Welcome to the supplemental episode to the main episodes about investing using a Canadian Controlled Private Corporation (CCPC). In this episode, we apply some of the knowledge-base from the main episodes on corporate investment taxation and investing strategy. We’ve picked three cases that highlight different common conundrums that people face trying to mesh their investment strategy within a corporation. While also fitting that corporate investment account into their larger portfolio and financial planning puzzle.
The idea is that you will consider how the situations apply to you. It is not specific advice, but hopefully you can relate to aspects of them and use that in your own thinking or with your advisor.
Case 1: Fitting a Corporation, TFSA, & RRSP Together
Case 2: Will You Get Corporate Bloat?
Case 3: Over-Focus on Eligible Dividends & Capital Gains
Transcript
- Intro
- Case 1: Fitting a Corp, RRSP, & TFSA Together
- Case 2: Will You Get Corporate Bloat?
- Case 3: Over-Focus on Eligible Dividends & Capital Gains
Intro
[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.
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.
This is our sixth case conference supplemental episode. We do hope that you’re finding them useful as complements to the main episodes. In this case episode, we’re covering the content from episodes 10 and 11 on corporate investing. We want you to keep in mind that the idea here is that you’re going to consider how the situations that we talk about apply to you. But keep in mind that our guidance to the hypothetical scenarios is not advice. We’re just hoping that you can relate to aspects of the cases and then use them in your own thinking, or with your advisor.
[0:00:58] MS: Yeah, that’s right. In the main episodes that go along with this supplemental episode, we talked about how investment income is taxed in a corporation. As mentioned, corporations are a great tax deferral vehicles. However, there’s also a number of measures in the tax code discourage their overuse for tax deferral. Still, understanding how they work can help you use a corporation to invest pretty efficiently. Plus, if you plan well over the long run, that tax deferral could also translate into tax savings as well.
Our first case, we will walk through the decision to retain earnings in your corporation. This comes up a lot. There’s a common piece of advice to just keep everything in the corporation. You have to weigh that against taking money out to invest in other accounts, like your personal RRSP and your TFSA. We’re going to cover that in the first case.
Related to that somewhat is our second case, which is actually going to be a number of cases. We’re going to go through some simulations to talk about how you could potentially sabotage the benefits of a corporation by letting its passive assets get too big. We’ll finish up with discussing another common temptation. That’s focusing on building your corporation into a tax efficient, eligible dividend machine.
[0:02:13] BF: That machine can run into some mechanical problems that we’ll talk about. All right, so in the first case, we’re going to be looking at the RRSP versus the corporation versus the TFSA.
Case 1: Fitting A Corporation, RRSP, & TFSA Together
In this case, we’re going to be thinking about an incorporated professional who’s recently paid off all of their loans and startup costs for their business, or their practice. They’re starting to generate some serious cash flow, and they need to decide what they’re going to do with that. They have been paying themselves a modest salary and have built up some RRSP room. They have a completely untouched TFSA, so they’ve got lots of room in both accounts. Now they’ve got to decide whether they’re going to retain earnings in their corporation to invest, or pay themselves personally to invest in their registered accounts.
[0:02:52] MS: This is a pretty common one that’s out there. I think people get that an RRSP is pre-tax dollars, but they do struggle with using their TFSAs, because they’re going to have to take money out and pay tax to contribute to the TFSA. This is a pretty common dilemma that people face.
[0:03:07] BF: It’s a pretty interesting mathematical problem, actually. We’ll try and talk through that. As we mentioned in the main episode, there is tax advice out there suggesting that people with corporations should just pay themselves dividends, rather than salary and then retain everything that they don’t need to live inside of their corporation, which means not using the RRSP and TFSA accounts in favour of keeping everything inside the corporation.
Taxation of RRSP & TFSA vs Corporate Account
Corporate bloat aside, which is a concept we’re going to cover in the next case, I want to talk through the benefits of using the RRSP and TFSA accounts when you have a corporation. It’s important to remember that investments in your corporation are taxed close to the highest personal marginal tax rate, unless you’re paying yourself dividends to recover some of those taxes. There’s a close to the highest personal marginal rate, but a big chunk of those taxes are recoverable, or refundable when you pay yourself a dividend. Of course, paying yourself dividends also means that you’re paying personal tax on the dividend that you receive.
The RRSP and the TFSA behave exactly the same way. You’ll remember this from our episode on registered accounts. If you’re taxed right now, then the future is constant. If you have, say, a 50% tax rate today and a 50% tax rate in retirement, you’re indifferent between using these two accounts. They’ll give you the same after-tax result.
The difference is that the RRSP comes with future tax rate risk. Now, I’m calling that a risk, but there’s nuance to that. If future tax rates increase, you would have been better off using the TFSA than the RRSP. The other side of that is that there’s an opportunity to withdraw from the RRSP at a lower tax rate in the future.
Now, the corporation has that same benefit. With proper planning, you can probably take dividends in retirement at a much lower tax rate than you would have paid on income in your highest earning years. That tax deferral advantage is one of the interesting aspects of the corporation.
The main advantage of the RRSP and the TFSA over the corporation is that unlike corporation, growth in the account is not taxed. There’s no material tax drag. There’s little bits of tax drag from withholding tax in some cases, but the bigger tax drag, we don’t have that in the RRSP and TFSA.
[0:05:14] MS: Yeah, those points are really important. You have seen some people model some situations, where you really bizarrely invest, and you could have a corporation that potentially beats an RRSP. However, they assume no tax drag on investment income. Just perfectly flowing through eligible dividends and capital gains only. That is not the reality of a sound diversified investing strategy. I think it’s important to remember that RRSPs and TFSA’s are tax shelters. A corporation is not a tax shelter.
Use Any Unused RRSP Room. No Current Tax Hit.
[0:05:41] BF: It’s a huge point for people to understand. As you mentioned earlier, the RRSP is an easy decision, because you can make a tax deferred contribution. You can bonus yourself out of the corporation, or take salary in the corporation and put it right into the RRSP without paying personal tax.
There’s no immediate tax hit at any level, because the bonus is a deduction to the corporation. While it’s taxable to the individual, that tax is fully offset by the RRSP contribution. That means that if you have a lower tax rate in the future, the RRSP benefits you even more.
For most professionals using the RRSP, if you have room, it’s going to be a pretty easy decision to make an RRSP contribution. Now, in our case, in the case that we’re talking about, they had built up some RRSP room already from the salary that they had been paying themselves before they had money available to invest. Using that available room is generally going to make sense. When I run the numbers on this, it’s really hard to find scenarios where, like you said earlier Mark, where the RRSP makes you worse off than retaining in the corporation.
Dividends vs Salary For RRSP Access
Both vehicles let you access lower tax rates. For making that assumption that you’re going to have lower tax rates in the future, both the corporation and the RRSP are beneficial from that perspective, but the RRSP lets you grow your investments tax-free. Whereas, with the corporation, you have tax drag. Now, the harder part with the RRSP is deciding whether you should be taking salary, or dividends to pay yourself in the first place.
Of course, one of the big implications of that decision being that you don’t get a RRSP room if you’re paying yourself dividends. That question’s harder to model, but it’s something that we have modelled, and we will talk about in our next episodes, where we’re going to do a deep dive on how to pay yourself from your corporation and how generating RRSP, future RRSP and IPP room factors into that decision.
[0:07:25] MS: I think one of the things that people often miss when they’re modelling RRSPs versus TFSAs and salary versus dividends is that they consider that, well, with a dividend, you’re not going to be paying into the Canada Pension Plan, and then they forget the fact that, well, okay, sure, with the salary, you’re paying into the Canada Pension Plan, but that’s not money that’s lost. That’s money that actually, you’re going to get back at some point in the future. You can’t count that as some extra cost of using salary, because it’s not really. It’s just a different way of investing.
[0:07:55] BF: I’ve seen that argument so many times that CPP is like a tax that you want to try and avoid. CPP is a defined benefit pension plan. That’s actually pretty sweet.
[0:08:06] MS: Yeah. Indexed to inflation with a survivor benefit.
[0:08:08] BF: Yeah, exactly. It’s a pretty nice asset and has a bunch of other features, too, actually, that this is a whole rabbit hole we could go down, but CPP is good. We’ll leave it there. Generally good. Okay, so if you have RRSP room contributing, this is probably going to make sense from the corporation. If you don’t have RRSP room, whether or not to pay yourself salary or dividends in order to create future RRSP room is a more involved discussion that we’ll cover in our next episode.
TFSA & Tax Once vs Keep in Corp & Tax Annually
Now, the TFSA, it’s a little harder than the RRSP, because you’re pre-paying the tax to get the money into the TFSA at your current tax rate. The RRSP, you’re deferring current tax and paying future tax. the TFSA, you’re paying the income tax now to get the money into the account. The corporation has tax drag working against it, but it also has tax deferral on its side on the assumption that you’re going to have a lower tax rate in the future.
The specific answer to whether or not the TFSA makes sense is going to depend on your circumstances, but the general relationship when you model this is that given a long enough time horizon, the TFSA is going to work out better than the corporation. Even if your future tax rate is lower than your current tax rate. That’s because the TFSA is going to grow at a faster rate than the corporation on an after-tax basis, because there’s no tax drag in the TFSA.
Now, how much longer, how long your time horizon has to be is going to depend on the difference between your current and future tax rate. When I’ve modelled this, even at the most extreme of the highest current tax rate and the lowest future tax rate, which not many people are going to be in that specific scenario, but even in that case, in that extreme case, I find the breakeven to be around 50 years.
If you have a really long time horizon, which anybody with a TFSA does, because you want the TFSA to be the last asset that you touch in your financial plan most of the time. So most people, even if you’re 45, you might have a long enough time horizon for the TFSA to make sense in the most extreme case. Most people, again, aren’t going to be in that most extreme case.
Then the other thing to think about is that there are opportunities to get money out of the corporation at a lower current tax rate by doing things like, realizing a capital gain in the corporation, paying a capital dividend out and using those funds to contribute to the TFSA. That makes the spread between current and future tax rates much smaller.
[0:10:21] MS: Yeah. You can use those opportunities to fund your TFSA tax efficiently. Most people aren’t going to have that extreme situation. I mean, when I’ve modelled it too, I mean, with reasonable parameters, somewhere around 10 years seems to be a reasonable breakeven point for a reasonable portfolio and some movement between tax brackets. Like you say, if you’re not going to touch the TFSA, hopefully till the end, then you’ve got a long time-horizon ahead. Not just ’till retirement for high-income people, Probably well into retirement.
[0:10:50] BF: The TFSA is the ideal estate, because it’s not taxable to anybody. You could leave it to a beneficiary, or a successor holder, and there are no tax implications in either case. If we think about it that way, that it’s either the TFSA, or the corporation at the estate, your tax rate for the corporation is likely going to be pretty high in that case.
[0:11:10] MS: It’s even useful before you die, too. If you have old age security as part of your plan, well, TFSA, if you need to take us some extra money some year for something, there’s no tax and no clawback on OAS from that. Whereas, if you take stuff from your corp, if it’s a dividend, well, it’s going to be grossed up and you’re going to have a massive clawback. Having that TFSA in your arsenal is pretty important.
[0:11:29] BF: Yeah, definitely.
Case 2: Will You Get Corporate Bloat?
[0:11:30] MS: Awesome. Okay. Let’s going to move on to the second case, which is case two about corporate bloat. We’ve mentioned the main power of a corporation for investing is tax deferral. In the last case, we showed how the additional tax sheltering of a TFSA and an RRSP can make them better over long time periods. That is due to the improved tax drag compared to a corporation and assumed that the corporation is moving money through as efficiently as possible.
Reality: Corporate Tax Efficiency Varies
It’s not going to be perfectly efficient, because of tax integration, which isn’t perfect, which we talked about in the main episode. But it’s going to be highly variable in reality. It’s not going to be always perfectly efficient. It’s going to depend on the type of investment income, the amount of active income, how they interact with each other, and the money flowing out that you’re going to use for personal purposes.
Still, people get really worried about increased corporate taxes. I just wanted to do three simulated cases that illustrate when it may matter, when it doesn’t matter, and a little bit about how to deal with it. This is also going to be a teaser for our next episode on how to pay yourself from your corporation.
The Simulators
What I’m going to do is I’m going to use an optimal compensation algorithm to keep the corporation as efficient as possible for as long as possible through some different time period simulations. I built this all into a simulator that I made that does annual personal and corporate tax calculations and monitors portfolio growth, and does that over time periods. It’s not as fancy as the professional software that Ben uses at PWL, but it was good enough to illustrate some of the key concepts.
[0:12:59] BF: You were building your calculator at the same time that my research team at PWL was building some software to model the exact same thing. We were doing it at the same time. We ended up comparing notes, and we came to pretty similar conclusions around what optimal compensation looks like and how a corporation fits in with all the other accounts. I do want to say, that it’s easy for you to say, Mark, that your spreadsheet, or your model is less fancy and that ours is a fancy software, but what you built is just as comprehensive. As I mentioned, it’s capturing all of the little nuances and tax details that matter, and we found pretty similar conclusions.
[0:13:33] MS: The biggest difference is that I use constant returns, although I do discount them slightly to try to fudge for the impact of variable turns, which usually drops the return over time just because of movement of the markets up and down at different times. Your modelling software uses thousands of Monte Carlo simulations with semi-variable returns. The big messages are going to be the same though.
The Portfolio Input
What I did for this is the investment portfolio that I used is a globally diversified 80% stocks, 20% bond portfolio. The returns and inflation projections are based on the 2023 Financial Planning Canada projections.1 I just went to their document and I used the yield for the different asset classes as the 10-year average, because the price fluctuates up and down and that can make dividend yields and interest yields fluctuate quite dramatically. I tried to average that out just to make it a more reasonable long-term type of projection. That came out to about 2.5% yield after deducting a 0.2% asset allocation ETF level of fees to that. Nice, simple globally diversified asset allocation ETF type of strategy is what I ran in the model.
[0:14:41] BF: You mentioned FP Canada. They’re the body that administers the CFP designation in Canada, and they also do a bunch of financial planning research and then produce lots of good resources. They produce a set of financial planning assumptions that are just free on the Internet for anybody to use. PWL also produces a set of assumptions. I’m actually on the committee with FP Canada that creates their assumptions. My fingers are in both, I guess.
I do want to just say on this that future return assumptions are necessary for this type of long-term thinking, which is why FP Canada and PWL produce assumptions, because you need to assume something and hopefully, is something reasonable. That’s the thing is FP Canada and PWL both do this, because left to their own devices, financial planners could use whatever. Maybe they use the historical US stock returns of 10%, which is a common number to see people using. That’s probably not a good expected return number anyway. I just want to say, it’s important to keep in mind that the actual future is unknown. We’re talking through this based on a set of assumptions.
[0:15:37] MS: I mean, it’s reassuring that at least, there’s a group of people that are giving it some careful thought and trying to make a guess together. Yeah, the future will certainly be different. However, I would say that minor differences won’t matter to the main points that we’re going to make with these simulations. What I will also do is I’m going to use a few different income and spending levels for people, because that impacts the outcome quite a bit, actually. That’s probably the biggest variable.
Earning, Spending & Provincial Tax Inputs
I’m going to use someone who’s incorporated in BC for a change. I know we always do Ontario, but I thought we’d do something different. The tax rates are going to be similarly high to many other provinces. I will make a few comments about Ontario, in that Ontario, New Brunswick, do you have this anomaly where exceeding the passive income limits can be beneficial under the right circumstances. It makes a minor difference for a short period of time. I would also say, if we’re talking about long-term projections, it’s pretty hard to know that that anomaly is not going to be rectified sometime in the near future when governments inevitably come looking for more money. We’re ignoring that for this analysis.
$350K/yr Earned & $150K/yr Spent
[0:16:38] BF: I agree. That makes sense. The first combination of earning and spending we’re going to look at is a $350,000 earner and a $150,000 spender. They’re earning a $350,000 and spending $150,000. We’re going to think about them as a 30-year-old incorporated professional spending the $150,000, plus maxing out their TFSA. They’re using up all of their RRSP room generated by their salary. With optimal compensation, that’s mostly going to be salary in the early years, but some shifting to dividends to release RDTOH as their corporate investments spit out more income over time.
Remember, we’re using Mark’s optimal corporate compensation algorithm. Then like I mentioned, their corporation is earning $350,000 per year net of overhead and before owner salary.
[0:17:24] MS: Great. With those parameters, their corporate investment tax drag is going to be about 0.7% per year. That’s due to the 50% tax on passive income that’s collected. They get 30.67% refunded as dividends are paid out. The refund is going to be a little bit less for foreign dividends. For eligible dividends, all of the tax is going to refund it in an equal amount to the dividends that are paid out from those eligible dividends. It accounts for the different efficiencies of the different income types.
Because this person is using their RRSP and TFSA in addition to their corporation, probably after listening to this episode, they’re going to be saving about $65,000 per year in their corporation to start. They’re using all of the different accounts, including $65,000 in their corporation. At that savings rate, their corporation is going to slowly grow over time.
Now they are spending enough on the other end to easily require enough dividends to fund their lifestyle that keeps that refundable dividend tax generated by the corporate portfolio flowing out. Passive incomes receive, they flow it out, get the refunds, and their corporation keeps that high efficiency right up to around the age of 65 when you model it that way.
The other issue is that their corporate passive income does actually start to exceed that $50,000 passive income limit that we’ve talked about in the main episode. It does that in their early 40s. That does start to shrink down their small business deduction for the active corporate income. You have to remember, it’s not just passive income. It’s how much active income you have.
They have $350,000 of active income. That’s before you account for their salary. It’s $350,000 minus their salary. That’s going to give their corporate’s net active income. With that bumping down their income for the active income, they don’t actually get bumped into the higher general corporate tax rate by going over that threshold, and until they’re well over the age of 65. It doesn’t really become much of an issue for them.
They also have more than enough in their portfolio, even after tax to access it. Just accounting for some of the tax deferral and getting that money out, they’d be financially independent that that spending level around the age of 65.
The other thing I would say is that it’s notable that about 62% of their portfolios in their corporation, 31% is in their RRSP, and that 7% is in their TFSA. They have lots of options of being able to draw from different account types to draw down on their assets over retirement. It’s going to help their efficiency on the other end as well.
[0:19:50] BF: That’s worth emphasizing a little bit. It’s one of the points that we covered in the main episode. This person, because of the way that they’ve saved, they have multiple buckets to draw from for their retirement income.
Like you mentioned earlier, Mark, being able to use the TFSA to smooth income out to avoid OAS clawback. For example, all of those buckets have different tax treatment on withdrawals. This is going to offer both flexibility in planning, like the TFSA versus OAS clawback example, but also, some level of protection from tax changes on one account blowing up the entire plan. Like you mentioned, the example of the anomaly in Ontario and New Brunswick for dividend tax treatment in certain cases. If you built an entire plan based on that and that changed, that could be not so good.
Take-Home Message For Moderate Earner & Spender
[0:20:31] MS: The reason why I did this case is because I think the take-home message here is that if you have a moderately high income and you spend proportionally and you use your registered accounts in addition to your corporation, you probably don’t need to worry much about passive income in the corporation. Don’t lose sleep over it. Also, don’t lose money by paying for more complex products, or approaches to try to address a problem that you’re probably not actually going to have. This person has good corporate bowel health. They make regular movements of money out of their corporation that they spend on their lifestyle and funding their registered accounts.
[0:21:06] BF: Making poop jokes? Yeah.
[0:21:08] MS: Oh, yeah. I’m going to escalate now.
[0:21:10] BF: Okay. Yeah. I’m into it. The next case we have is a larger corporation and the thrifty, or frugal retiree. In the previous case model at age 65, they had about 4 million dollars in the corporation, 2 million in an RRSP and $425,000 in a TFSA. That could easily support their spending at $150,000 a year, likely more than that.
$350K/yr Earned & $75K/yr Spent In Retirement
Now let’s say, instead, they are thrifty and spend much less. We’re going to cut their spending to $75,000 per year. We know the corporate tax laws discourage passive income in the corporation by having those high personal tax rates, or equivalents to high personal tax rates if you’re not spending from the corporation. That happens through the RDTOH mechanism.
[0:21:53] MS: This is probably the point where a lot of the people that live in high-cost living areas say, that’s totally impossible. No one could possibly live on $75,000 a year. I can tell you, there are people that I know who actually earn high-income physician type of incomes live in pretty low-cost living areas. They’re quite happy spending $75,000 a year. They ask about these issues. This is actually a real case.
If you take that 80/20 globally diversified portfolio, that’s going to be spitting out about $24,000 in eligible dividends, $37,000 in foreign dividends and $19,000 in interest when it’s up to that high level around 4 million dollars. That’s going to be $9,000 in corporate tax on the eligible dividends. That’s actually going to be refundable as the eRDTOH when you give out $24,000 in eligible dividends. $24,000 comes in, $24,000 goes out, and there’s no tax on that to the corporation once you account for the refunds.
Now, for interest and foreign dividends, the tax is going to be around $28,000. It’s going to be about $13 600. That’s going to be refundable as that non-eligible NRDTOH. To get that refund of around $28,000 [CORRECTION $13600 refund], you’d have to pay out around $36,000 of non-eligible dividends. When you do that, you pay personal tax on that, and then you get that refund back to the corporation. A lot of numbers there, but basically, $24,000 of eligible and $36,000 of non-eligible dividends per year for the corporation to give to the person is going to get all of those refunds back to the corporation.
Now, at some point, what is going to happen in addition to having to take that money out of the corporation, or keep it efficient, they’re also going to have to take other money from other sources that they’ve been contributing to and deferring tax on. CPP, OAS, and they’re going to have to convert their RRSP to an RIF. That tax deferral is now going to be money that they have to take out and pay tax on.
They can delay that to older ages, but let’s just say for simplicity that they’re going to start taking CPP and OAS at 65. That would be about $24,000 a year based on their income over their lifespan. That’s just a rough guess. The calculation is actually pretty complicated. When we put their CPP, OAS, the corporate dividends together, that’s going to have about $84,000 in personal income.
They’re going to have to pay about $9,000 in tax on that. They’re going to have their $75,000 left over. It’s enough to fund their lifestyle. Their corporation is going to get refunded the $23,000 in refundable taxes. Everything’s very efficient. They have enough to fund their lifestyle. The refundable taxes get refunded by the corporation.
Involuntarily Gas Release in Retirement
Now, when they hit the age of 71, then they have to start withdrawing money from their RRSP. It gets converted to an RIF. They have to start taking money out. At that point, because they haven’t touched it, their RRSP is worth about 2.6 million dollars. And the minimum withdrawal on that at age 71 is going to be about a $129,000.
You add that plus their OAS and CPP and their taxable income is going to be a $153,000 before giving out any of the dividends from the corporation, which if they want to get those refunds, the corporation will have to be giving out dividends on top of that. Now they’re getting into this situation where they have to make some tougher decisions and the math gets more complicated.
If you look after tax and OAS clawbacks, they’re going to have $107,000, which is more than the $75,000 that they need to live on. We’ve mentioned this a few times, but the reality is that if you defer tax to the future, at some point, the money’s going to come out. At some point, it starts getting forced out, in the case of an RRSP and taking your CPP. But with a corporation, either you pay tax upfront near the highest rates, like 38% on eligible dividends and 50% for other income, or you’re forced to take that out, essentially, by trying to get the refunds.
When you add this altogether with their taxable income, they’re going to be paying a net for if they want to take more eligible dividends out to try to get that refund of their corporation. Because right now, they’ve just gotten all the income from their other sources, nothing from the corporation. We want to get some refunds in the corporation. To do that, they’d have to take out some eligible dividends to get that eligible dividend tax refunded.
At the personal tax level, they’d be paying about 19% on those eligible dividends, and then they’d get 38% refunded back to the corporation. That makes sense, actually, in that case, even though they don’t need the money to pay themselves extra dividends, because those eligible dividends are going to have a lower tax rate at 19% than the 38% that gets refunded. If they do that, that would bump their taxable income to at least a $186,000. They’d have some excess personal money.
Bloat From Trapped nRDTOH
Now, the other thing that’s still in the corporation is we still have all that NRDTOH, or that non-eligible refundable dividend tax. That’s the refund that was collected on that 50% tax on other kinds of income and about 31% of it is refundable. If you look at their marginal tax rate at that level, it’s going to be around 40%, which is much higher than the 31% refund that you’d be getting by paying out extra dividends. In that case, it does not make any sense to just be paying out extra dividends when you don’t need that money. You wouldn’t want to pay extra non-refundable dividends, or non-eligible dividends, even though you get that corporate refund because it’s less.
What that effectively does is that takes that NRDTOH and it’s effectively trapped in the corporation until you actually need the money. By doing that, that means that interest foreign dividends are effectively taxed at 50% in the current year. That’s a big jump in corporate tax drag from the passive income, because you can’t officially pass it through anymore. This is what I would call a case of minor corporate bloat, where you’re starting to get some of this refundable tax trapped in there until you need it. It’s only going to be relieved if you decide to release some gas and pass more income out to spend, or give away.
Take Home Message For The Frugal Corp Owner
[0:28:02] BF: The take home message from this scenario is that when you build up a large portfolio with tax deferred investments in the corporation, that money eventually does need to come out. You can either choose to spend more, or pay higher taxes. If you leave as much in there as possible, deferring all the tax until you die, then the ultimate estate is going to be less tax efficient. You have the opportunity to bleed out income over time, or release gas over time, instead of having the big explosion in the estate.
Likely at the estate time, most of the assets are going to be taxed at the highest marginal rates. Plus, you can have probate to deal with. Instead of just deferring the tax as long as you can, having that exit plan and releasing some of that corporate bloat, some of that gas over time lets you spend the money more efficiently while you’re alive.
There are also opportunities to give to charity very tax efficiently from a corporation without having that huge tax bill. At the end, now this stuff does get more complicated and more involved. I do think that a financial planner, or a good CPA who’s good at long-term thinking can be really helpful here.
$500K/yr Earned & $150K/yr Spent
We’re going to move on to our next case, which is a higher earner. They’re earning $500,000 this time, and they’re spending a $150,000. $150,000 on lifestyle, plus enough to fund their TFSA each year, also enough to use the RRSP room generated by the salary that they’re taking to pay themselves.
In this case, because of the high income, they’re able to live quite a bit more in the corporation, about $200,000 a year being retained each year to start. Now, those partially taxed dollars in the corporation are going to grow much more rapidly, because they’re retaining so much more, plus their growth on the investments. With their spending, they’ll pay out enough dividends to keep RDTOH flowing and the corporate investment tax drag at around 0.7%/yr.
Hitting Corporate Passive Income Limits
[0:29:48] MS: That goes well for a while, but because everything’s growing so rapidly, around the age of 45, they’re going to start to get some corporate bloat. Their corporation is going to have about 4.5 million dollars at that point. It’s going to be churning out about a $100,000 a year in passive income, and that’s going to start to shrink their small business deduction threshold. At that age, it would be shrunken down to about $250,000. A $100,000 of passive income shrinks the small business deduction threshold down to $250,000 of active income.
They’ve had to pay themselves dividends to keep that refundable tax flowing. Their salary is down to about $225,000 a year, and that makes their net corporate income $275,000 a year. You take that $500,000 a year of income, you subtract their salary, which is an expense. It’s going to be around $275. There’ll be some other stuff in there, but that’s a pretty good guess.
That $25,000 that’s over the shrunken [$250K] small business threshold is going to get bumped up. That $25,000 is going to get bumped from the small business tax rate, which is around 11% up to the general tax rate of 27%. That’s a pretty big tax bump.
The other thing to remember, though, is that corporate income that gets bumped up to that general corporate tax rate also generates GRIP. We talked about that in the main episode. What that GRIP does is that gives the corporation the ability to pay out eligible dividends, instead of non-eligible dividends to account for the fact that the corporation paid more tax upfront, so you’re going to pay less tax as an individual. They can use that, and they pay themselves $18,000 a more a year in eligible dividends, instead of non-eligible dividends. They spend enough that they could take advantage of that and pay a little bit less personal tax than they would otherwise.
However, they also have to reduce their salary further to do that, because now they’re having more dividends flowing out to keep the refundable taxes flowing and they don’t need extra money, so the salary that they need to pay themselves to make up the difference is shrinking. With that and the amount of dividends that they need to keep it all flowing, they actually end up still losing their small business deduction completely over the next five years, because you have passive income that’s growing, and you’re paying less salary, which is a corporate expense. The corporate active income rises, the passive income rises, and that small business deduction quickly vanishes. Takes about five years.
Once that’s disappeared, they’re going to start generating GRIP all the time, because all of their corporate income is now being taxed at the general rate. They’re going to be generating a lot of GRIP every year, and they don’t need all of it. Some of that’s going to be stuck in the corporation as well.
Sticky GRIP
[0:32:31] BF: This is an example where we’re really seeing the passive income limits kick in, and they’re not spending enough to attenuate the impact by being able to use all of the eligible dividends that they’re allowed to. They can use some eligible dividends now, but some of that GRIP is going to be trapped. They’re going to have to use it later.
[0:32:47] MS: We talked about this in one of the main episodes that GRIP is priced in nominal dollars, too. When it sits there, the buying power that it represents is slowly eroding over time. There is actually a bigger impact than what people realize. What this translates into is the net effect of the corporate taxes rise by about $75,000 a year, and the personal taxes drop by about $30,000 a year, because you’re using those eligible dividends. There’s less efficiency in the corp, a little bit more efficiency personally, but overall, you’re still paying more tax overall, because of the passive income limits.
If you take that effect of the passive income limits and attribute it back to the passive income, because that’s what caused it in the first place and put that as part of your tax drag. What it does is it increases the tax drag of corporate investments from around 0.7% a year, up to about 1.9% a year. More than doubles it. If you think of that 1.9% a year, well, that’s more than half of the yield, which was about 2.5% a year.
A lot of the corporate investment income is now being eaten up by tax. Essentially, you’re forced in that situation. You can make some of it up with less personal tax to fund your consumption, but it’s still a big drag on investment growth. This is what I would call moderate corporate bloat when this is happening. If you aren’t passing out the eligible dividends that are taking advantage of that GRIP, then that’s going to be severe bloat, because you’re going to have that high corporate tax rate, and you’re not taking advantage of it, at least to give some eligible dividends.
Essentially, what has happened is that by growing more passive income in the corp, eventually it has to be released. I mean, the passive income rule forces the issue. It’s like gas. If you don’t let it out, then there’s bloat. That manifests as extra corporate tax and more tax overall. Also, without increasing personal spending and moving increasingly more money out of the corporation, it actually gets worse. It’s worth noting that this spending level of a $150,000, this person hits these issues in their mid-40s.
That’s around the same time that the corporate bloat starts happening. It’s also around the time where they can start to choose to use that financial power and start spending more. You can try to deal with that bloat by moving more money out. You can move more money out gradually over their life, rather than letting it continue to build and bloat more.
Bloat Relief Can Be Pleasant. Holding It In Hurts.
[0:35:12] BF: I think that raises a really important point that we brought up in one of our earlier episodes. I think it was in episode four on financial independence, which is that you need to be able to measure your progress to your goal. If you realize that you’ve achieved financial independence earlier than you expected to, it might change your behaviours. It might change your decisions. If you don’t have that data point, if you don’t know what it takes for you to achieve your goal, then you might not change your spending, like you just mentioned, you could in this case.
[0:35:38] MS: You mentioned this in one of the other examples. If they don’t change their earning as spending and they retired age 65 and they die at age 90, this person would end up having an estate worth more than 20 million dollars in inflation adjusted dollars. Massive estate, most of that taxed with the highest marginal rates that’s passed on to anybody other than a charity, that is more lost to tax than if you had just taken money a bit more out each year, while alive and in lower tax brackets and enjoyed it a long way.
[0:36:07] BF: Yeah. You can’t quantify the enjoyment aspect. It’s like, this is a bit of a tangent, but we were speaking with someone yesterday who’s a wealth psychologist for wealthy families. We talked a little bit about cases exactly like this, where kids of parents who had a lot of wealth but didn’t spend it, when the parents pass away, or when the parents show their assets and will to their children, typically, what the wealth psychologist told us is that the children tend to be really angry, because they look at all the wealth that the family has and they’re like, “One, why didn’t you trust us to tell us about this earlier? Two, why did we live like we didn’t have this wealth? We suffered and struggled, because you wanted to keep all this wealth sitting.” There’s a lot of hard to quantify aspects of what we’re talking about here.
[0:36:54] MS: Yeah, we’re going to have to do an episode on that.
[0:36:57] BF: That’s an upcoming Rational Reminder guest. It was James Grubman who’s written a ton of good stuff on this. That could be a really interesting episode. Anyway, I’m done with my tangent.
The take home message from this case, and from the one before, is that the money needs to come out of a corporation at some point. Tax deferral works best when you defer at a higher rate and take money out at a low rate. The larger your corporate investment portfolio gets, the harder it is to get money out at those lower rates. The RDTOH mechanism and/or the passive income limit essentially force you to take money out, or pay more tax.
[0:37:28] MS: Looking at your current and projected wealth and spending can help you plan and adjust course, both in advance to prevent too much bloat, or moving forward if you are experiencing some bloat already. It may be better to let little bits of gas out of the corporate bag over time when it’s that advantageous. Like crop dusting. If you don’t do it, it may be forced out at a bad time later, like in an elevator. If you just hold it all in, well, that does not end well.
[0:37:56] BF: I just want to make sure that listeners are aware that we are making fart jokes, right?
[0:38:00] MS: That’s right. Yeah, I’ve graduated from my usual corny dad jokes to full-on fart jokes.
[0:38:05] BF: Okay, I like it.
[0:38:07] MS: It’s the price of admission for free financial education. Then you probably have a few points to add as someone who coaches clients on how to release their corporate gas.
Multi-Modal Corporate Decompression
[0:38:21] BF: There are a lot of different approaches to dealing with the issue. I think knowing how you’re doing, like I mentioned earlier, relative to your plan and considering whether you adjust your earning, or spending, that’s one really important point to think about. Then also, keeping in mind the more subjective elements that I talked about, like ending up with a massive estate and having your kids wonder why the family didn’t use that to enjoy their lives together earlier.
We’ve also talked about using the TFSA’s and RRSPs to help redirect money from the corporation in these cases. I think that’s another really important thing to do. Of course, the room to do that is relatively limited. Most professionals are going to fill those up pretty quickly. While it’s important, it’s not an overall solution. I think in IPPs, which are individual pension plans, those are another alternative to RRSPs. They give you more room effectively. We’ll talk to the details later, but there’s more room in an IPP than an RRSP after the age of 40, approximately. That’s one way that you can make pretty large ongoing tax deductible to the corporation contributions into a vehicle that does not have tax drag. IPPs for people who are dealing with corporate bloat, I think can be quite interesting.
Without using those other accounts, the corporation’s going to experience corporate bloat sooner. Again, there’s a point where the IPP doesn’t help anymore, because if someone has so much income flowing into their corporation that they just can’t get it out, they’re still going to be corporate bloat eventually. But using RRSPs, TFSAs, and IPPs can help defer that issue. Permanent insurance is often going to be sold as a solution to this problem. I think it’s only appropriate in very specific and relatively niche cases. I think using it to solve corporate bloat just leads to other inefficiencies.
You deal with your bloat, but you get, I don’t know. I don’t know what the analogy is there. Some other medical condition. I don’t know. You would have a better crack at making a funny joke there.
[0:40:16] MS: Yeah, side effects and complications.
[0:40:18] BF: There we go.
[0:40:19] MS: The medical term is iatrogenesis imperfecta.
[0:40:22] BF: Perfect. Perfect. You don’t want that.
[0:40:26] MS: No. It’s bad.
[0:40:27] BF: Sounds bad. I think working with your accountant, or your financial advisor to make sure that you’re using the right mix of salary and dividend to keep the money flowing out and keep the refund tax flowing, I think that can be really helpful. Then there can also be strategic opportunities to move chunks of money out of the corporation tax efficiently using things, like the corporation’s capital dividend account. For example, paying a capital dividend to a lower income shareholder spouse to invest in their taxable account. There’s even weirder stuff, too. If you pay a fully taxable dividend to a shareholder spouse, they’ll pay tax at the highest personal rate, because it’s tax on split income. It’s TOSI. Well, if it is. It wouldn’t always be, but you could even do that intentionally if they have a low enough personal tax rate that it’s still in the long run makes sense. Depends how creative you want to get, but there’s all kinds of fun things you can try.
[0:41:12] MS: Yeah, the math would be like, when you’re thinking about a TFSA, you take an upfront tax hit. But if it’s super-efficient over a long horizon, then you make up for it.
[0:41:21] BF: That one has limited room, not in a literal sense, but just in the sense that enough assets in the lower income spouse’s hands will force them to no longer be a lower income spouse and it stops working.
[0:41:33] MS: Yeah, you have to keep them pretty low tax brackets for that to be effective.
[0:41:37] BF: Yeah, exactly. Lots of little tricks and interesting things that can be considered to deal with corporate bloat.
Case 3: Over-Focus on Eligible Dividends & Capital Gains
Our third case, we’re going to talk about the over-focus on Canadian dividends and capital gains. We’re going to think about an investor for this case who’s decided to focus on building their corporate portfolio using only Canadian dividend paying stocks due to their perceived tax efficiency. To recap on that, all of the tax on Canadian eligible dividends is part four tax, which is fully refundable when dividend is paid from the corporation.
Now that’s especially compelling in contrast to foreign dividends, which have imperfect tax integration due to the interaction between refundable tax and foreign withholding tax. If you’re looking at, should I invest in Canadian stocks, or international stocks and you’re just looking at the dividend tax rates, Canadian dividends look really, really nice.
[0:42:27] MS: This may sound crazy too, but I have quite a few friends actually, who have had this strategy. And yes, they talk about their portfolio and they’re talking about how it’s underperformed, or been volatile. Then you ask them what they’ve got and it’s all Canadian dividend payers with nothing else. This is actually a real thing that happens.
Three Main Problems
[0:42:46] BF: Oh, I’ve seen it, too. We could talk about this with lots of different angles. We’ll keep going with the corporation angle. There are three big problems that you get when you focus on the perceived tax efficiency of eligible dividends and capital gains relative to other forms of income.
Corporation is a large account
One is that a corporation often becomes the largest account and it’s easy to become top concentrated in a single asset class. This is like, you’re keeping everything in the corporation, because you think it’s really tax efficient. You end up with a big account that has only Canadian equities.
Even if you’re diversified in your other accounts, you’re super top heavy, or whatever you want to call it with a single asset class. That’s true both geographically, because you’ve got a lot in Canada, which is 3% of the global market. There’s a huge home bias in that case. Then also, by industry, because the Canadian market is so concentrated in a handful of industries, like financials and commodities. You end up with a really, really concentrated portfolio just in terms of the economic risk that you’re exposed to, which is not ideal.
Tax-Efficiency Can Change
I think the other issue is asset location, or trying to optimize which assets go in which accounts, which is basically what we’re talking about here, is really difficult. It comes with its own set of risks and trade-offs.
Temptation To Stock Pick
Then lastly, a Canadian dividend focus can lead to the temptation to pick Canadian stocks, rather than using low-cost, diversified ETFs. I see this with dividend investors from all walks of life, not just people with corporations, but there’s a huge temptation to select individual stocks based on their dividend yield, or their perception of being a good company related to the fact they pay dividends.
We did cover this in our episode on portfolio management that the diversification is good. Some Canadian home country bias can make sense for tax reasons and other cost reasons, but too big of a bet on a single country, I think, is a really, really big risk in the long run. Individual country performance is actually also related to the challenges with asset location. I mentioned that asset location introduces its own risks and trade-offs. It’s really hard to know how any individual asset class is going to perform in the future. Even if one asset class is more tax efficient than another, pre-tax returns have a big impact on after-tax returns.
Yes, we can say, look, the tax rate’s lower. If the pre-tax return of a less tax efficient asset class is higher, then your after-tax return can actually be better despite less tax efficiency. A lot to think about.
[0:45:07] MS: Better to pay a bit more tax, because you made a lot more money.
Underperformance Risk vs Tax Efficiency
[0:45:09] BF: Exactly. Right. It doesn’t even have to be a lot more, which is one of the comments that I’m going to make. The long-run variance in stock returns is massive. But it’s only a small variance that’s required to make a concentrated position in a single country suboptimal, both before and after-tax. I ran some numbers on this. I think it looked at a 20-year horizon and just a simple model. I found that despite the relative tax efficiency of Canadian dividends, you only need about half a percent of additional capital gain return for international stocks relative to Canadian to make their after-tax returns equal.
I just had dividend yield was the same in both cases. It only took an extra half a percent of capital gain return from international stocks to make them better on an after-tax basis in a corporation.
[0:45:53] MS: You don’t have to look very hard to find an example of where that hurts. I can say, looking at friends who have been Canadian-heavy over the last decade compared to the American markets been been way, way, way more outperformance by the US markets compared to Canada. They’ve trailed very significantly way beyond any tax savings, whatsoever.
Now, no one can say whether that’s going to happen in the future. I mean, Canadian and the US markets, they both thrive at different times we don’t know. But boy, a decade of underperformance sure doesn’t feel great. Probably around the exactly the time where you throw in the towel is exactly the time where one market starts to outperform, and the other one starts to underperform.
[0:46:34] BF: Totally. That’s the thing. You look at the historical performance of different markets, Canada and the US from 1900 to, I think, 2009 have about the same performance. Then since 2009, US has just taken off. Then if you look at the history of international, excluding US versus US markets, there have been long periods where international ex-US outperforms US. It’s like, you just said, if someone heard what you just said, well, US stocks have done that much better. I’m just going to invest in those. There’s a pretty good chance that the next 10 or 20 years, it’s going to reverse course, as it always has historically.
At a moment in time, right now, it feels nothing can beat US stocks, which has been true for quite a while. If you look longer back in history, and it has not always been true. There have been long periods where other countries and other regions have outperformed the US market. Anyway, all that to say that variance matters a lot. Having a single country for tax motivated reasons is a pretty significant risk. There’s a saying that I really like for this thinking that we’re doing about asset location, which is that trying to get this right is like measuring with a micrometer and cutting with an axe.
Micrometer is the perfect model of after-tax returns that leads us to believe that our corporations do only hold Canadian stocks, but the axe that we’re cutting with is the actual market returns that we’re going to get. It’s a pretty messy exercise to try and optimize stuff like that.
The third challenge is that if you use a bunch of individual Canadian stocks, which I mentioned, is a temptation to do, it can get pretty cumbersome to manage. I think Mark, you actually have some personal experience with that one.
Mark’s Confession & Reasons For Repentance
[0:48:07] MS: I’m making a lot of confessions on this podcast, but this is something that I did for a little bit of time. I’m now extracting myself from when we started to do it at a pretty large corporation at the point in time where I started to think about this, and it was large enough that I was starting to go, “Okay. Well, maybe it would be cost effective if I use a bunch of individual Canadian stocks. I can pseudo-track the TSX60, so it would be easy for me to cost effectively buy that number of stocks.”
I thought when I did this, okay, well, I could do this and I could save the money on the MER that I would pay if I used an ETF. Thinking about it now, I can realize just how stupid that was. I mean, the MER for an ETF that covers the Canadian All Cap Index, which is even broader than the TSX60 is only 0.06% a year. It would be pretty hard to beat that, especially when you start factoring in bid-ask spreads and the trading costs. It’s almost impossible. Then the amount of time that goes into it has value to, which is the other part that’s cumbersome.
The other reason why I did it besides that, which was a stupid reason, was that I thought I figured, okay, I was going to give you lots of options when I’m choosing to do tax planning. What I can do is I can harvest capital gains from things that are doing really well, and I could use that to pay out capital dividends. I could donate appreciated stock from my highest capital gain, because we donated appreciated stock every year to charity, and we could just pick the ones that have appreciated the most and get the most tax benefits from doing that. Honestly, that actually has been pretty handy.
However, I would say after a few years of doing it, I am phasing it out to just use ETFs again. The hassle just isn’t worth it. It’s way too much work and way too much opportunity to make mistakes with it as well. The benefits, as you said, are measured with a micrometer and I’m cutting with an axe. I think that’s a great saying. Moving forward, I plan to use a Canadian market ETF. I’ve already started planning how I’m going to transition to that over the next little while.
What I may do, even if I use the ETF, and I still want to have some tax planning opportunities, what I could do is when I start to have significant gains, I could add in another ETF that’s very similar, and just start building on that one, So, I’d have one with a high capital gain, one with a low capital gain, and I could do tax planning that way without having to manage all of these issues. That’s going to be really important, because it has to be easy to execute, especially if something happens to me.
I’m teaching my wife how to manage our portfolio, so that if I’m gone, she can do it, too. I want it to be nice and easy to execute. Even if we were to use an advisor, which we certainly will, when we get a bit older, it’s going to be a simpler cost-effective approach. That’s easier for an advisor to execute as well. For negotiating fees, that might be something we could use on our side in that discussion.
[0:50:51] BF: Fee negotiations are actually a regulatory priority for 2024. They’re cracking down and they think it’s a conflict of interest. If two clients from the same firm receiving the same service have different fees, regulators are saying, “You can’t do that.” Negotiating might be hard in the future.
[0:51:06] MS: We’ll just have to make sure everybody does this, so they can negotiate to the bottom.
[0:51:10] BF: Yeah. Yeah.
[0:51:11] MS: Everyone gets the lowest.
[0:51:13] BF: It takes time to do these things. Whether it’s an individual or an advisor, it takes time and time costs money, because you have to pay people to do it. There’s a market for talent in financial services, so you’ve got to pay market salaries. If you’re trying to do things like asset location for a whole bunch of accounts, you have to charge higher fees for everybody in order to do that. There’s no way around it. There’s a market for people and you need people and time to do this stuff. You’re right. If everybody’s using simple portfolios, well, I guess, it ties back to a firm that uses simple portfolios will generally have lower fees. That’s what it comes down to.
[0:51:53] MS: Exactly. More reliable execution.
[0:51:56] BF: Humans are bad at doing things systematically. Systematizing things like portfolio management, I think, is really important. All right, I think that concludes our case conference episode. Thanks everyone for joining us.
Related Resources
Rational Reminder Episodes
Ep 282: James Grubman: The Psychology of Wealth
Loonie Doctor Blog Posts
CCPC Income Dispenser Calculator
A calculator to optimize personal and corporate compensation to targeted lifestyle spending and investing goals. Based on the corporate active and passive income. The simulations in this episode used a model of this algorithm annually over a 35-year period. Plus, retirement drawdown.
Dividends To Maximize Corp & Personal Cashflow
A backgrounder on how dividends are used as part of my optimal compensation algorithm.
Why To Pay Yourself Salary
A backgrounder on how salary is used as part of my optimal compensation algorithm.
Leave a Reply