In the last episode, we discussed taxable investing for an individual taxable investor. We dove into the different forms that investment returns can take, and how they interact with your tax bill. We also talked about attribution rules, tax deferral, and tax drag.
In this episode we cover investing in a Canadian corporation. Investment returns earned in a corporation are generally taxable, but the way that the taxes work is complicated, and there are potential pitfalls. Efficiently flowing investment income from your corporation into your personal hands is the holy grail of investing for incorporated business owners. Join us for this episode to avoid tax booby traps in your corporate investment account.
Transcript
- Transcript
- Introduction
- What a Corporation is and Is Not
- Active and Passive Income
- “Notional” and “Real” Accounts
- Post-Op Debrief
Introduction
[0:00:02] BF: Welcome to the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, portfolio manager and Head of Research at PWL Capital, and Dr. Mark Soth, AKA The Loonie Doctor.
[0:00:17] MS: Great. Welcome back. In our last episode, we covered off the basics of investing in a personal taxable investment account. That included the various forms that investment returns can take, their tax treatment and tax integration and how that works to bring it all together. We’re going to revisit that concept of tax integration today, but we’re going to do it in the setting of how that affects taxation by income for Canadian companies. Investing using a professional corporation, or any other type of corporation.
We also in that last talk covered about attribution rules, and that really is about how investment income is attributed to different people for tax purposes, plus also a few common missteps that people can make.
[0:01:01] BF: Today, we’re going to cover the topic that I suspect everyone has been waiting for based on the audiences that we have, Mark, which is investing in a Canadian corporation. Actually, this is a topic that was the genesis of this podcast, because it was the topic that is too niche for us to talk about on Rational Reminder, and it’s something that you’ve spent a lot of time doing work on. It was this idea that was like, maybe we could do a podcast stemming from this.
[0:01:28] MS: Boy, if we spent a lot of time doing other parts to build up to it as well.
[0:01:33] BF: Before you invest in your corporation, you have to think of it all the other stuff that we covered and we wanted to do a comprehensive curriculum for this podcast. We’ve done that and now we’re here. We’ve arrived. Like a personal taxable account, investment income earned by a corporation is taxable, but there are a lot of differences and nuances in how the taxation of investment income works in a corporation.
[0:01:57] MS: Because of this complex mix of how the investments work, how the taxes work, this is a topic that is actually very important for a corporate and business owners to have some basic understanding of. That’s also probably why no one else really talks about it, because it is complicated. Even if you use an accountant, or a financial advisor, this is something that you need to know about, because you need to make sure that whatever the investment strategy is and your tax planning strategy is, that they’re actually working together, because they’re very related to one another.
Unfortunately, that is not always the case, without you being an educated client and asking the right questions and bringing the right information to the table. I mean, fortunately, there are some good, simple approaches that you can use to keep corporate investing very tax efficient if you do ask the right questions and you plan ahead.
[0:02:43] BF: The other thing that I want to point out is that complexity introduces the opportunity to sell complex financial products and strategies that are aimed at different aspects of corporate investment taxation. When you have a complex situation, you become in a lot of ways a target for people selling complex financial products. Complexity is one of the ways that financial product providers can hide a lot of fees.
We’re going to plan to start using the water pump on the Money Scope to blast away some of the gunk that can obscure what is actually important. You don’t want to exchange some potential tax savings only to lose more than you save in tax to fees and other risks.
[0:03:20] MS: That’s right. I think we’ve got the Money Scope all fired up and the water pump is filled. It’s going to be a little pedal down by your foot there. I think we’ve prepped as much as we can for what is actually going to be a pretty complex procedure. We do anticipate that this is something you’ll need to come back to with this episode more than once for follow up procedures. Let’s get going and dive right in there.
What a Corporation is and Is Not
[0:03:44] MS: Great. We’re going to start off with talking a little bit about what a corporation is and what a corporation isn’t. There’s a lot of mythology that’s out there, some terminology that confuses people and I think we just need to clear that up right away before we start to get into how it works and how we can use that to our advantage.
The basic thing is that a corporation is a separate legal entity from the owner of a business. They can take different forms. But in the case of professionals, most are variations of a Canadian Controlled Private Company, or a CCPC. If it’s formed to house the business of a professional, like a doctor, or an accountant, or a lawyer, etc., then it’s commonly called a professional corporation. That’s just a subset of CCPCs. A CCPC, or corporation that just holds investments is commonly called a holding company, or a HoldCo. The corporation that actively provides goods or services is called the operating company, or the OpCo. That’s a lot of terminology that’s turned around.
What’s important to understand is that the hold co and op co are just terms to use described corporations. The actual tax treatment, all these different corporations depends on their usage and the income and they’re not what they’re called. All those terms get thrown around, but it’s how you use it that matters. For example, most physicians that incorporate have a medical professional corporation, or an MPC. They’ll conduct their medical practice using it, just like an OpCo, but they can also hold passive investments in that exact same corporation. They don’t usually have a separate HoldCo to hold those investments different from their practice. There are reasons for that. The importance of this will come up later, but corporations with over 25% cross ownership are considered associated. That’s the official legal term for that.
This can also happen with multiple professional corporations that are sharing a common clinical practice as well. The implication of that is that they’ll share their small business deduction for active income. Another important point that goes with that is that moving money from an OpCo to an associated HoldCo doesn’t actually dodge the tax on split income rules, or TOSI rules that came into play for us to avoid income splitting the family members. There are lots of ways that HoldCos were used differently in the past, but now with them being associated corporations, these new rules, there’s not a big advantage for that.
[0:06:06] BF: The main reasons for a separate operating company and a holding company, separating liability is one. If you have all of your investment assets in a holding company, that is separate from your operating company. If you have some liability that comes up in your operating company related to your business, having the investment assets in the HoldCo maybe gives you some layer of protection. It’s not the best argument though, because you can probably solve that better with insurance than with separate entities.
Then the other one that’s less applicable, I think, to physicians, but is often applicable to other types of business owners is the idea of purifying the operating company for the purpose of accessing the lifetime capital gains exemption. If you want to sell your business, you can’t have too much in passive assets inside of that business if you want to access the lifetime capital gains exemption.
If you start a company, it becomes successful, you build up a bunch of passive assets inside of that company, the advice will often be to move the passive assets into a holding company, so that your operating company is mostly active business assets. Now again, with physicians, I don’t know if you’re going to be able to protect yourself from medical liability using a holding company. It’s probably better solved through insurance. Physicians, as far as I know, Mark, and you would know better than me, they’re not typically selling their MPC. It’s not a saleable business in most cases.
[0:07:23] MS: Yeah, most cases. Yeah, like if you built up a big private clinic, or something that has a lot of equipment and a value to it, then you can sell that and potentially take advantage of it. I mean, dentists and vets and other people will do that pretty frequently. Physicians is a little more difficult, because it’s often not as valuable to be able to sell that.
[0:07:43] BF: Yeah, I’ve definitely seen cosmetic practices that can be sold. In those cases, the advice has been before the sale, move the passive assets into a holding company. If you’re working at a hospital, for example, and you’re being paid through an MPC, probably less saleable in that case. In the case of physicians, it’s usually an MPC. But other business owners, it’s relatively common to have both an operating company and a holding company.
[0:08:08] MS: For us, it doesn’t protect us liability-wise, but we have malpractice insurance for that. The same would apply for some other companies, too. For example, let’s say, you had a real estate company with real estate investments, and even as a physician, that may happen. You may want to have those real estate investments in a separate corporation from your professional corporation. That may help separate the liabilities. Like, if someone slips the lobby, or something else happens. Again, that could probably also be addressed through insurance as well.
The other thing to be aware of with professional corporations is that they are regulated by the professional provincial bodies that affect whatever profession you’re part of. For some of those, I know that’s the case with medicine. They won’t really allow you to have real estate that’s not directly related to your practice held in your professional corporation. That does vary by province, and there are some nuances to that, but that’s something to be aware of as well. That might be another reason why you’d have a corporation that’s separate from your professional corporation.
[0:09:09] BF: I think the other common misconception related to this is that a corporation owning an investment property, it doesn’t mean that you get free personal usage of that property. We see this a lot, where someone has a bunch of retained earnings inside their corporation, and they want to buy a cottage. They’ll say, “Well, I’m just going to buy it inside my corporation.” That comes with a whole bunch of potentially messy implications. Personal use of corporate assets, like a vehicle, or a property is considered a taxable benefit. That means that you owe personal tax on the market rate value of the benefit that you’re receiving, which means that you pay tax on market rent whenever you use the property. Which if you’ve got a high tax rate, can be expensive and annoying to actually account for.
A corporation is a separate legal entity. You can’t just mix your personal and corporate income and spending without passing through with appropriate tax channels. They’re treated separately for taxes, and you’ve got to keep a clean paper trail for accounting and tax preparation. Which usually means separate personal and corporate bank accounts, investing accounts, credit cards. Having that true separation is really important. Related to the fact that there’s no free lunch for using a corporation for personal benefits is that there are no special business deductions for a corporation.
I saw a post on Reddit about this the other day about setting up a corporation to be able to deduct business expenses. It’s like, no. As a sole proprietor business, or an incorporated business, you deduct the same expenses.
[0:10:35] MS: It’s pervasive, though. That comes up all the time. I think it’s part of this envy thing that people think, “Oh, well. Business owners have some break. That special and evil corporations get special tax breaks that they can write off that no one else can.” It’s actually not true. It’s the same for everybody. That’s just part of the mythology.
We’ve gotten a lot of this common terminology, mythology out of the way. Basically, a corporation is a separate way of managing the income and expenses for the business for a business owner, and separate from the owner themselves. Even though they may or may not be separation of liability with that, there are other potential advantages and disadvantages to using a corporation. Those centre around smoothing personal cash flow and tax deferred investing.
Now, with that in the mix is tax integration. Tax integration we’ve talked about before, it’s designed to make it so whether you’re an income personally directly, or through a corporation, you have a similar overall tax bill once you account for both the corporate tax, plus all the personal taxes together. Integration also applies whether that income is earned through active business, or through passive investments.
[0:11:42] BF: In the rest of this episode, we’re going to focus on taxation of passive investment income inside of a CCPC, of a Canadian Controlled Private Corporation. It’s also important to understand some of the basics around active business income. We’ve got to touch on both of those things. One reason for that is that passive income can actually change how active business income is taxed. That’s the so-called passive income limit, which we’ll talk through shortly here.
The other reason is that how you pay yourself from your corporation affects how passive income is taxed, whether the money used to pay yourself comes from earned business income, or passive investments. That’s touching on the idea of refundable taxes on passive income, which again, we’re going to dive into in a second.
Active and Passive Income
Active Income
All right, so let’s start with active income. Active income is the income a corporation gets from providing goods or services. It’s also net of business expenses. Those business expenses are not only overhead, office-based equipment and stuff like that, but also, salaries, the salary that you pay yourself and any employees. The CPP and EI expenses for employees and including yourself again, that net income is taxed at the corporate tax rates. There are special situations for some companies, but for most small business owners, there’s a small business deduction rate in the 9% to 17% range depending on province. Then there’s also a higher general corporate rate ranging from 23% to 31%, again, varying by province.
The first $500,000 of net income usually gets taxed at the lower rate, at the small business rate. Quebec has some extra hurdles to get that rate and then income over that is taxed at the higher general business rate. For example, if I have a corporation that bills a million dollars and I have $400,000 in overhead, including payroll, that leaves $600,000 of net corporate income. If my corporation is eligible for the small business deduction, then $500,000 is going to be taxed at the low rate, like 11% or 12%. Then the additional $100,000 above the small business limit is going to be taxed at a higher rate. That’s the 27 or so general business rate. Then the money left after tax, which in this case is a little over $500,000 is called my retained earnings.
[0:13:53] MS: There’s a reason why this happens. The intention with those lower corporate tax rates is to leave corporations with more money to reinvest and grow their business. It’s been designed that way on purpose. You could pay yourself a dividend from retained earnings and pay personal tax, or you could take those retained earnings and reinvest that money. Now reinvesting it in active business expansion would usually make for deductible business expenses, and therefore, no actual tax on that.
However, you could also invest those retained earnings in passive investments instead of active investments for your business. Business may do that, because they want to park some money now and grow it while they’re waiting for a strategically right time to then invest it into the active business. There are good economic reasons why the tax system is set up this way for corporations.
However, doing that on a large scale, passive investing for the long term is not really what the tax code was trying to encourage. What it does to round that is it taxes that passive income really heavily at approximately the highest personal tax rate. What happens is the corporation has only paid a low tax on its active income. The money that’s leftover, that’s tax deferral, because you are going to pay more tax later to access it personally, and to discourage that deferral from being an unfair tax advantage. If you do invest it for passive income, it’s taxed at this high rate upfront.
Now there can be a refund of some of that tax when you pay money out as a dividend from the corporation and then pay the personal tax on top of that. That’s really tax integration at work when you flow it all the way through. Now, it is complicated and there’s lots of nuances and ways that work to achieve tax integration, we’ll come back to that soon. However, it was deemed this wasn’t enough to discourage passive corporate investing, because people are still using corporations to build passive investment income streams often for retirement.
Further taxes and complexity were introduced again in 2018. This is the so-called passive income limit. To understand how this extra layer of tax works, which is more complicated, it’s really too important for us to define what passive income actually is.
Passive Income
[0:16:06] BF: We already talked about active income, net income from providing goods or services, which gets taxed at a low rate, while passive income gets taxed at a much higher rate upfront. Passive income got some pretty clear definitions when the extra layer of taxes that you just mentioned, Mark, we’re at it. Interest and dividend income is passive income. Interest from short-term deposits that are used for operations of the business is active income. Like a bank account balance that’s used for active business, that’s not going to be part of passive income. The interest on that is not going to be part of passive income.
The taxable half of capital gains is considered passive income, unless it’s donated as appreciated stock to a registered charity. Then the other way that a capital gain can be considered part of active income is if it’s from the sale of assets that were used for active business.
[0:16:54] MS: If I sold the building that I practice out of, or some equipment that had appreciated somehow, then that would be active income.
[0:17:02] BF: Exactly. The other nuance on capital gains in a corporation is that losses can be used against them. They can be carried forward, or applied backwards, just like in personal taxation. For purposes of the extra passive income limit, so for calculating what your passive income is for the purpose that we’re talking about, they can only be applied in the current year. Whether real estate counts as active or passive is a bit tricky. Rental income is usually considered passive income. But if it’s provided alongside other services, like cleaning meals or security, then it may be considered active.1 That’s going to be up to CRA’s interpretation.
If the corporation has at least five full-time employees that focus on managing investments, then income might be considered active income in an investment business. That can be earning rent. It can also be for earning dividends, or royalties. When you add up all the passive income of a corporation and subtract investing costs, that is this funny term called adjusted aggregate investment income. That’s a bit of a mouthful. We’ll just stick to calling that passive income for the purposes of our discussion.
[0:18:06] MS: We’re going to try to make this as simple as possible, because there’s a lot of terminology, and it’s really actually not very intuitive. What’s called the passive income limits is really an active and passive income limit, because they work together.
Active-Passive Income Limits
This impact of excess passive income above that passive income limit is not very intuitive, because it actually does interact with active income. It’s actually now mixed both together. Basically, what happens is that the passive income over $50,000, which is what everybody talks about with this passive income limit, when you have income above that, what it does, it grinds down the small business deduction threshold. That’s that threshold below which your active income is taxed at that lower tax rate, and it does this at a rate of five to one.
If I have $1 of passive income over that $50,000, that’s going to reduce my small business deduction limit by $5. Active business income above that gets bumped from the low rate of 12% up to the higher jump corporate of 27%. It’s a pretty big jump, roughly double, or maybe a little bit more, and that big jump occurs at a five-to-one rate, so it’s actually much higher than that. The small business deduction would be completely gone at that five-to-one rate by the time you have a $150,000 of passive income.
Basically, at that point, all active income from your corporation will be taxed at that higher general corporate tax rate. The other nuance with this is just to make it more confusing, the passive income in the current fiscal year would decrease the small business deduction threshold for the subsequent fiscal year.
Now, the upside of that is when it does happen, it does give you an opportunity for the following year to plan how you’re going to handle that. Now, the amount of the actual tax bump does vary by province. In Ontario and New Brunswick, there are some nuances. It got a little bit more messy, because those provinces didn’t follow the federal lead on this tax site, which is highly unusual. Most times when the federal government takes the flack for raising taxes, all the provinces happily jump onboard and take the increased revenue. But Ontario and New Brunswick did not.
What happened there is that it broke tax integration. Now, we’ll have to unpack that in detail somewhere else for safety reasons. It’s really confusing. You’d have to wear a helmet, basically, to contain all the brain matter that would be splattered by trying to understand this. Basically, what happens is when the corporate taxes jump, that can also be attenuated by paying yourself more dividends. The net effect is extra tax for the corporation, when you consider what’s going on in Ontario and New Brunswick, there is extra tax. If you pass all of the money through as eligible dividends that gets generated, then there’s actually reduction in the personal taxes as well, but it’s actually a little bit more than the corporate tax site.
There’s all these little nuances in how tax integration works that results in that potential advantage, where it was meant to be a disadvantage. Now, you’re going to find this is a common theme throughout the entire episode, is that if you aren’t passive income through, it actually is still a really big tax bump.
For most people, when they hear about this tax bump, they get pretty worked up about it. I know in 2018, this came out. There was a lot of hubbub about it. There’s town halls and people scrambling to sell products to fill this gap. There was a lot going on. People get really worked up about it, because it is actually a potentially big tax bump.
I just want to lay out at the beginning, if you have a moderate net active income, it may not affect you until you have a pretty large passive income. When you actually look at how it’s been implemented, for example, if I had a corporation that gets $500,000 from my practice, and I pay myself $250,000 as a salary to live on, that’s going to leave me with $250,000 of active income, because my salary was an expense.
If that’s the case, it would take a $100,000 of passive income from my corp before that small business deduction rate gets ground down to that level where $250,000 would be above it. If you’re in that moderate range, it may not – you can have a fair bit of passive income, not just $50,000. It could be much more. If that $100,000 of passive income came from an investment portfolio and say, that portfolio is yielding 3% a year in passive income, I could have a $3.3 million corporate portfolio yielding 3% before I run into trouble with these active passive income limits to my corporation.
Plus, in addition to that corporate portfolio, I probably would hopefully have scrolled away money in my RRSP and my TFSA over time. When you put all of that together, that’s a pretty large total portfolio before there’s any impact at all. Even if there is an impact, I could attenuate that impact by earning less, or spending more. There’s lots of ways to deal with it. I’m explicitly listing this up at the beginning, because this can be a mid to late career problem for many people if it ever is. Unless, you’re a big saver and a low spender. People that save a lot of money and don’t spend much and keep a lot of the corporation can run into these issues at a much younger age.
You can also, as you’re getting into that stage of life, you should also be thinking about, do you want to make changes to your work and your consumption that can be to your benefit? Or if you have all of this excess money that you’re going to be using, maybe you want to consider doing some charitable donations from the corporation, which can be extremely tax-efficient for both you and the charity. There’s other complex and expensive strategies that will probably get sold to you to try to avoid the passive income limits.
There are ways around it and to deal with it that aren’t just expensive, or complex strategies. Just make sure you think about all of those together. We’ll delve into the details of that later in this and as well as some of the other episodes that we’re going to get into.
[0:23:43] BF: Can we just spend a second and talk about how this was such a big deal in 2018? So many people were so upset and I think that fear still exists in a lot of people, where they worry about the passive income limit. Can we just say like, it’s not that big of a deal? It’s really not.
[0:24:00] MS: No. I think there’s a couple things that contributed to that. When they first were going to do it, it was basically $50,000 and bang, you get hammered with a massive tax. It would have totally broken tax integration completely when they realize that and heard all the pushback, and they actually changed their stance from the beginning. I think the other thing that’s happened, too, is when that was happening and still happens now, people will quote a 75% tax rate, which could potentially happen, but that’s a almost a worst-case scenario. People that want to sell you products to deal with it will push that as like, this is this massive tax bump, but you needed to avoid it by buying whatever we’re selling you to get around it. There are different ways to deal with it, but they always give the headline number. Yeah, and if you are deliberately trying to be inefficient, it is super nasty, but it’s so easy to get around that.
[0:24:54] BF: Ultimately, the loss of deferral, there’s no additional tax once the passive income kicks in. It’s just that you’re paying more of the tax upfront. But then when you pay yourself personally in the future, you’re paying less tax, because you’re taking out eligible dividends, because you pay tax, the general business rate. I was really worried about it, too. We did a lot of work on it when it was coming down the pipe.
[0:25:12] MS: So as I. When it came down the pipe at the same time, as we’re going to get a rid of income splitting and what everybody did, personal tax rates are going up. It was tax, tax, tax, tax, tax.
[0:25:20] BF: True.
[0:25:21] MS: It was a little bit of shock and awe that went on. This is the other thing that I think we’re bringing up, that it’s really just a loss of tax deferral is important. One of the other concepts which we’re going to keep bringing up is that you all have to pay all the tax eventually. There’s this thing out there to just leave everything in your corporation, let it grow until the end of time. That’s not going to work, because eventually, you lose tax – It has to come out, and there are mechanisms to force you to take it out. Even if you don’t, if you just leave it on there, it comes out eventually at the highest tax bracket, where you’ve defeated the purpose of tax deferral.
[0:25:55] BF: Definitely. There is one other lesser-known way for where the small business deduction can be ground down. That’s when a corporation has a large amount of aggregate taxable capital employed in Canada. That kicks in at 10 million dollars of aggregate taxable capital employed in Canada and fully eliminates the small business deduction at 50 million dollars. You’re probably more likely to hit passive income limits before hitting this thing, but it’s still worth mentioning.
The final important point as we embark on diving further into the taxation of corporate investments is that tax is a secondary consideration. You touched on this a second ago, Mark. Tax will often be used to sell complex and expensive strategies for people with corporations. Tax should be secondary, at least in my opinion. I know you agree on this. It’s super important. Don’t get me wrong. Super, super important. You want to build your investing strategy. You want to have a low-cost, well-diversified, robust investing strategy first, and then think about taxes second. If you build the strategy around taxes, you end up with a whole bunch of complex and expensive products that are honestly, probably going to make you worse off in the long run.
[0:27:04] MS: The good news is that they’re actually very compatible. You can have a good, diversified, sound investing strategy. With just understanding the stuff we’re talking about today and in the next episode, you can make it all run very tax efficiently.
[0:27:16] BF: Totally. All right, so now we’re going to talk about notional and real accounts. This is funny, because they’re both imaginary.
[0:27:26] MS: Yeah.
[0:27:26] BF: I’m thinking about that. It’s like, notional accounts are accounting accounts. We call them notional accounts, because they’re not real dollars, but they are real dollars.
[0:27:35] MS: I know. I was trying to come up with a name for whenever I talk about this, and I landed on real just for lack of it. You could say physical, but nothing’s really physical anymore either.
[0:27:44] BF: Yeah, it’s not physical.
[0:27:45] MS: It’s all digital.
[0:27:46] BF: Everything’s notional. Okay, so we’re going to refer to notional accounts as these accounting mechanisms that are specific to corporations and real accounts are an actual investment account, or bank account that you could go and open up at a financial institution. That’s the distinction we’re making. Notional accounts are accounting mechanisms. Real accounts are actual accounts that you open up.
“Notional” and “Real” Accounts
At the beginning of the episode, we mentioned that the potential advantage of a corporation is managing cash flow and tax deferred investing. Tax integration aims to make that as neutral as possible, which is probably a good thing overall. But there are nuances that impact that integration. To understand the cash flow and tax integration, you need to know about the corporate account types. The real account types are the ones that hold your actual cash, or investments, although it’s still not actual cash. They’re all just numbers on a screen.
Then there are the notional accounts. The notional accounts only exist in your financial statements and in CRA’s record books, but they’re still super valuable. That’s why I stumbled earlier, when I said that they’re not real money, because they are.
[0:28:47] MS: Well, I always like to say that they only exist on paper, but the reality is they’re probably not even on paper half the time now either.
[0:28:53] BF: Yeah, I know. It’s a funny thing to try and explain. Everything’s imaginary. What the notional accounts do is they track potential tax refunds, so that’s the refundable tax accounts and opportunities to move money at the corporation tax efficiently, which is the capital dividend account. We’ll talk more about what those things mean, but the general idea is that these accounting mechanisms that are super important for the way that investments in a corporation are taxed. It all comes back to integration.
Real Accounts
On real accounts, the most common real accounts that a person with a corporation is going to have are going to be bank accounts to handle revenue and expenses for the operating company. There can also be investment accounts that are typically held at a brokerage. Could be through a financial advisor, or at a discount brokerage, either way. Those are going to hold your stocks and cash and bonds, mutual funds, ETFs, whatever else may be in there. Now, what’s important to understand is this is the corporation’s money. Separate legal entity. The corporation’s investment account is not your personal investment account. They’re distinct legal entities, and you have to cross a tax threshold to move between the two.
You may get investment income from an investment account, and there are some taxes that may be collected on that. Some of that tax gets refunded when the corporation pays out dividends to you as the shareholder personally. Those dividends can be paid out of the corporation’s operational account. You don’t have to pay them from the investment account. Same with the special tax-free dividends, like capital dividends that we’ll talk more about later. Refunds are tax-free. Refunds and tax-free, those are a couple of exciting terms that probably got people’s attention, which is a good thing, because now we’re going to get into those notional accounts. It can be a little bit mind-bending. As I mentioned a minute ago, there’s real money involved here.
[0:30:36] MS: It’s all real money involved. It gets a bit mind-bending, because as you mentioned, it’s all corporate money. People get artificially compartmentalized that in their brains as I’ve got my active business accounts, I’ve got my passive income accounts. They think of paying, “Well, if I pay a tax on my passive income, I have to sell my investments to pay the tax.” Well, you don’t. It all comes out of your corporate money. You can take out whatever account that you want to take it out of to pay yourself dividends, or any of those things. That really confuses people.
The other thing that’s confusing with these notional accounts is because, as you mentioned, they exist on paper digitally and they just track amounts of money that are part of the tax system.
Notional Tax Accounts
At the corporate level, tax integration is implemented using the Income Tax Act and uses these notional accounts. There’s a bunch of them out there. The big ones that we’re going to talk about are the eligible and non-eligible, refundable dividend tax on hand, which would be ERDTOH, or NRDTOH. It’s a big mouthful. I’ve also seen it be any RDTOH, which is like NRDTOH, which I think is pretty cool, because I am a nerd.
The RDTOH, or RDTOH, which sounds like a Klingon word, those are refundable dividend taxes. There’s two of those now for each of the types of dividends you can get. There’s also the general rate income pool, or GRIP. It’s called general rate, because it’s tracking money that was taxed at that general corporate tax rate, that higher tax rate, and then it allows you to give eligible dividends from it.
The fourth big account is this capital dividend account, which you’ll hear called the CDA. These are all notional accounts, because they exist as part of these accounting mechanisms for tax integration. When a corporation earns passive income of the various types that we talked about earlier, it pays tax at the rate close to the personal marginal tax rate for that income. This is done to remove that tax at advantage of investing personal tax deferred dollars in the corporation. They get their pound of flesh upfront. The money gets fully taxed when it comes out.
Now, to avoid double taxation when the funds eventually do flow out to the shareholder, what happens when that money is taxed upfront is a significant portions of those taxes are tracked in this refundable dividend tax account. You pay taxes. Part of that’s going to be refundable, which is tracked by the RDTOH.
When the shareholder then pays out personal tax on that, and then pays themselves a dividend from the corporation, they pay personal tax on that dividend, which is going to be at their marginal rates. What happens to try to integrate all this is the dividend is gross step, which means multiply by a factor to make it more similar to the original amount of income. It’s taxed at your marginal rates. Then a credit is applied to try to account for the tax that the corporation already paid. It’s just back and forth process that’s attempting to try to make the amount of money paid and tax the same, whether it’s earned directly, or through the corporation, and whether that actually lines up with just earning it directly, really, it depends on the type of income. We’ll get into that.
[0:33:42] BF: Dividends paid to shareholders, they can either be eligible, or non-eligible, depending on the source of the funds. As an example, income that was taxed at the higher general corporate tax rate, at some point, allows for eligible dividends to be paid. The retained earnings from other sources of income, like interest foreign dividends, or the taxable half of capital gains can all be moved out as non-eligible dividends.
Refundable taxes are triggered corresponding to the type of dividend paid to the shareholder. That’s why we have those two separate RDTOH accounts that you mentioned, Mark. For example, to release the NRDTOH, a non-eligible dividend, which is taxed at a higher rate personally has to be paid. Then as you mentioned, the previous section, even though RDTOH refunds have to do with investment income, the triggering dividend can be paid from any corporate account. Can be from your bank account, or investment account.
You would commonly be paying out some dividends to help fund your personal consumption, in any case. You can pay a dividend out of your personal account to pay for your kid’s private school tuition, or whatever. That can still trigger the RDTOH.
[0:34:47] MS: Yeah, sorry. You pay the dividend out of the corporate account to your personal account.
[0:34:51] BF: From the corporation bank account to your personal bank account, and that can trigger the – That’s right, right?
[0:34:59] MS: Yeah. No, it’s easy to get messed up with this. This comes up with people asking about it all the time, too, where they want to just pay everything directly from the corporation. Technically, there are ways to do that. Your accountant can then account for it later, but it can get pretty messy and hard to track and your accountant may not be very happy with you for doing that. When they’re not happy, they’ll probably charge you fees for sorting out the mess.
[0:35:19] BF: They definitely will. I think the main point there was that it doesn’t have to come out of your corporate investment account. It can come out of the corporate bank account and into your personal account. That’ll still trigger the refund on the refundable tax. Similarly, the tax refund is just part of your corporate tax filing and may reduce the net corporate tax is owing, or result in an actual refund. In the following sections, we’ll detail how the notional tax accounts interact with after-tax investment returns.
ERDTOH and GRIP
We’re going to talk about the ERDTOH and GRIP first. Eligible refundable dividend tax on hand, ERDTOH, that gets created when a corporation receives eligible dividends from non-connected Canadian corporation. When an eligible dividend is received by a corporation, it pays a tax called part four tax at a rate of 38.33%. But 100% of part four tax is added to the ERDTOH, which is a refundable at a rate of 38.33%, when an eligible dividend is paid to a shareholder.
Eligible dividends are only paid up to the amount in the corporation’s general rate income pool, or GRIP. GRIP accumulates either when a corporation pays tax on its active business income at the general rate. That’s that higher rate. Or when it has received an eligible dividend from a non-connected corporation. At the shareholder level, eligible dividends receive favourable tax treatment due to the eligible dividend tax credit and the gross up, all the stuff that you mentioned a minute ago.
The ERDTOH, GRIP and enhanced dividend tax credit all work together to achieve this idea of tax integration. A shareholder is theoretically indifferent to earning an eligible dividend in their corporation, or in their personal accounts. ERDTOH and GRIP are directly related, because ERDTOH requires a GRIP balance in order to be refunded. In the case of active business income tax, the general business rate, there will be GRIP, but no ERDTOH. Quite the mind-bending thing to think through.
In the case of eligible dividends received from a non-connected corporation, there will be both GRIP and ERDTOH. Walk through an example to try and help you think through it. A corporation receives a $100,000 eligible dividend from a non-connected corporation. $100,000 is added to its GRIP. It pays $38,333 of part four tax. Then it has the same amount, $38,333 added to its ERDTOH. If a $100,000 dividend is then paid to a shareholder, $38,333 of ERDTOH is refunded to the corporation, and the shareholder pays personal tax on the dividend at their tax rate. For example, we’ll use the highest rate in Ontario in 2023, which would be 39.34%.
Alternatively, if the shareholder had earned a $100,000 in eligible dividends directly, personally, they would similarly pay 39.34% in tax. In the case of eligible dividends, tax rate integration is pretty well perfect.
[0:38:16] MS: It works well to flow the money through. As you alluded to, which is mind-bending, it’s possible to pay out enough eligible dividends to release all of the ERDTOH back to your corporation, yet still have some GRIP left in your corporation, because it also had some active income tax that the general corporate tax rates.
The thing with GRIP is GRIP can come from receiving eligible dividends, in which case, that allows you to pay them out. But it also can be generated when you’ve paid general corporate tax rate from your corporation, not just some investment, it generates this GRIP. It is possible for you to clear out all the investment income, but still have some GRIP that’s left over from paying active income at that higher rate. You can still pay out some potentially – some more eligible dividends than what you’ve received from the investments if your corporation’s being taxed at a higher rate.
That sounds tempting to do that if you have this GRIP left over from your active business income. But you actually have to weigh that against the other type of refundable dividend tax. When you pay it out and you get this 38% RDTOH refund, sometimes it can make sense if you’ve got non-eligible dividends to give out, to release some of the non-eligible RDTOH back instead, because that refund is going to be higher for that RDTOH refund than what you’d save by paying out eligible dividends. The refund for NRDTOH, which we’re going to talk about in this next section is around 30%, or 31%. The savings from using an eligible dividend compared to a regular one is in the 8% to 10% range.
The most valuable refundable tax to get out there is the ERDTOH. The next thing is to get rid of the NRDTOH, we’re going to talk about next. If you do have some extra GRIP left over after that, that would be the final one to be dealing with. Let’s talk a little bit about NRDTOH, or NRDTOH, NRDTOH. This is this non-eligible refundable dividend tax.
NRDTOH
When a corporation earns passive income from something that’s other than an eligible dividend, like interest, or the taxable half of a capital gain, or foreign dividends, is generally going to pay tax at an overall rate that is close to the highest personal tax rate.
In Ontario in 2023, a corporation pays 50.17% in combined federal and provincial tax on those types of income. That’s compared to 53.53% tax for an individual in the highest personal tax rate. It is a little bit below the top personal tax rate in Ontario upfront, but that’s also going to maybe made up for when the money flows through personally. It’s not really an advantage when the money actually makes it all the way through to your pocket. That’s going to be variable depending on the province. Some provinces, the rate’s a bit lower.
What is constant is that a large portion of this tax, 30.67% of it is generally going to be refundable. That 30.67% may be reduced a little bit if it’s foreign dividends, which we’ll talk about later, but that’s going to be the basic refund rate. The refundable rate constitutes the NRDTOH, which is refunded at 30.67% when you give out non-eligible dividends to the shareholder. Recall that a non-eligible dividend is going to be taxed at a higher rate than an eligible one at the shareholder level. You’re paying more personal tax, you’re getting a little bit less of a refund than the tax that was collected.
It’s important to note that only the higher tax, non-eligible dividends release NRDTOH, not eligible ones. If you want to release this type of RDTOH, you have to use non-eligible dividends. You can’t use eligible ones to pass it through. I’m going to run through an example of this just like we did with the other refundable tax. Let’s say, a corporation receives a $100,000 in interest income. That gets taxed at a combined rate of 50.17% in Ontario for the corporate tax rate. A total tax bill with $50,170.
30.67%, or $30,670 of that $100,000 is going to be refundable tax, subtract in the NRDTOH account. When non-eligible dividends are paid out, that are going to release that tax. What happens with the tax collected minus the refund, that really essentially leaves $80,500 in the corporation to distribute as a non-eligible dividend. If you did that, you pay out the $80,500. In Ontario 2023, you would owe 47.74% personal tax on that. That would leave you with $42,069 after tax in your hands.
That’s passing the money through a corporation, a $100,000 of interest income. You do the corporate tax, the corporate refund, the personal tax, you’re left with 42,000 bucks. If you contrast that, if you just earned that income directly and were taxed at the highest personal rate of 53.50%, you’d have $46,470 left.
[0:43:25] BF: In contrast to eligible dividend income, which we saw had perfect tax integration with interest income, it’s not quite perfect. More tax is paid flowing investment income through the corporation than would have been paid personally. In the example, we just gave in Ontario’s top tax bracket was 4.4% more tax. A corporation does not save tax when income is flowed through to the shareholder level.
Now, the issue of unfavourable tax integration is actually even worse with foreign dividend income, which is where we’ll go next. There’s this uncomfortable interaction between the NRDTOH and foreign withholding tax. This gets messy. I mean, as far as messiness goes with all of this stuff, this is got to be the messiest one, right?
[0:44:10] MS: YEAH, this has got to be the peak. I only actually figured this out this past year with your help.
NRDTOH and Foreign Withholding Tax
[0:44:16] BF: It’s ugly stuff. When foreign equities are owned inside of a Canadian corporation, there’s this really uncomfortable and unfortunate interaction with the NRDTOH. When you look at the T2 corporate tax return, you can see the details of how this calculation works. I don’t know how some of it’s derived. I’ll get to it in a second, but where do these numbers come from? There’s a reason somewhere. Just cryptic. I don’t know.
[0:44:39] MS: Whoever came up with this is probably retired or dead.
[0:44:44] BF: Actually, though, I found something like this in an old government document. It was related to insurance taxation. I was trying to figure out where they got their numbers from. It was actually that scenario you just described. I started tracking down the people that had written the report. I found one of them, and he was retired, but still doing some other stuff, but didn’t have the answer. He sent me to someone else. They didn’t have the answer. They said someone else had done the work. It was just like, where did this information come from? It’s –
[0:45:06] MS: Wow.
[0:45:07] BF: Your joke was a real thing. Rather than simply multiplying foreign income by the 30.67% as we would with interest or net capital gains, foreign income first gets reduced by foreign withholding tax multiplied by 75 divided by 29. That’s the ridiculous fraction that I was just talking about. Like, what?
[0:45:26] MS: That’s crazy. Where did that come from?
[0:45:27] BF: The reduction in RDTOH, ultimately increases the overall taxes paid by the shareholder and the corporation combined to a level that actually significantly exceeds the rate that they would have paid if they had earned that income as an individual. If we think about US companies, they would hold 15% in tax when they pay a dividend to a Canadian entity. That’s 15% foreign withholding tax is what that’s called. That’s what’s going to interact with that 75 divided by 29 fraction. That’s 15% from US companies.
If we look at a developed markets index, so the MSCI, EFI, IMI index, the average withholding tax rate last time I looked earlier this year was about 8% on average. Then if we look at emerging markets in the MSCI emerging markets, IMI index, the holding tax rate is around 13% on average. Let’s talk through how that interaction plays out, ultimately, to the shareholders tax bill. A corporation receives $100,000 in foreign dividend income. Fine. Same as the past examples. 15% gets withheld by a foreign tax authority. In this case, probably the US, at that rate.
The total taxes paid, including the foreign taxes withheld amount to $50,170. But then in calculating the NRDTOH, we have to account for the $15,000 in foreign taxes by multiplying it by 75 divided by 29, and then subtracting the product, which is 38,793 from a $100,000. That number, 61,207 is then multiplied by 30.67 to find the NRDTOH of 18,772 in this case. The corporation has $68,602, $49,830 post-tax income, plus $18,772 in NRDTOH, available to distribute as a non-eligible dividend. At the highest personal tax rate in Ontario in 2023, the end result is $35,851 available to the shareholder, or an effective tax rate of 64.15% on the foreign income that they earned in the corporation by the time that it lands in the hands of the shareholder. Then if they’d earned that personally, it would have been 53.53% in tax.
It’s a pretty meaningful difference in tax on those dividends. It is pretty sensitive to the withholding tax rate, though. I mentioned the other developed in emerging markets withholding tax rates. If we look at the approximately 8% foreign withholding tax rate, we get an NRDTOH in our example of $22,738, and the combined corporate and shareholder tax rate, in that case, is 62.08%.
[0:47:59] MS: 62.08% instead of 53.5%. A pretty big jump. I am so happy you had to do that section, not me. I find that math so dizzying, and I had to get it through step by step and make an Excel spreadsheet to actually do it for me. I’ve distilled it down to my own take-home from that. To me, the big take-home message is that a corporation pays about 50% tax upfront. When you go through all of that complicated math, depending whether it’s US, or non-US and the holding taxes and everything, it works out to be that about 18% to 22% of it is refundable, instead of the usual 30.67%.
That’s important, because tax integration was based on that 30.67% refundable tax. In this case, it’s going to be less, 18% to 22%. After everything flows through, that difference is going to be about 10% more tax than you would have paid by investing personally. That’s me. This is the bottom line with all of the confusing, weird numbers for foreign withholding taxes.
At this point, after we’ve gone through some examples of tax integration, and most of it is actually not favourable with the exception of eligible dividends, the question is, why would you bother using a corporation to invest, since tax integration actually doesn’t favour it? The answer to that is the tax deferral. Paying a low corporate tax rate now will actually give you more capital to invest and grow. That can make up for some of this tax drag that happens due to unfavourable tax integration. Depending on what you’re deferring from now is your current tax rate and what you pay taxes on in the future. It’s very similar to when we were discussing RRSPs, where you’re deferring tax from now to the future. If there’s a lower tax rate in the future, you’re going to save money on top of that.
Plus, with this, we have eligible dividends and capital gains that actually do flow through pretty tax efficiently through corporation. If you have more capital to invest initially, then you’re going to be able to grow more of those investments that are producing those eligible dividends and capital gains. That’s going to give you a larger pot in the end by deferring the tax, growing more capital and getting more of that passive income compounding over a long period of time.
That actually brings us to the, what I think is the most valuable notional account, which is the capital dividend account that deals with capital gains.
The Capital Dividend Account
The capital dividend account, or CDA, what this is, is when a Canadian private corporation realizes a capital gain, 50% of the gross gain is then credited to the CDA. It’s just like the 50% that is excluded from taxation for an individual. CDA tracks how much in a capital dividend can be paid from the corporation to shareholders. Capital dividends are a special kind of dividend that what you have to do is you have to file a special election where your accountant looks at all your capital gains and losses and make sure that it all balances out, that you have overall capital gain in that account, and that allows you to pay this capital dividend, which is a tax-free dividend.
From a tax integration standpoint, what that’s supposed to emulate is the fact that only half of realized capital gains at a personal level are taxed. You get to give out the – you don’t pay tax on half a capital gain as an individual, so you’re able to move out half a capital gain tax-free as a capital dividend from a corporation. It’s very attractive, because of that tax-free status. It’s a great way to do some nice tax planning manoeuvres.
Now, there’s several factors that make capital gains in the CDA really powerful with corporate investing. One is that you’re generally going to have to pay yourself money from your corporation to live on anyways. If you can do that using a capital dividend, instead of a regularly taxed one, well, then that’s a tax efficient way to move money out of your corporation and into your hands tax-free right now, instead of having to pay more out and pay tax. Really, what it essentially does is improves tax deferral, because you will eventually pay tax to get money in the corporation, but not today.
Since this capital dividend is not taxable, it’s also something that you could put use to put money into the hands of a lower income spouse, if they’re a shareholder of the corporation, because the attribution rules don’t apply to capital dividends. It’s not taxable income.
[0:52:22] BF: Can we just take a minute to say how crazy that is?
[0:52:24] MS: It’s awesome.
[0:52:25] BF: That blew my mind, while I learned about that planning opportunity. Yeah, it’s crazy.
[0:52:29] MS: Oh, yeah. No, it’s great. Over a long period of time, that’s huge. My wife and I’ve done this for quite a while. I’ll talk more about this later, but it’s the way of spreading out your tax risk and you have some lower tax personal money to draw from for splurges and everything else. It’s great. It’s a big deal that is not commonly known.
The other big benefit of a CDA, which not everybody realizes is that if you’re philanthropic. If you donate appreciated securities to a registered charity, that has three big effects. Not only does it remove the tax liability of the capital gain, because remember, a capital gain in a corporation is just tax deferral, so you’ll pay tax eventually. But if you donate appreciated stock to charity, you remove that tax liability. Plus, it’s a donation, so you get a deduction against income. You can use that to reduce your corporate tax bill as well on top of removing the liability.
This is the other big kicker is that the whole capital gain gets added to the CDA, not just the excluded half. If I have a $100,000 capital gain, instead of $50,000 going to my CDA, I donate appreciated stock, the full $100,000 goes to my CDA and I could give myself a $100,000 capital dividend tax-free, or to my spouse. Not just half. There’s really great tax planning opportunities, which we’ll talk more about that in other episodes, but it’s a bit confusing and it’s really important. I think the more times you mention it, the better.
Also, it takes advantage of using the capital dividend and leaves more money in the corporation to grow. The big advantage of a corporation is having more starting capital invest. That magnifies the capital gains and then you can move capital gains out efficiently. That’s where a corporation is super powerful.
Permanent Life Insurance and the CDA
[0:54:09] BF: Yeah, super interesting stuff. Another topic that we’ll cover in much more detail in a future episode, but we’ll touch on it a little bit here is whole life and universal life insurance. These are often brought up as a way to invest in a corporation. One aspect that’s touted is that premiums can be paid with pre-personal tax dollars. That’s supposed to make them special, largely because of what can potentially happen at the back end, which is that in some situations, all, or a large portion of the death benefit can be paid out tax-free through the capital dividend account. The pitch is, well, you can pay with your pre-personal tax dollars inside the corporation. Then on death, the funds flow through the CDA, so you’re bypassing tax.
It is important though to keep in mind that CDA is not specific to life insurance. It applies to all capital gains on passive assets in the corporation. When we’re comparing strategy, that’s really important to consider insurance versus conventional investing net of all fees and taxes and with proper tax planning. That’s another thing there that you can show that a corporation will be extremely tax efficient in an estate by applying three different layers of tax to the estate plan. That’s the worst-case scenario with a corporation. There are two tax planning strategies that I’m not going to go into right now, but there are two tax planning strategies that you can use with corporations that eliminate through different mechanisms the extra layers of tax. You end up with not as crazy of a tax bill, basically.
[0:55:35] MS: They’re not complicated and hard. They’re transparent and easy.
[0:55:39] BF: Yeah, exactly. This is just good tax planning, or good estate planning, I guess, or tax and estate planning. But it’s not a fancy, exotic strategy. It’s something that a good accountant is able to do without crazy high fees, or opacity. The other thing with permanent insurance is that while it’s pitched often as being tax-free, I mean, I don’t know how many times I’ve seen it said that the growth in a permanent insurance policy is tax-free, there are fees and taxes that are embedded within insurance policies that are really hard for most people to understand. They’re really hard to see. They’re not disclosed very clearly. We’ll talk more a little bit more about that later in the episode.
There’s also a strong financial incentive for insurance agents to steer corporate investors into these products, instead of more transparent, flexible, and low-cost, simple alternatives. Nobody earns a commission when you buy shares in an index fund in your discount brokerage account. But an insurance agent can stand to make a massive commission when you buy a big permanent insurance policy. I want to be clear that I’m not saying all insurance agents are bad and conflicted. There are places where permanent insurance makes sense, but the conflict of interest and how they influence product sales in the insurance industry are pretty well documented in academic research. This is not just me spouting off.
[0:56:53] MS: It comes back to the concept, which I think we’ve mentioned before, and we’ll talk about it again in our insurance episode, but you buy insurance to insure against catastrophe. Permanent life insurance can have some insurance uses. Some of it can be for insuring, basically what it comes down to probably when you really unpack it is ensuring against not having a good financial plan to deal with your estate and your taxes and how that’s going to work out. It is an insurance policy against not having a plan. But having a plan is probably a better, more transparent, flexible option.
[0:57:23] BF: A 100% agree. Permanent insurance, it’s like an option on your life. If you had a portfolio of risky assets, the classic example is a cottage. You have a family cottage that you want to make sure it stays in the family, but a cottage on the death of a second spouse, there will be a potentially, a capital gain. In some cases, if it’s a very old cottage, it can be a large capital gain. The worry is always that there won’t be enough liquidity in the state to pay the tax bill. Therefore, the kids will have to sell, or whoever, the heirs will have to sell the cottage.
There’s two ways you can solve that. Liquidity in the estate, making sure you have it. Well, I guess, an insurance is one way to ensure that. If you buy a permanent insurance policy, especially if it’s paid up, you pay all the premiums upfront, that’s just a contract that’s in place that will pay it when you die. That provides liquidity on death. It’s often sold as if there’s no other way to get liquidity on death. If you have liquid investments, or cash, or whatever, then that also can pay the tax bill. It’s just a funny thing.
You’re right. If you really screwed up your investing and you lost all of your money and you had that insurance contract in place, then yes, it would accomplish the goal. It would ensure that tax liability. But it takes a lot of mistakes to get to the point where you actually need it.
[0:58:26] MS: I think that it’s one of those things. It’s just like any other insurance policy, you’re paying a premium to shift risk. Some people are happy to pay that premium to not have to worry about it, or do other things. Hopefully, by understanding all of the options, you can then actually make a more educated decision about what’s best for you. That’s why we’re trying to present you with everything that we’ve got as options,
so you can put it in this perspective.
Post-Op Debrief
[0:58:48] BF: All right, let’s move on to our post-op debrief and recap and think a little bit about the things that we covered in this episode. We covered investing using a CCPC. A very exciting topic. I don’t say that jokingly. The retained earnings of a corporation have only been partially taxed, either at the low small business rate, or the higher general corporate tax rate. Either way, that’s usually quite a bit lower than personal tax rates, especially for professionals. A corporation is a tax deferral vehicle and leaves you with more capital to invest in a personal account. What if you were to flow those earnings through to the personal level? Whether that tax deferral translates into tax savings, or not depends on the tax rate at which you eventually take the money out of the corporation, you would pay the rest of the tax at that time.
With tax integration, simply flowing investment income through a corporation should have the same total taxes earning it personally. But we know that integration is imperfect and usually, does not favour a corporation. If you defer taxes well on a high tax bracket until you’re in a lower tax bracket in the future, then your lower personal tax rate can actually mean less taxes, even though there are some integration inefficiencies with the corporation.
[0:59:57] MS: Yeah, there’s a number of mechanisms built into corporate tax law to prevent us from deferring too much tax and building massive passive income streams within a corporation. One is the $50,000 passive income limit, which as we talked about is really shrinkage of the small business deduction threshold from $500,000 down to zero as passive income rises from $50,000 to $150,000. It’s not an all or nothing event. That active income that’s bumped over the small business deduction limit is taxed at a much higher rate about double.
However, some of that is offset if you pay out eligible dividends from the GRIP that’s generated. GRIP is one of those notional accounts. It tracks the corporation’s ability to pay out eligible dividends. Eligible dividends have a lower personal tax rate to account for the taxes that have already been paid by the corporation at a higher general corporate tax rate.
[1:00:53] BF: Another notional account is the refundable dividend tax on hand, RDTOH. To discourage tax deferral investment income in a corporation is taxed at roughly the highest personal tax rate upfront, a little bit lower, but pretty close. All are part of that tax is added to the RDTOH and refunded when you flow money out of the corporation using a dividend, which results in paying personal taxes. The overall tax bill gets mopped up at the personal level and you get a refund in the corporation.
Eligible dividends flow through ERDTOH and all of the tax is refundable. Interest net rent foreign dividends flow through the NRDTOH and it’s partially refundable when the corporation pays out non-eligible dividends. The taxable half of capital gains also flows through the NRDTOH mechanism. However, the excluded non-taxable half is tracked by different notional account called the capital dividend account, or CDA. The amount in the CDA allows your corporation to file a special election to pay out a tax-free capital dividend.
[1:01:51] MS: In summary, eligible dividend income and capital gains can flow tax efficiently through a corporation. Other types of investment income flow through a little less efficiently. As long as you’re paying out dividends from the corporation, the tax drag on growth is still pretty reasonable. If you’re not paying out money for personal consumption or investing, then there are high upfront tax rates to discourage that tax deferral.
Also, if the passive income level becomes high enough to bump corporate active income over that small business deduction threshold, then there’s a dramatic rise in corporate taxes. Again, that can also be attenuated by flowing money out of the corporation.
[1:02:27] BF: Because the complexity in different taxes, a number of strategies and products get aimed at people with corporations. Those include insurance, corporate class funds, and asset location strategies. We’re going to unpack in more detail the pros and cons of those in future episodes, because you don’t want to just exchange some tax savings for increased fees and costs. It’s really important to understand what’s going on under the hood with a lot of those things. We touched on a bit of that there. Hopefully, people are armed with some good information.
The good news though is that there are some simple things that you can do. You can keep flowing money out of your corporation to fund your lifestyle and make good use of your registered tax shelters. You can ask your accountant about your notional account balances and be sure to pay yourself from the corporation in a way that efficiently uses them. The money has to come out of the corporation eventually and an efficient plan that meshes the investment income with how you compensate yourself. That’s what I alluded to earlier about dynamic salary, or paying yourself a mix of salary and dividends over time to put yourself in an optimal position.
Optimal consumption is actually where we’re going to spend an entire episode in the next episode. In the meantime, we hope that you’ll join us for the Case Conference supplemental episode, where we’ll illustrate some more of the concepts from this episode.
In the meantime, please join us for our case conference and we’ll illustrate some of the concepts from this episode with some common scenarios, or dilemmas.
Footnotes
Related Resources
Loonie Doctor Blog Posts
The material in episode 10 is strongly related to the Incorporation Module of The Loonie Doctor Core Financial Curriculum. For those looking to open a self-directed corporate investment account, there is a step-by-step page (using Qtrade) in my DIY Investor Hub. Here are a few selected articles closely related to this episode of The Money Scope Podcast.
Corporation Account Types: Know Where The Money Is
A quick summary of “real” and “notional” account types in corporations.
Investing Through A Professional Corporation
How investments are taxed in a corporation can seem scary. Plus, the rules can change. However, when you know how to regulate the flow of income, corporations can be highly efficient.
Dividends To Maximize Your Corporate & Personal Cash Flow
How efficient corporate investment income is handled depends on how you hand your notional accounts. That means using some dividends. However, the efficiency can change over time and understanding where a corporation sits relative to your personal account options also impacts longer-term strategies.
Philanthropy or pro-social spending is a skill we must master to maximize our happiness and life satisfaction. There are many ways to give, but some are more effective and rewarding than others. Learn how to give effectively. Both to maximize your impact, and life satisfaction. You don’t gain much satisfaction when you are dead. So, don’t save your giving for your estate. Make it a part of your life.
Leave a Reply