Taxation of investment income in a corporation

Taxation of investment income in a corporation

If you thought navigating the maze of personal finance and investing options was challenging enough, you haven’t seen anything yet. Taxation of investment income in a corporation can be quite frankly, overwhelming.

How best to invest in a corporate account can be filled with a myriad of choices, decisions with many pros and cons based on the structure of our Canadian tax system and what objectives you have as an investor.

With thanks to Neal Winokur, my friend who is a Grumpy Accountant, I started to explore the world of paying yourself a salary or dividends from your corporation and hinted at what types of investments could be included inside a corporation:

Should take a salary or pay yourself a dividend from your corporation?

How might you invest inside a corporation?

I’ll link to these at the end of this post as well…

Taxation of investment income in a corporation

Today’s post is going to dig a bit deeper with some references, support and general guidance on the subject of taxation of investment income in a corporation.

But I didn’t want to do this post alone. I wanted to share and profile someone with direct experience with this on the site.

With thanks to Mark McGrath, who holds Chartered Investment Manager (CIM®), CERTIFIED FINANCIAL PLANNER®, and Chartered Life Underwriter (CLU®) designations as a Wealth Advisor with Wellington-Altus Private Wealth in Squamish (site link at end), I figured Mark would be the perfect person to expand on the work that Neal and I started – to highlight the taxation impacts of investment income in a corporation.

Mark works primarily with Canadian Physicians, of which about 70% are incorporated. So he deals with the taxation of corporate investment income on a near-daily basis.

While none of this post, like Neal’s, can be considered any tax nor investment advice, you are encouraged to use this information (current to the time of this post) as a guideline to trigger further due diligence with your tax professional or appropriate tax firm to ensure you are making the most suitable financial decision for your corporation and related needs. 

Mark, great name! Ha. Welcome to the site. A pleasure to discuss this valuable and comprehensive subject with you!

Thanks Mark, a pleasure to be here! Hopefully we don’t confuse your readers, both being Marks and all.

I’ll keep my questions in bold 🙂

Mark, thanks for following My Own Advisor with interest. It’s fun to run the site and interact with professionals like yourself. Let’s learn about you, Mark, including your background and experiences and a bit more if you don’t mind. So, tell us about yourself!

Well, I was going to be a famous rock star, but it didn’t pan out. I went to university with the intention of becoming a dentist since my dad told me that would be a great idea. One day a friend of mine introduced me to the Canadian Securities Course, and I fell in love. I quit university on the spot to study personal finance and investment management full-time, and here I am about 15 years later.

Over the past decade, I’ve worked primarily with Canadian physicians on financial planning, including tax, insurance, retirement, investment, and estate planning. I’m a bit of a planning geek, so I also spend a lot of my free time reading and writing about it. But when I need a break, I still occasionally pick up my guitar and remind myself why my dream of being a rock star was destined to fail.

Great stuff.

Mark, personal finance is personal – is a constant refrain on this site. Meaning, everyone’s financial situation is different albeit there are a few rules of thumb and general guiding principles everyone could consider. What’s your personal finance philosophy?

I couldn’t agree more. In fact, on my office bookshelf I have a sign that says ‘Keep Finance Personal’. I can’t take full credit for that, since I took it (with permission) from another advisor on Twitter. But you’re absolutely right – each family is unique, and everyone has different goals, knowledge levels, risk tolerances, and financial abilities.

I’m big on risk management and getting the important things right. If you do that, you’ll likely meet your goals. Sure, we can tune and optimize a lot of areas, but generally speaking – manage your budget, invest wisely, and don’t pay more tax than you need to, and you’ll likely meet your goals.

Before we get into some corporation and taxation nuts-and-bolts, how are you investing these days yourself? What personal finance taxation principles are you mindful and supportive of? (Example, are you a HUGE fan of the TFSA as much as I am?!) 

Managing the refund well is the linchpin in the RRSP vs. TFSA debate

How can you not be a huge of the TFSA? Especially now that the contribution room is starting to be meaningful for a lot of people. I’m regularly seeing TFSA balances north of $125k now, and for younger folks that can continue to compound their money tax-free over decades – it’s going to be a significant source of retirement income.

As for my investment philosophy, I’m a huge fan of indexing and factor-based strategies. My client portfolios are primarily all-in-one index ETFs, Dimensional Fund Advisors Global portfolios, and here and there a sprinkling of alternative assets where it makes sense.

On factor-investing, there’s compelling academic work that shows tilting your portfolio towards small-cap value stocks and profitable companies provides excess returns over long horizons. To implement this I use the Dimensional Funds I mentioned above. It’s not for everyone, but I’m a fan.

In my portfolio management client presentations, I present five core tenets of sound portfolio management – low-cost, well-diversified, passive, tax-efficient, and simple. There’s no perfect portfolio, unfortunately, but if you get the core philosophies right, you will be okay.

That’s great context for our continued discussions…

For many years, Canadian small business owners earning active business income within a Canadian Controlled Private Corporation (CCPC) have been eligible for the “small business deduction” – which allows the first $500,000 of profit to be taxed at the low 12.2% rate. Profit above $500,000 is taxed at 26.5%. That’s Ontario anyhow!

(Just a footnote for readers, this differs by province, for example in BC it’s 11% and 27%)

That mentioned, we know some small business owners are very profitable and they might consider investing within their corporation, with excess funds available to them.

Before small business owners even consider investing with excess funds available to them, what should they consider first? Maintaining an excess cash float perhaps or paying down debt? Thoughts?

Like all things in financial planning – it depends. Incorporating your business provides other advantages in many cases – like enhanced liability protection and access to the lifetime capital gains exemption on sale of the QSBC shares. So, for many, incorporating the business can make sense even if they aren’t seeing huge excess profits yet.

As for building a corporate investment portfolio, that also depends (sensing a theme yet?). While I’m no fan of debt, some people are comfortable with it and would prefer to keep their debt, in favour of building their investment portfolio. I think that argument is harder to make with current interest rates, but if you can earn a higher return on investment than you can by paying down debt, it can make sense.

Generally speaking, if paying down debt is a priority for you, you might want to delay incorporating your business until you’ve got that under control. If you’re not retaining money in your business, and you’re just paying it all out to yourself to pay down personal debt, then the advantages of being incorporated are reduced.

Like individuals, businesses need emergency accounts too. How much depends on the type of business and its sensitivity to cyclical effects or seasonality. This isn’t an issue for most of the physicians I work with, so their need for business emergency funds is low.

You’ll also need to set aside money each year for corporate income tax, accounting and legal fees, and depending on the business, GST/HST.

So overall, if you have retained earnings in your company, have your emergency and expense needs met, and have either paid off your debts or are comfortable keeping them – it’s probably time to put those profits to work and invest the money. Otherwise, it’s just sitting in your corporate bank account burning a hole in your pocket.

Thanks Mark.

Assuming Canadian small business owners have excess funds to invest, let’s consider the basics before different investment products – and any pros and cons of those investment products.

What are your thoughts on these references?

Reference 1:

https://enrichedthinking.scotiawealthmanagement.com/2022/11/04/passive-income-taxation-for-canadian-controlled-private-corporations/

Reference 2:

https://www.manulifeim.com/retail/ca/en/viewpoints/tax-planning/taxation-of-investment-income-within-a-corporation

It seems like income including interest, is taxed at roughly 50% across Canada!

Unfortunately, it is true. But it’s even more complicated than that.

First let’s make an important distinction – passive income in this context is income generated from investments inside your corporation. If you hold stocks, bonds, GICs, or rental properties for example – you’ll earn investment income in the form of interest, dividends, rental income, and capital gains. It’s this income that is subject to potentially high tax rates. Your active business income – the income you earn from running a business – is taxed quite favourably, as you mentioned above.

Different types of investment income are also taxed differently. For example, only half of a capital gain is taxable, whereas the full amount of interest earned is taxable. Understanding this allows you to build a more tax-efficient investment portfolio by avoiding or reducing certain types of investment income.

As the articles you referenced mention, once you have over $50,000 of taxable passive, your $500,000 small business deduction limit starts to get reduced. That means potentially more of your business income is taxed at the higher general rate, and less is taxed at the small business rate. It’s not the end of the world, and there are other tax mechanisms and strategies you can employ to offset some of this, but it sure gets complicated. Also, you can’t easily get around this just by having a holding company, since CRA will generally look at both corporations as one entity for this purpose. Understanding this yourself or having a good professional team that understands it can help you achieve one of those philosophies I mentioned – don’t pay more tax than you need to.

Totally.

Let’s walk through a couple of examples.

First, how about the consideration that some Canadian small business owners might want to invest in Canadian dividend paying stocks, inside their corporate account.

Let’s compare this to investing inside the RRSP. Thoughts?

As you and many of your readers are aware, your corporation can open an investment account with an online discount brokerage – the same way you can open a personal RRSP or TFSA. That corporate investment account can hold the same types of investments as your personal investment accounts – stocks, bonds, ETFs, mutual funds, GICs, etc. As we’ve discussed, taxes can be high on these investments, and it makes sense to first ensure your RRSP and TFSA are maxed out. This does a few things for you:

1. Tax diversification. We know how RRSPs and TFSAs are taxed, and that’s not likely to change. Tax legislation has targeted small business taxation several times historically, and who knows how your corporation will be taxed in the future. By spreading out your investments across multiple account types, you reduce the impact of any potential tax change on any one of those accounts.
2. You reduce the amount of money in your corporate investment account. This can help reduce your passive income and maintain the small business deduction limit. It also helps preserve the lifetime capital gains exemption if you go on to sell your business down the road.
3. RRSPs are usually protected from creditors. If you are sued personally, assuming you didn’t stuff money into your RRSP specifically to protect the money, it should be creditor-proof. But the shares of your small business corporation are fair game.
4. You can split RRIF income with your spouse after age 65 in Canada. This can lower the overall family tax bill. That’s not a default option with your corporation unless your spouse also owns shares of the company, which may or may not be the case. And it’s not as simple as just giving your spouse shares – there are some complex tax rules preventing that.

The downsides are:

1. The money is no longer available for business use. With good planning, this shouldn’t be an issue, but it’s something to consider.
2. To get RRSP room, you need to pay yourself salary. Because dividend income is not considered earned income, it doesn’t generate RRSP contribution room. So, in some cases your only option is the TFSA, and for many that’s just not enough contribution room to make a difference. And since you need to pay tax on the dividend, you have less capital after-tax to contribute to the TFSA.I usually like to see physicians and business owners paying a decent amount of salary for this reason.

But you asked about Canadian dividend-paying stocks.

It’s complex, but a special type of income tax is applied to a corporation’s investment income. It’s commonly known as refundable tax, and it’s to dissuade people from setting up personal investment corporations just for tax benefits. Basically, when you earn passive investment income in a corporation, the Federal Government hangs on to some of that income until you pay yourself a dividend from your corporation, at which point you can get that tax refunded. Canadian dividend income is special, though – the entire amount of tax you pay is refundable. So, Canadian dividends pass right through the corporate investment account without getting taxed. Of course, you’ll pay tax personally by paying those dividends out to yourself, but overall, Canadian dividends are pretty tax-efficient in a corporation.

(Mark Seed – more reading: https://www.cibc.com/content/dam/personal_banking/advice_centre/tax-savings/in-good-company-en.pdf)

(Mark Seed personal comment: I continue to max out my TFSAs and RRSPs, and then depending on my personal tax bracket over time, I will take extra dividends or bonuses and invest it personally over time. Certainly, if my corporation does well, it could be smart for me to keep retained earnings given the corporation can still provide a decent or significant tax deferral. Thoughts readers?)

OK, another example.

What about passive investing and being tax-efficient in doing so. I interviewed Mark Noble from Horizons ETFs a while back and highlighted some ETFs that Horizons (and other providers offer) for that reason.

What are the pros and cons of investing inside the corporate account, with such ETFs with a total return approach vs. using a personal taxable account?

I’m a big fan of the Horizons Total Returns ETFs and use them frequently in corporate investment accounts for clients. As your readers likely know, they convert investment income into deferred capital gains. So instead of receiving a dollar of interest or dividends, the ETF’s share price goes up by a dollar. This helps not only by reducing tax on investment income but also by deferring it.

You can use these for personal non-registered accounts too. Depending on your tax bracket, they can be very efficient. These ETFs do have additional costs compared to the more well-known index ETFs, but that additional cost can be offset, and more, in tax savings.

Indexing in general is pretty tax-efficient for two reasons:

1. Low turnover. With an active investment strategy, you or the fund manager are buying and selling securities. This can create capital gains and losses, which are taxable in the year they are realized. Usually, the more turnover, the higher the realized capital gain, and that creates a tax drag on your portfolio. Essentially you realize more taxes on average than you would be if you were able to defer that capital gain into the future.
2. ETF structures are different from mutual fund structures. While there are index mutual funds and actively managed ETFs, I’m guessing most of your readers that are using an indexing strategy are using ETFs. And the actions of other ETF shareholders have no bearing on the taxes you pay. I like to explain it like this – imagine you’re a mutual fund investor, and you have $100,000 in XYZ mutual fund. The only other investor is Warren Buffet, and he has $100,000,000 of his money in the fund. Well, what if Warren Buffet decides to sell his stake? In that case, the fund managers sell 99% of the stocks to get Warren his money, but any capital gains they trigger are spread out among all the unit holders, pro-rated. So, you end up paying capital gains on your shares based on the actions of the other unitholders.

There are two big differences between using these ETFs in a corporate account vs. using them in a personal account:

1. Your starting investment balance will be reduced if you invest personally. Say you have $100,000 of retained earnings. In your corporate portfolio, that’s $100,000 you get to invest. But if you want to invest that personally, you must pay yourself a dividend or salary and pay tax first. If you’re in the top tax bracket, that means you’re starting with less than $50,000 after-tax to invest personally.
2. Capital Dividend Account. When you earn capital gains on the investments in your corporation, only half of the gain is taxable – much like if you earned a capital gain personally. The other half is tax free. So, if you have a $10,000 capital gain in your corporation, you can then generally pay yourself a $5,000 tax-free capital dividend. The other half goes on the corporate tax return and is subject to those high tax rates we talked about. Overall, it’s pretty tax efficient.

So, in some cases it can make sense to invest the money in your corporation, and then pay out the capital dividends tax-free. You can use that money to fund your RRSPs, TFSAs, or invest in a non-registered account.

Exactly where I’m going, Mark.

As we start to wrap, what should Canadian small business owners leave with when it comes to the taxation of investment income inside a corporation?

• First, it’s important to have a good tax accountant, and if you use a financial planner make sure they understand the tax nuances of corporations. Beyond just the investment portfolio, there is a lot of complexity with insurance, retirement, and estate planning, and you want to ensure you’re working with someone who understands the impact to these areas. I know most of your readers likely don’t work with advisors – hence the name of your blog – but for those that do, this is paramount.
• Weigh the potential benefits of using a corporation for your investment portfolio vs. the additional complexity and cost. In some cases, you might opt to pay the money out of the company and invest it personally. While you might give up some tax benefits in doing so, you can gain some simplicity and peace of mind, and for many, that’s valuable.
• In your articles with Neal you talked about tax integration, which is the mechanism that ensures that whether you are incorporated or not, you’re going to pay a similar amount of tax in the end. While you can optimize things to pay less tax using a corporation, you can’t eliminate the tax bill – only control the timing of it.
• Look to increase the tax efficiency of your corporate investment portfolio by targeting investments that pay capital gains and Canadian dividends. But don’t let the tax tail wag the risk-management dog – you still want to be diversified.
• Understand the impact of refundable tax on your corporate investment income, and make sure you’re paying yourself enough dividends to get this back.
• Look to pay out capital dividends – that’s the tax-free half of your capital gains – when you can. Note that your accountant will charge a fee for this, since there’s an election to file. So you might want to do this every few years or whenever it makes sense from a cost-benefit standpoint.

Ultimately, whether a corporate structure will benefit you comes down to your specific situation. Can you retain significant earnings consistently? Do you need the liability protection a corporation provides? Can you sell your business one day and take advantage of the lifetime capital exemption? Are you comfortable with some added costs and complexity if it means the potential for some of the benefits listed above?

If you answer yes to any of those questions, it’s at least worth exploring whether a corporation is right for you.

There are a lot of other considerations that are beyond the scope of our discussion, Mark. Areas like estate planning and insurance are deeply impacted by incorporating as well. Maybe a topic for another chat!

Indeed, let’s consider that!

Mark, very prudent and detailed information. Thanks for doing this.

Readers, I first want to thank Mark McGrath for taking the time to share his expertise. Second, while none of this post can be considered tax advice there are some considerations above to think about including if it even makes sense to invest inside a corporation. Third, our tax system is unbelieveably complex on a good day so on that note, incorporation is not for everyone. Some folks can and should consider running any small business as a sole proprietor with proper business insurance. When in doubt, seek professional tax advice.

I look forward to posting more detailed content on this site. If can’t find what you’re looking for, via my Search bar, then hit me up with an email or a comment below. I will do my best to accommodate.

Mark (Seed) 🙂

Disclaimers:

This post is about general tax perspectives and is not considered personal tax advice to My Own Advisor or any reader. You are encouraged to seek the personal and professional counsel of a tax expert whenever you are in doubt or should you need any support for your personal or corporate investing needs.

Mark McGrath is a Wealth Advisor with Wellington-Altus Private Wealth (WAPW). (Site Link).

The information contained herein is the opinion of the author and not of WAPW. This article is for informational purposes only and is not intended as investment, tax or legal advice. Please contact your financial advisor for advice with respect to your personal financial situation and objectives. WAPW is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. You can also follow Mark McGrath on the Twitter machine like I do @MarkMcGrathCFP.

Related Reading:

Learn about tax efficient investing using Horizons ETFs.

Should take a salary or pay yourself a dividend from your corporation?

How might you invest inside a corporation?

How much cash on hand should you really keep?