menu

Toronto Team  

 
Contact
  • T416.203.0067
  • 1.866.242.0203
  • F416.203.0544
  • 8 Wellington Street East
    3rd Floor
  • Toronto, Ontario M5E 1C5
September-28-17

Corporate Taxation: The “Eggs-act” Science of Capital Gains Taxation

In past posts, when I’ve mentioned making corporate investments to better feather your company nest, I’ve suggested taking a relatively conservative approach. Companies and individuals alike can get burned by flying too high in pursuit of hot stock tips. That said, a modest allocation to the stock market can make sense, lest your nest eggs ultimately yield little more than a goose egg’s worth of returns.

If you do choose to invest some of your corporate investments in equities, some of the returns will take the form of capital gains, so let’s brush up on the tax implications of earning these within a corporation.

For our example, we’ll assume an Ontario business owner purchases $10,000 in stocks for their corporate account in 1997. Fortune smiles on the investment and, by 2016, it’s worth $30,000. (Caveat: Remember stocks can just as easily underperform, especially across a few years, so it’s usually best to temper riskier equity investments with some safer holdings as well.)

To lock in the ample returns, the business owner sells the holding, realizing a $20,000 capital gain ($30,000 – $10,000). At tax time, they enter the purchase and sale details on Schedule 6 of their 2016 corporate tax return.

Source: 2016 Corporate Taxprep, Schedule 6 (Summary of Dispositions of Capital Property)

 

Two sides of the same coin

For corporations and individuals alike, only half of the realized capital gain is taxable as income, while the other half is tax-free. So, for reporting purposes, what happens to that $10,000 taxable portion, and where does the non-taxable half go?

First, federal taxes of 38.67% are levied on the taxable portion of the capital gain (with 30.67% refundable and 8% non-refundable), followed by non-refundable provincial or territorial taxes. In Ontario, this results in 50.17% of total investment taxes payable (38.67% + 11.5% in Ontario).

Tax integration for the taxable portion of capital gains also works the same as for interest income. Both the after-tax corporate income and the refundable taxes are available to distribute to shareholders. Once these are distributed, they are taxable in the shareholder’s hands at their personal ineligible dividend tax rate. (I’ve included the same example below from Corporate Taxation: Tax Integration of Canadian Interest Income.)

Corporate Taxation and Tax Integration of the Taxable Portion of Capital Gains

General Formula Amount Calculation
Taxable portion of capital gain $10,000 $20,000 × 50%
Deduct:
Part I tax – non-refundable
($800) $10,000 × 8%
Deduct:
Part I tax – refundable
($3,067) $10,000 × 30.67%
Deduct:
Provincial or territorial tax – non-refundable
($1,150) $10,000 × 11.5% (Ontario)
Equals:
After-tax corporate income
$4,983 $10,000 - $5,017
Add-back:
Refundable taxes
$3,067 $10,000 × 30.67%
Equals:
Amount available to distribute as a taxable dividend
$8,050 $4,983 + $3,067
Deduct:
Personal tax payable
($3,647) $8,050 × 45.30%
Equals:
After-tax cash
$4,403 $8,050 - $3,647

 

It’s not half bad

That’s not the entire story though. There’s still the matter of the non-taxable half of the capital gain. If this weren’t separately accounted for, it would end up taxed as an ineligible dividend when it was eventually distributed to the business owner (which doesn’t seem fair, as individual investors pay no tax on this part of the gain).

Thankfully, capital dividends come to our rescue. As it turns out, the government allows the non-taxable portion of the capital gain to be distributed tax-free to shareholders. The balance of tax-free amounts available for distribution are tracked in a notional account cleverly entitled the capital dividend account (CDA). If there is a positive balance in the CDA, these tax-free capital dividends can be paid to shareholders.

As you might expect when the phrase “tax-free” is involved, the Canada Revenue Agency is very strict on the steps required to distribute capital dividends. For the dividend to be tax-free, the company must file an election using Form T2054 - Election for a Capital Dividend Under Subsection 83(2), on or before the earlier of the day that the dividend is paid or becomes payable. A certified copy of the Director’s resolution authorizing the election, and a calculation showing the amount of the corporation’s CDA balance must also be included in the filing. Any errors can result in significant tax penalties.

Once the dividends have been paid from the capital dividend account, they are included on line 510 of Schedule 3.

Source: 2016 Corporate Taxprep – Form T2054 - Election for a Capital Dividend Under Subsection 83(2)

 

Source: 2016 Corporate Taxprep - Schedule 89 – Request for Capital Dividend Account Balance Verification

 

Source: 2016 Corporate Taxprep - Schedule 3 – Dividends Received, Taxable Dividends Paid, and Part IV Tax Calculations

 

If you’ve been following my corporate taxation series, the only new concept from this blog post is the use of the capital dividend account, which makes this post a relative recess for you. Next up, we’ll get back in the classroom to discuss a corporate capital gains tax strategy called Tax Gain Harvesting.

By: Justin Bender | 0 comments
September-14-17

A Scotia iTRADE Commission-Free ETF Portfolio Even Costanza Could Love

George Costanza: I'll sniff out a deal. I have a sixth sense.

Jerry Seinfeld: Cheapness is not a sense.

 

I have a brother I love a lot … and who reminds me a lot of George Costanza. I’ll bet every family has one. If you don’t think so, look in the mirror; it’s probably you. When it comes to sniffing out deals, my real-life bro is every bit as talented as the fictional George, so I wasn’t surprised when he asked me to create a set of commission-free ETF portfolios he could implement in his Scotia iTRADE account.

Challenge accepted.

Scotia iTRADE gets a massive fail for charging $25 trading commissions on portfolios below $50,000 (unless you’re a loyal customer). Maybe to make up for the price gouging, Scotia offers 50 commission-free ETFs you can trade without fear of depleting your hard-earned nest egg. (And no, that’s not a picture of my brother there … although it could be.)

Before you get too jazzed up about that, the majority of these misfit commission-free ETFs have no place in a prudent portfolio. Luckily for you, I’ve sorted through the mess, back-tested the strategies, and selected five of them that made the cut, and should hopefully track my official model ETF portfolios reasonably well over the long-term. Deal-sniffers of the world, rejoice!

Download the Scotia iTRADE Commission-Free Model ETF Portfolios

In the commentary that follows, I’ll discuss some of the main differences between the original ETFs and Scotia’s commission-free replacement ETFs for each asset class.

Canadian Equities

The Horizons S&P/TSX 60 Index ETF (HXT) replaces the Vanguard FTSE Canada All Cap Index ETF (VCN) in the commission-free version of my model portfolios. HXT excludes mid-size and smaller companies, making it less diversified than VCN. It also uses a more complicated swap structure to obtain its Canadian equity exposure, which some investors may not like. On the plus side, HXT is the cheapest Canadian equity ETF available, with fees of only 0.03% per year.

U.S. Equities

The Horizons S&P 500 Index ETF (HXS) replaces the iShares Core S&P U.S. Total Market Index ETF (XUU). HXS also excludes mid-size and smaller companies, and uses a swap structure to obtain its U.S. large cap equity exposure. Fortunately, this swap structure allows HXS to avoid the additional tax drag from foreign withholding taxes in registered and tax-free accounts, saving investors roughly 0.30% per year. Unfortunately, this swap structure also adds 0.30% annually to the fund’s trading costs, completely offsetting the initial tax savings. HXS is also slightly more expensive than XUU (0.11% vs. 0.07%).

International Equities

The Vanguard FTSE Developed All Cap ex U.S. Index ETF (CAD-hedged) (VEF) has a number of notable differences from the iShares Core MSCI EAFE IMI Index ETF (XEF). First off, VEF hedges away its foreign currency exposure, while XEF rides it out, for better or for worse. In years when the Canadian dollar has significantly appreciated (depreciated) against a basket of foreign currencies, I would expect that VEF would outperform (underperform) XEF.

Secondly, VEF includes an 8.3% allocation to Canadian equities whereas XEF excludes Canadian equities. In a typical balanced portfolio, this would result in an additional ~1.25% portfolio allocation to Canadian equities. This is not really something to lose sleep over, but I point it out for the record.

Third, VEF (unlike XEF) doesn’t hold its underlying stocks directly – it simply holds its US-listed ETF counterpart, the Vanguard FTSE Developed Markets ETF (VEA). Although this may seem like a reasonably efficient way for a Canadian fund company to avoid reinventing the wheel, it results in an additional layer of foreign withholding taxes. If you hold VEF in a registered or tax-free account, I would estimate the additional tax drag at around 0.37% per year, relative to holding XEF.

Finally, as VEF follows a FTSE index, it includes Korea as a developed market. (XEF follows an MSCI index, which still considers Korea to be an emerging market.). This only becomes an issue if you combine a FTSE-following developed markets ETF with an MSCI-mimicking emerging markets ETF; you’ll end up holding Korea in both ETFs. Which brings us to our next asset class …

Emerging Markets Equities

The iShares Core MSCI Emerging Markets IMI Index ETF (XEC) is the only fund you’ll find in both my regular model portfolios and on the Scotia iTRADE commission-free ETF list – so no substitution required. As I mentioned above, MSCI treats Korea as an emerging market, resulting in a double allocation to the country’s stocks. The end result for a balanced portfolio would be an additional ~0.75% allocation to Korean stocks. I think even an index investing purist can live with this.

Fixed Income

Plain-vanilla, broad-market bond ETFs tend to be highly interchangeable, so it was an easy decision to ditch the BMO Aggregate Bond Index ETF (ZAG) and replace it with the iShares High Quality Canadian Bond Index ETF (XQB). XQB does have a few slight differences, such as a 40% allocation to corporate bonds, versus ZAG’s allocation of just under 30%. If you’re holding your fixed income in a taxable account, you may want to ditch these ETFs entirely and consider a more tax-efficient product, like the BMO Discount Bond Index ETF (ZDB). Even if you have to eat a trading commission, the trade-off seems worth it.

Dimes worth of difference

So brother against brother, which of “our” portfolios is expected to come out ahead after costs? Although the above differences may result in over- or under-performance from year to year, I would expect both of us to share similar performance over the long term. That should make my parents happy, as they always hoped we’d eventually learn to share.

Here are a back-tested return comparison table and chart for the balanced portfolios from each model. As you can see, the results were almost identical over the past 20 years.

Model ETF Portfolio Return Comparison as of June 30, 2017

Measurement Period Balanced Portfolio (Scotia iTRADE Commission-Free ETFs) Balanced Portfolio Difference
YTD 3.98% 4.29% (0.31%)
1 Year 10.14% 9.74% 0.40%
3 Years (annualized) 7.04% 7.10% (0.06%)
5 Years (annualized) 9.43% 9.74% (0.31%)
10 Years (annualized) 5.41% 5.75% (0.34%)
20 Years (annualized) 6.32% 6.34% (0.02%)

 

By: Justin Bender | 0 comments
September-05-17

Corporate Taxation: The End of Refundable Taxes?

By now, you’ve likely been bombarded by articles – shelling out nearly as many opinions – on the government’s proposed tax changes for private corporations of all size. Remember that dividend refund “magic act” I covered? Guess what – that’s one of the tax breaks targeted for elimination. As you might imagine, this is causing quite a stir in the business community, with outcries ranging from “Government extortion!” to “It’s about freaking time!”

To inject some objectivity into the emotionally charged debates, let’s take a look at the numbers. Conclude what you will, and if you’d like to weigh in on the matter, the Department of Finance is inviting comments through October 2, 2017.   

All’s fair in love, war … and tax codes

As I introduced in my dividend refund post, the federal government currently taxes 38.67% of a corporation’s passive interest income (plus provincial or territorial taxes). The corporation can then file for a 30.67% refund (with 8% non-refundable) once the taxable dividends are paid out to shareholders.

The government has proposed eliminating that refund entirely. Instead of just 8%, the entire 38.67% would become non-refundable.

What’s with the change in heart? Although the dividend refund mechanisms I described in my previous post allows integration to function reasonably well in theory (so everybody pays their fair tax share), it has tended to play out a little differently in reality. Small business owners are initially taxed at a much lower rate on their active business income than regular taxpayers incur on their personal income. In Ontario, the difference is 15% for small-business corporate taxes versus a top tax rate of 53.53% on personal taxes. This gives small businesses a big head start on the after-tax cash they’ve got left to invest in passive corporate investment portfolios. In industry jargon, they’re scoring an impressive tax deferral benefit.

To re-level the playing field, the government considered a few other ideas, but scrapped them as impractical for reasons I won’t inflict on you at this time. By settling on the current proposal – making all corporate taxes on passive investment income non-refundable – the goal is to make it a relatively moot tax point whether business owners invest their active business income in their corporate passive portfolio, or distribute the income to themselves (or other shareholders) for investing personally.  

That’s the theory. Will it work in reality? Keep reading to see how the numbers compare. (And if you’re really a glutton for punishment, here’s a spreadsheet with the background calculations.)

Two’s company, three’s a crowd

In the example below, I’ve compared three taxpayers:

  1. An individual taxpayer
  2. A corporation taxed under the current (refund) system
  3. A corporation taxed under the proposed (non-refund) system

All three start with $100,000 of income that’s initially taxed at the top Ontario tax rate of 53.53% for the individual or the small-business tax rate of 15% for the corporations. The after-tax proceeds are then invested in portfolios earning 3% annual interest, taxed again, and then reinvested each year. The corporations pay 50.17% tax on their investment income each year, while the individual pays tax at 53.53%. At the end of 10 years, the corporations’ active business income and investment income is distributed to the business owners and taxed in their hands.

Starting portfolio (Ontario)

  Individual Corporation: Current System Corporation: Proposed System
Income $100,000 $100,000 $100,000
Combined federal/provincial personal or corporate tax ($53,530) ($15,000) ($15,000)
Starting portfolio $46,470 $85,000 $85,000

Sources: KPMG 2016 Personal Tax Rates, KPMG 2016 Corporate Tax Rates

 

On your marks … Get set … Get a head start

Under the current and proposed systems, the individual taxpayer’s starting portfolio is $38,530 less than either of the business owners’ portfolios ($85,000 - $46,470). The individual earns $1,394 of investment income in the first year ($46,470 × 3%) and pays $746 of federal/provincial taxes ($1,394 × 53.53%), leaving $648 of after-tax investment income after year-end ($1,394 - $746).

Both corporate portfolios earn $2,550 of interest in year one ($85,000 × 3%) and incur $1,279 in corporate taxes ($2,550 × 50.17%), leaving $1,271 of after-tax investment income ($2,550 - $1,279). The only difference is that the corporation under the current system designates $782 of the federal taxes as refundable ($2,550 × 30.67%), while the corporation under the proposed system makes no such distinction – all taxes are non-refundable.

Although this distinction initially makes no difference to the corporate taxes payable after year one ($1,279 either way), we’ll soon see how it paves the way for a dramatic impact on a business owner’s net worth once taxable dividends are distributed from the corporation to its shareholders after many years of investment growth.

After-tax investment income after 1 year (Ontario)

Return on investment in year 1 Individual Corporation: Current System Corporation: Proposed System
Starting portfolio $46,470 $85,000 $85,000
Earn: 3% interest $1,394 $2,550 $2,550
Deduct: Federal/provincial personal tax ($746) - -
Deduct: Part I federal tax – refundable - ($782) -
Deduct: Part I federal tax – non-refundable - ($204) ($986)
Deduct: Provincial taxes – non-refundable - ($293) ($293)
Equals after-tax investment income $648 $1,271 $1,271

Sources: KPMG 2016 Personal Tax Rates, KPMG 2016 Corporate Tax Rates

 

The better part of a decade

After 10 years, the individual taxpayer (who has already paid taxes on the initial income, plus annual taxes on the 3% investment returns), has no additional taxes to fork over. Their portfolio is now worth $53,370.

Under the current corporate system, $8,368 of refundable taxes have accumulated, as well as $98,596 of active business income and after-tax investment earnings. The total taxable dividend amount of $106,965 ($8,368 + $98,596) is then distributed to shareholders and taxed in their hands as ineligible dividends – roughly 45.30% for an Ontario taxpayer in the top tax bracket. Once integration has supposedly done its job (so everyone ends up shouldering an equal tax burden), the business owner now has a net worth of $58,505. Whoops – that’s $5,135 more than the individual investor after 10 years ($58,505 vs. $53,370).

Enter the proposed corporate system, with its one tweak to eliminate refunds on all of a corporation’s passive investment income. Without the refundable taxes, that leaves only $98,596 (instead of $106,965) to distribute as taxable dividends to the shareholders. After they pay their personal taxes on the proceeds, they’re left with $53,928. That’s just $558 more than the individual investor ($53,928 vs. $53,370).

It would appear that the proposed system would come much closer to true integration between business owners’ and individual taxpayers’ investment interests.

After-tax portfolio value after 10 years (Ontario)

  Individual Corporation: Current System Corporation: Proposed System
Portfolio value after 10 years $53,370 $98,596 $98,596
Add: Refundable taxes - $8,368 -
Equals: Available dividends to distribute to shareholders - $106,965 $98,596
Deduct: Personal tax on dividends - ($48,460) ($44,669)
Net worth $53,370 $58,505 $53,928

Sources: KPMG 2016 Personal Tax Rates, KPMG 2016 Corporate Tax Rates

 

Every decade counts

As you might guess, under the current system, the further out we extend our illustration, the bigger the gap grows between individual and corporate after-tax passive investment returns. Below, I illustrate the dramatic difference the proposed change would make after 30 years.

Sources: KPMG 2016 Personal Tax Rates, KPMG 2016 Corporate Tax Rates

 

It ain’t over yet

As touched on above, everything I’ve just covered is still just a proposal, which means it is subject to change after the October 2, 2017 consultation period ends. That’s blog-job security for me, since I’ll want to take another look at it once the final results are in. Coming up next, we’ll see how capital gains are taxed within a corporation.

By: Justin Bender | 8 comments