Corporate investment portfolios – Opportunities and obstacles

Informing your returns by understanding passive tax rules

The taxation of passive income in corporations is a very complex topic. The intention here is to provide a general overview to help you discuss with your accountant and your investment advisor how this may apply in your circumstances.

As the owner of a corporation, you know your active business income is taxed at a rate that is usually well below your personal rate. Presumably, that’s part of the reason you are using a corporation in the first place.

Top personal tax rates are near or beyond the 50% mark, but general corporate rates are in the area of 26% to 31%, and small business corporate rates (on active business income up to $500,000 in most provinces) range from 9% to 15%. The variance depends on the provincial rates where a corporation is resident, with federal rates being consistent across the country.

Is passive income tax-preferred in a corporation?

In a single word, the answer is “no”, but it’s much more complicated than that.

For active business income, those lower corporate rates allow more after-tax cash to be reinvested in a business that is run through a corporation. The public policy purpose is to help businesses grow.

However, those low rates do not extend to non-business income earned in a portfolio – known as passive income – such as interest, dividends (Canadian or foreign) and capital gains. So, if passive income isn’t entitled to reduced tax rates, why invest in a portfolio within a corporation?

There’s more investible money if it stays in the corporation

When you use a corporation, income tax is charged first at the corporate level, with the net-of-tax amount added to the corporation’s retained earnings. Those retained earnings are eventually distributed as taxable dividends to shareholders. To protect taxpayers from double-taxation, the arithmetic is designed so that a shareholder’s personal tax on a dividend is reduced by the amount that the corporation has already paid.

Note though that a corporation is not required to immediately distribute its retained earnings. Apart from reinvesting in the business as noted above, those funds could go into a passive investment portfolio. As compared to paying a dividend (reduced by the associated tax) and investing in a personal portfolio, there will be more dollars to invest if the portfolio is at the corporate level.

But … the public policy response

As more can be invested at the corporate level, proportionately more passive income could be earned there. While this is understandably appealing to a shareholder and corporation, from the policymaker’s perspective it is an unintended consequence of this two-stage system: The use of the corporation as a more efficient form for business growth has arguably led to an extra benefit for earning passive income.

Emulating top personal tax rates

In response, additional corporate tax is imposed, making it less appealing to invest corporately. The additional tax takes the corporation approximately to the top personal tax bracket rate. Much of that extra tax is refunded to the corporation (see RDTOH following) when later dividends are paid – but not necessarily all of it. Again, it varies by province, and also by the type of income earned. For example, the combined corporate and personal tax can be 4% to 8% higher on interest earned through a corporation, as compared to earning interest in a personal portfolio.

The (intended) equalizer: Refundable-dividend-tax-on-hand

Historically, that extra tax has been tracked in the corporation’s refundable dividend tax on hand (RDTOH) account. In truth there are two RDTOH accounts, depending on whether the original income was charged the general corporate rate or the small business rate, but for simplicity in this article we’ll refer to it in the singular. Either way, RDTOH is effectively a deposit with the Canada Revenue Agency (CRA) that earns no income. Most taxpayers aren’t so generous to make such interest-free loans to the CRA, and that’s why it’s usually a priority to get that money back – refunded – so that it can be put back to work in the corporation, whether that’s as a business reinvestment or an addition to a passive portfolio.

When a taxable dividend is paid to a shareholder, a portion of the RDTOH balance is refunded to the corporation. The current refundable rate for present purposes is 38 1/3%, but a simpler way to express it (as a rough estimate) is that for every $5 dividend paid from the corporation to a shareholder, about $2 comes back to the corporation from its RDTOH.

Previously, any taxable dividend could recover refundable tax. As of 2019, refunds are generally only paid on dividends where the original corporate income was charged the small business rate (non-eligible dividends) or where it arises out of the corporation’s passive investment income.

Reduction in small business deduction threshold

A further implication of earning passive corporate income is the potential reduction in how much active business income (ABI) is entitled to the small business deduction (SBD) or rate. The SBD is available on income up to $500,000, but for every $1 of annual passive income, that threshold is reduced by $5. That means that if passive income exceeds $150,000 in a year, all active business income will be charged the general corporate rate.

What’s a shareholder to do?

As much of a challenge as all this presents, all is not lost for corporations and their shareholders.

First, your corporation pays no tax on Canadian dividends that are passed through to you as shareholder. Those dividends maintain their preferred tax treatment, the same as if the security had been in a personal portfolio. And as more dollars are available to be invested at the corporate portfolio level, as discussed above, more of those Canadian dividends can be generated.

Second, a corporate portfolio that grows through unrealized capital gains defers income realization. This in turn delays application of the passive rules. Ideally the portfolio would remain intact until there is a personal need for the funds. By cashing out the investment at the same time as an intended dividend, there will be minimal, if any, inefficient refundable tax balance.

Third, only a portion of capital gains are taxable, with the non-taxed portion able to be paid as a tax-free dividend. The current income inclusion rate is 1/2, with the corollary that the non-taxed portion is also 1/2.

And finally, a shareholder is likely to be at a lower tax bracket in later years. By consciously leaving an appropriate amount in a corporate portfolio, tax can be both deferred and reduced.

As always, tax should not be the primary consideration when investing. It can however have an especially large impact when income is originally earned in a corporation. With awareness of the passive tax rules, you can have a more informed conversation with your accountant and your investment advisor about how to manage your corporate portfolio.

When does corporate cash become investible?

Operational efficiency to investible surplus

Apart from pursing a passion, the purpose of running a business is to generate income. To the point, eventually you intend on spending what your hard work produces, and using the excess to invest in yourself and your future.

Sometimes the route from contributed capital to surplus cash is quick, direct and transparent. More often though, invested cash takes on a variety of forms as it travels through the enterprise before emerging as profit. How complex that route is and how long it takes depends on the scope and scale of the business.

That being the case, it can be difficult to determine when, where and how to use portfolio investments in a corporation.

It may help to use the analogy of the earth and its gravitational pull to follow the movement of cash through a corporation.

Operational efficiency –
Running the business

1. Inner core

Cash cycles through current assets such as prepaid expenses, inventory, and accounts receivable, and is applied to current liabilities as they come due. Some may be held in physical currency, but its use is more practically facilitated through deposits and short-term credit tools.

2. Outer core

Working capital is the continuous float – the ebb and flow between current assets and liabilities – that keeps a business running. Usually it is supported by a revolving line of credit so that the owner can focus on the business, and not accounting balances.

Working capital is not itself investible, but to the extent that efficiencies are applied (eg., timely use of payment terms, prompt account collections, optimal inventory levels, smart foreign exchange practices, etc.), more cash may be freed up to move up and out of a corporation.

3. Mantle & crust

Long-term assets are the structure within which the business produces its wares. They last for many years, but eventually have to be replaced in order to sustain productive capacity.

The cost of replacement is commonly managed through a combination of asset-backed loans and capital reserves. To assure that reserves are available when needed, safety and liquidity are the top priorities.

Investible surplus –
Breaking the business’ gravitational pull

4. Surface

Retained earnings is the after-tax money of the corporation. The portion of it that is not needed for business operations or capital reserves may be appropriate for passive portfolio investment.

5. Orbiting

A holding company may receive tax-free inter-corporate dividends on shares it holds in an operating company. This puts the extracted funds beyond the reach of operating company creditors, so may be a preferred place for portfolio investments. Where there is more than one business owner, each might establish a holding company so that respective funds and investment portfolios may be isolated.

6. Beyond gravity

Dividends to a shareholder may be placed in a personal non-registered investment account. Such dividends are taxable, meaning the personal investible amount is less than if it remained in a corporation. On the other hand, investment returns are taxed less favourably in a corporation, and sooner or later will have to cross that threshold for shareholder personal use. Tax advice is a must.

Estate freezing in an economic downturn?

A tax planning prompt for business owners[1]

For a few years beginning in 2020, the COVID-19 pandemic caused tremendous disruption and pain in both the personal sphere and in business activity. Owners of closely-held small businesses were especially vulnerable, with both their primary income source and invested capital at risk.

The stops and starts of multiple waves of the virus wreaked havoc and sewed uncertainty. Ironically though, this strange economic rollercoaster opened a window of tax opportunity for business owners who may have been hemming-and-hawing about succession. At the time it was the pandemic, but any economic condition that causes a dip in business value could present a ripe opportunity to proceed with an estate freeze.

Tax exposure on succession

Think of an entrepreneur who established a business corporation years ago, and now wants to bring adult children into ownership. The problem is that a direct share transfer would be a disposition. The capital gain is calculated as the difference between the fair market value and adjusted cost base (ACB). That could be a hefty tax bill for the parent, with a 1/2 income inclusion on capital gains up to $250,000 in the year such a transfer happens, and 2/3 inclusion on gains beyond that.

Whether the parent intends to make a gift or to have the children buy their way in, quite often the children don’t have the cash at present anyway. That means the parent will have to use other cash to pay that tax bill. A more likely reality for many business owners is that the bulk of their wealth is tied up in the business, so there is little if any readily available cash.

Thus, the prospect of paying that tax could be paralyzing. Business growth would continue to accrue to the parent as current full owner, as would the associated growing tax ty.

Enter the estate freeze

An estate freeze offers a more tax-efficient way to go about it. Future business growth is transferred to the successors, and the past growth is frozen in a way that ensures that no tax is incurred by the current owner in the present.

A familiar scenario is for the parent to exchange their common shares for preferred shares with the same value. These new ‘freeze’ shares won’t increase in value but will usually carry voting control and dividend rights. Often, it’s possible to increase the ACB on the shares using the lifetime capital gains exemption (LCGE), which stands at $1,250,000 in 2024 . Whether or not the LCGE is used in this way, no tax arises at the time of the exchange.

Tax is deferred until the parent disposes of these freeze shares. Sometimes the shares are redeemed by the corporation over a course of years, providing cash to the parent and spreading tax recognition. Otherwise, there’s a deemed disposition at the parent’s death, or on the later death of a spouse if the shares are rolled over to the spouse on that first death.

A new class of ‘growth’ shares is issued to the children for nominal cost. Alternatively, a trust may be set up to hold these shares for the children as beneficiaries, with legal control left in the hands of the parent as one of the trustees. No tax arises on this part of the plan either.

Future growth has been pushed down a generation, allowing for years or decades of deferral before future gains are exposed to tax.

Why freeze on a dip? Or re-freeze?

Apart from the terrible health crisis of COVID-19, it also had a negative impact on the financial value of many businesses. But with that downturn came opportunity. While there was no guarantee when and how much a given business may recover, those who executed a freeze at a depressed value were able to push a greater amount of future growth to their next generation.

Consider as well the LCGE, this time looking at the successors. The exemption applies on a per-person basis, allowing for a multiplication of its total benefit based on the number of new shareholders. And if the value falls so far that the parent is not able to use the full LCGE on the share exchange, the parent could choose to take some of the growth shares and thereby also participate in the upswing.

What about those who undertook a freeze years ago at a much higher value before the economic downturn (pandemic or otherwise) ate away at the business value? In that case, a thaw and re-freeze might be in order, effectively resetting at the current depressed value, again in anticipation of the recovery of the business itself.

As to determining the appropriate value, it needs to stand up to scrutiny should the Canada Revenue Agency inquire, so the best approach is to have a professional valuation.

Implications for life insurance

Upon a freeze, the parent’s taxable gain becomes both known and capped. This is an ideal application for life insurance on that parent, or a joint last-to-die policy on the parent-couple. Of course, less insurance is needed with a freeze at a lower value, but that’s only half the story.

The successor children will now expect to reap a greater proportion of the gain. Allowing that the amount of the gain is unknown (unlike for the parent) and that the LCGE may reduce the tax, this is a still a good time to open the insurance dialogue. If the child’s entrepreneurial drive matches the parent’s, greater growth may yet be ahead, and the insurance put in place today will feel like a bargain in hindsight when the child considers their own estate freeze down the line.

[1] A version of this article appeared in Advocis Forum.