How Business Owners can increase their Retirement Savings by Investing within their Corporation.
A great strategy many owners of Canadian-controlled private corporations (CCPC) use to build up retirement savings is to invest within their corporation using the benefit of the tax deferral between their personal income tax rate and the small business income tax rate.
Why invest with your CCPC?
Investing within your CCPC offers the potential to defer the taxation versus simply paying out the income to yourself and then investing the after-tax capital. The reason is if your company is earning active business income, you should be able to claim the small business deduction (SBD) which allows a Canadian-controlled private corporation (CCPC) to pay a lower tax rate to a $500,000 threshold in most provinces. This tax rate could be lower than your personal tax rate.
This strategy has become more complex recently with the introduction of the new passive investment rules in 2018, but it can be managed.
Active Business Income:
In Ontario for example, the small business tax rate is 12.20%. If you don’t require all of the after-tax profits from your company for your current lifestyle, you may have the opportunity for a significant tax deferral. This is the dollar value difference between leaving the money in your corporation and paying the money out of your corporation to yourself. The tax deferral is the difference between the top personal tax rate in Ontario of 53.53 % and the 12.20 % Corporate Tax rate, which is about a 41.33% tax deferral.
For instance, at various income levels in Ontario:
Income Levels Marginal Personal Tax Rate Corporate Tax Rate Tax Deferral
$221,709 and up 53.53% 12.20% 41.33 %
$220,001-221,708 49.91% 12.20% 37.71 %
$155,626-220,000 48.35% 12.20% 36.15%
Source: Mackenzie Financial Personal Tax Quick Reference Card 2022
By way of illustration, let’s say your company’s business income was $450,000, you paid yourself $300,000 for lifestyle, (so you are at the top personal tax income level) and you had a surplus of $150,000 that you were thinking of investing within your corporation, or taking as income, paying the tax, and then investing. The difference between the two options are:
· Withdraw the additional $150,000 from the company, pay the tax (53.53%) and invest, which would leave you with $69,705 to invest after personal tax.
· Leave the $150,000 in the company, pay the corporate tax (12.20%) and then invest, which would leave you with $131,700 to invest after corporate tax.
· The difference is the tax deferral of 41.33% between your personal and corporate tax rate, or $61,995.
· You can see if you did this over numerous years, you could dramatically increase your savings.
Taxation of Passive Income within your CCPC
There is a difference between earning active business income, and passive business income within your corporation. Active business income is income from your on-going operations, and passive income is income generated from your investments.
Under the theory of integration, there should be no income tax advantage on the income earned from your investments within your corporation and flowing them out to you personally vs earning the investment income individually.
Integration of Taxes between your CCPC and Personal Income:
The income you earn on investments is taxed within your CCPC, and again when withdrawn and paid to you as a dividend from your company. To keep the level of overall taxation approximately the same there are two mechanisms at work, the Eligible and Non-Eligible Refundable Dividend Tax on Hand (RDTOH) and the Capital Dividend Account (CDA). These are notional accounts that your accountant will track for you.
For example, the non-eligible RDTOH means as non-eligible dividends are paid to you, the corporation is reimbursed some of the tax it has paid. The Corporate Dividend Account is a tax-free amount built up by the non-taxable amounts of capital gains. If you wish to know the specifics, please contact your accountant.
More importantly the tax rules do not allow a tax deferral on investment income, and as a result the investment income earned within a corporation is not eligible for the small business deduction (SBD). Instead, the corporate tax rate on investment income is much higher than active business income. The reason for this is the government does not want taxpayers gaining a tax deferral on investment income the way they do on business income.
Investing within a Corporation (Passive Income)
If you build up an investment portfolio within your corporation, using the advantage of the tax deferral, the tax implications will depend on the type of income the portfolio earns. Currently in Ontario, the flat tax effective income from most tax effective to least is:
1. Capital Gains — 25.3 % tax
2. Canadian Eligible Dividend Income – 38.3 % tax
3. Interest Income – 50.70 % tax
Source: Mackenzie Financial: 2022 Income in a Corporation
To reduce your tax burden you will want to have investments that generate capital gains and dividend income, and avoid interest income and foreign dividends.
The combined personal and corporate tax rate when the income is paid out to you as non-eligible dividends at the top marginal tax rate is:
1. Capital Gains — Est 29.0 % tax
2. Canadian Eligible Dividend Income – Max 39.3 % tax
3. Interest Income – Est 57.90% tax
Source Mackenzie Financial: 2022 Income in a Corporation for Ontario
Passive Investment Rule Changes 2018
Starting in 2019, there were changes to the passive income rules called the small business limit reduction. Once your passive income exceeds $50,000/year, the incorporated business starts to lose the small business tax rate for active business income under $500,000/year. For every $1 of passive income over $50,000/year, the business will lose $5 of the $500,000 small business limit. Once your passive income is over $150,000, you would no longer have access to the small business rate on active business income. (be sure to consult your accountant about this)
Based on the passive investment rules, you will want tax effective investments to preserve your access to the tax rate under the $500,000 small business limit.
These tax rules and calculations are complex, and you will want to make sure you work hand in hand with your accountant when you invest within your CCPC.
Corporate Class Mutual Funds – A Solution
Since you want to avoid interest income in your CCPC if possible, Corporate Class Mutual Funds can be used to reduce your overall tax burden. These types of mutual funds allow the CCPC to invest in investments that generate capital gains and dividend income, and avoid distributions of interest income/foreign dividends.
Corporate class funds are different from a regular trust version of a mutual fund since they are set up as a corporation. The main advantages or features of corporate class funds are:
· They can only generate capital gains or dividend income. This is regardless of the underlying asset mix of the portfolio, so you can have a globally diversified portfolio with fixed income investments.
· Taxable distributions tend to be lower than the trust version of the same fund.
· Many investment companies have high net worth programs with lower MERs (management expense ratio) and have structures to make the management fees tax deductible.
· They help to lower your overall tax rate to avoid the new passive investment income limit rules.
The Capital Dividend Account Advantage
Since corporate class funds pay out primarily capital gains, owners of CCPC can also take advantage of the capital dividend account (CDA). As mentioned, the capital dividend account is a notional account that tracks the various tax-free amounts accumulated by the corporation, which can eventually be paid out as tax-free dividends.
Due to the concept of Integration discussed earlier, 50% of the capital gains that are not taxable from corporate class funds are added to the CDA – which can eventually be paid out tax-free to the shareholder.
A great strategy to build additional savings for retirement is investing within a Canadian-controlled private company (CCPC), using the significant tax deferral mechanism. At the top personal tax rate, you could have a tax deferral of 41.33%.
The use of corporate class funds within this strategy can be a powerful benefit to:
· reduce the current tax burden with your corporation,
· build up your corporate dividend account,
· and help protect your small business tax deduction.
Be sure to review investing within your corporation using corporate class funds with your financial advisor and accountant to determine if it can be a benefit to your situation and retirement planning.
For more information you can refer to Preserving Wealth: The Next Generation – The definitive guide to protecting, investing, and transferring wealth by Jack Lumsden, MBA, CFP®
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Jack Lumsden, MBA,CFP® Financial Advisor, Assante Financial Management Ltd.
This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see me for individual financial advice based on your personal circumstances. The information provided is for illustrative purposes only. Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing.
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