Using a Corporation to Hold Your Investments

In December 2011, I wrote a post titled “Should your Investment Income be Earned in a Corporation”. Notwithstanding this post, I continue to receive questions and emails on two related topics:

1. Readers who are earning substantial personal investment income ask; should they transfer their investments into a corporation?

2. Small business owners with excess investable assets inquire if they should incorporate a holding company to hold the shares of their existing active corporation’s? An active corporation is a corporation that carries on a real business (manufacturing, providing services, etc.) that does not earn rental income (see exception below), royalties, interest, dividends or capital gains.

Based on these questions and the fact that my clients who have corporations that earn investment income, either ask me to “explain this again” each year or just roll their eyes, when I discuss the taxation of investment income, I figured I would give this topic one more try.

Please note that all tax rates noted below ignore (figuratively and literally) the May 1st Ontario Budget.

Reasons to Incorporate Investment Income

For income tax purposes (as I detail below), there are essentially no reasons to incorporate investment income. However, there are several non-income tax related reasons for which it may make sense to incorporate your investment income.

1. Creditor Proofing - If you have an active corporation (“Opco”), you can protect your cash and retained earnings from creditors (assuming this is not a fraudulent conveyance) by paying any excess cash or retained earnings as a dividend to a newly formed Investment Holding Company (“Holdco”). As long as the Holdco is connected to the Opco for income tax purposes (simplistically, owns greater than 10% of Opco), any dividends can be paid tax-free to Holdco.

This allows you to use tax-deferred funds to invest (i.e.: in Ontario, the small business rate is only 15.5%, so potentially you may defer and have 31% more funds to invest [46.46% high non-super tax rate if you earn income personally-15.5% corporate rate]). Once the excess funds have been transferred and your Holdco earns investment income on these funds, the tax is essentially the exact same amount you would have paid if you earned the income personally. Thus you have no significant tax savings by using a Holdco to earn investment income, the main benefit is creditor proofing. [Note: For fancier planning, you may be able to use a family trust to own Opco and have a holding company as a beneficiary of the family trust].

2. U.S. Estate Tax - if you own U.S. securities, you can avoid U.S. estate tax by moving these securities into a Holdco. However, again there are no actual Canadian income tax savings.

3. Rental Properties- Many people incorporate their rental properties. However, unless you are a large rental operation with more than five employees, the only reason to do this is for creditor proofing in case a tenant or visitor to the building sues you.

There may be a couple other reasons, but these are the three main reasons people use a Holdco for their investment income.

Double Taxation

The utilization of a Holdco is potentially problematic when you pass away. The reason for this is that upon death, you are deemed to dispose of your Holdco shares on your final terminal tax return for their fair market value (unless they are left to your spouse). So you pay tax upon your death on the value of these shares. However, when your estate starts selling the individual securities in Holdco, the Holdco has to pay tax on the same securities you paid tax upon on your final return, a double tax. In order to avoid this result, fancy tax planning is typically undertaken, which can be costly and cumbersome.

Why There are no Tax savings

If you read my December, 2011 post, you will realize that the reason there is no benefit to incorporating your investment income, is because of the extra layer of tax imposed by a refundable tax known as RDTOH (“Refundable Dividend Tax on Hand”).

As I mentioned above, I have been unsuccessful in trying to explain this RDTOH mechanism to my clients, and have now taken a new simpler approach which I will use below.

My examples will use a high-rate Ontario taxpayer (not super-rate) who pays tax at the rate of 46.41% on any interest income earned, 29.54% on eligible dividends and 23.2% on capital gains.

Interest

If you use a Holdco and earn $1,000 in interest income, you would pay the following corporate income tax:

Non-refundable corporate tax $195

Refundable tax $267

Total Tax $462 (46.2%)

As I note above, a high-rate Ontario taxpayer would pay 46.41% on interest income. Thus, for all intents and purposes, there is no benefit to incorporating investment income to earn interest income as the corporate tax rate is almost exactly the same as the personal rate. Further the administrative costs (especially the costs paid to your accountant) of maintaining a corporation would also impact negatively on the use of  a corporation.

Eligible Dividends

If you use a Holdco and earn $1,000 in public company dividends, you would pay corporate tax as follows:

Non-refundable corporate tax $0

Refundable tax $333

Total Tax $333 (33.3%)

As I note above, a high-rate Ontario taxpayer would pay 29.54% tax on an eligible dividend. Thus, the corporation pays more tax initially and there is no benefit to incorporating eligible dividend income (or non-eligible dividend income). However, when a dividend is paid by Holdco, the refundable tax is refunded by the CRA and the taxpayer ends up with an actual tax cost of 29.54%, so there is not an extra tax cost, just an initial disincentive to incorporate dividend income.

Capital Gains

If you use a Holdco and earn $1,000 in capital gains, you would pay corporate tax as follows:

Non-refundable corporate tax $98

Refundable tax $133

Total Tax $231 (23.1%)

As I note above, a high-rate Ontario taxpayer would pay 23.21% on a capital gain. Thus, again, for all intents and purposes there is no benefit to incorporating capital gain income, as the corporate tax rate is almost exactly the same as the personal rate.

I hope I have done a better job simplifying this complicated issue so I don’t have to revisit this issue again in the future; if not, I cry uncle anyways.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Should your Investment Income be Earned in a Corporation

Many people often ask should they own their investments in a corporation to avoid and/or defer income taxes. Although there may be reasons to utilize a corporation for liability purposes or to save on U.S. estate taxes if you own U.S. securities, there are currently no income tax savings or benefits to utilizing a corporation to earn investment income.

The overriding principle of taxation in Canada is that an individual should be indifferent between earning investment income through a corporation and earning that same income personally. This concept is known as integration. To achieve integration on investment income, Canada imposes a refundable tax on Canadian controlled private corporations that earn investment income.

If investment income earned in a corporation was subject to an income tax rate that was lower than the highest marginal personal income tax rate, it would be possible to have an indefinite deferral of income tax so long as the after-corporate tax funds were left in the corporation.

In order to ensure taxpayers do not defer income tax on investment income by using a corporation, the Income Tax Act imposes an income tax rate that is essentially the same as the highest marginal personal income tax rate. Thus, an investment corporation in Ontario would currently pay 46.41% on all its investment income earned, which by coincidence is the exact same rate as the highest personal marginal income tax rate in Ontario. In order to ensure that double tax is not incurred, when corporate funds are distributed out to an individual by a dividend, the high rate of corporate income tax is partially refunded.  This refundable tax prevents the corporation from having more after-tax dollars available to reinvest than the individual would have had if he or she had earned the money personally.

This may be more than you want to know, but the way the refundable tax system works is as such: the 46.41% corporate income tax rate is split into two components, the income tax component which is 19.74% and the refundable tax component which is 26.67%. The refundable component goes into a notional account called the Refundable Tax On Hand (“RDTOH”) account. Where a corporation has paid refundable tax, it will receive a refund of this tax when it pays a dividend to its shareholder(s) who will then pay the personal tax on the dividends. The corporation receives a $1 refund for every $3 in dividends it pays to a shareholder.

It is probably best to think of the refundable taxes as a prepayment of the eventual personal taxes to be paid on the investment income. Below is a model of how the investment income integration system works (this is theoretical not actual; see below for a discussion of the realities of integration in Ontario). As demonstrated by the examples, theoretically where investment income is earned through a corporation there should be no deferral of tax and no tax savings where the individual shareholder pays tax on the dividends at the highest marginal tax rate.

Integration model	Interest	Eligible Dividend	Other Than Eligible Dividend
A:
Investment income earned personally	100.00	100.00	100.00
Personal tax (2011)	46.41	28.19	32.57
Net cash for investment	53.59	71.81	67.43
B:
Investment income earned in a corporation	100.00	100.00	100.00
Corporate tax	20.00	-	-
	80.00	100.00	100.00
Refundable tax	26.67	33.00	33.00
Net cash for investment	53.33	67.00	67.00
Corporation declares dividend to shareholder and recovers $1 of refundable tax for every $3 of dividends paid to the shareholder(s)
Dividend refund	26.67	33.00	33.00
Cash to pay dividend	80.00	100.00	100.00
Personal tax to shareholder on dividend	26.41	28.19	32.57
Net cash for personal investment	53.59	71.81	67.43

In reality, integration is not perfect. For example, in Ontario there is a ½ point of absolute income tax benefit to use a corporation when earning interest income, a ¼ point of savings if earning capital gains and no tax savings when earning dividends; however, based on the professional fees and administration, one would almost never use a corporation for such a small benefit.

The refundable income tax system is a somewhat nefarious concept; hopefully I have provided some insight into the concept above and not confused you further. However, the key take-away point is; there is no income tax benefit to incorporate your investment income.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.