvesting capital gains in a corporation to flow through and fund a TFSA was beneficial across a wide range of provinces, incomes, and consumption levels in my modeling. You can also play with an online version of the model I used below.

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What about other strategies to catch up on a TFSA?

This post and its examples compared using a capital gains harvest to fund unused TFSA room vs doing nothing. Just continuing to “keep it all in the corp” as much as possible. Shifting money from the corporation to the TFSA drives most of the advantage and using a capital dividend is an efficient way to do that. However, other ways are also useful. The cost of paying an accountant to file for the capital dividend may also tip the scales towards regular compensation if their fees are expensive. Like trying to do a slam dunk wearing lead shoes.

For example, if you were to give a salary bonus to top up the TFSA at the moderate income/consumption level used in this example, it is much closer. Like with other examples of using a capital gains harvest, it is progressively more efficient if you normally draw higher levels of income from your corporation. That makes it easier to use the non-eligible dividends required to “process the harvest” and regular salary also faces a higher tax rate. Below are two examples at a $75K/yr spending level and a $150k/yr.

Those examples are funding the TFSA all at once. A clever advisor may be able to find an even more optimal strategy to fund a TFSA over several years balancing moving money out of the corporation using a small salary increase without bumping up too many tax brackets. That could be particularly attractive at low personal spending levels while also using any RRSP room generated as well. That’s more than I could automate with an online simulator and is an area where specific financial advice may add value beyond my “simplistic” modeling.