Investing inside a corporation: what you need to know

A MoneySense reader writes:

We have $550,000 to invest in our corporation and need something tax-efficient. Although we’re retired, we don’t need this money for the foreseeable future, so we’re investing for the long term. We’re considering either DIY investing following one of the Couch Potato-model portfolios or using a robo-advisor. As a third alternative, we’re also wondering if we should just buy Canadian bank stocks. Can you help?

FPAC responds:

Congratulations on your successful retirement! At a stage when most people are focussed on decumulation, you’re asking about establishing an approach for long-term, tax-efficient investing inside your corporation. Let’s walk through these important considerations:

Investment decisions: robo-advisor or DIY—and ETFs or bank stocks?

A robo-advisor is a great choice for automated, tax-efficient and low-cost investing. A robo-advisor will be able to set you up with a portfolio of low-cost, widely diversified ETFs. Regular rebalancing, quarterly reporting and ease of use will make this option attractive if you are looking for a hands-off approach. Most of the leading robo-advisor platforms in Canada will help you set up a corporate account. 

If you’re comfortable being a little bit more hands-on, you might consider implementing a multi-ETF model portfolio. This approach will require you to open an account at a brokerage and do some regular investment maintenance, including allocating cash, reinvesting dividends and rebalancing. 

Alternatively, you could also consider implementing an asset-allocation ETF solution. These “all-in-one” ETFs are available in different stock/bond allocations to suit your risk preferences, and they are globally diversified. 

You mention tax-efficiency being important to you. Broad index-based ETFs track an underlying market index. The stocks and bonds in these indices do not change often, so there isn’t a lot of buying and selling of stocks—also known as “turnover”—happening inside of your ETFs. A portfolio with low turnover will not stir up a lot of unwanted capital gains in years that you don’t want to take money out of your accounts, and less turnover means less tax payable year-to-year, leaving more of your money working for you. All in all, tax efficiency is a huge benefit of an index fund ETF approach to investing, especially if you’re investing inside of a corporation. 

You also mentioned bank stocks as an alternative. I can understand the appeal of this approach, as buying stocks of Canada’s large financial institutions has proven to be an effective strategy over the past several years. Unfortunately, the past performance of any investment strategy does not tell us much about its performance in the future. And, in the case of bank stocks, your investment will be very concentrated on a single sector, in a single country. This approach to investing carries risks that can be easily diversified away by using broad, globally diversified index-based ETFs. (In fact, Nobel Prize laureate Harry Markowitz famously called diversification “the only free lunch in investing.”)

Understanding the ins and outs of corporate investing

Investing inside of a corporation can be complicated. A corporation is taxed differently than an individual in Canada. As individuals, we are taxed based on a progressive income tax system, meaning higher amounts of income are taxed at higher rates. In your case, if you are earning (or realizing) a lower income in retirement, your last dollar of income is likely taxed at a lower rate than it was while you were working. When you combine lower tax rates with other benefits that the tax system provides to seniors—such as pension income splitting and age credits—it is possible that you will not be taxed at the high end of the marginal tax table in retirement. 

Passive investment income generated inside a corporation, on the other hand, is taxed at a single flat rate of around 50% in Ontario, or close to the highest marginal tax rate. Passive income tax rates are so high because the Canada Revenue Agency (CRA) doesn’t want us to have an unfair tax advantage by investing our portfolios inside corporations.

Given these high rates, you may wonder if you should simply take the money out of your holding company and invest it personally, especially if your average personal tax rate is lower than 50%. While investing personally may result in lower taxation on a year-to-year basis, you would incur a significant personal tax bill to get the money out of the company now, which means that there would be less money to invest and grow. 

Fortunately, in Canada we have a concept called “tax integration,” which helps ensure individuals are taxed similarly whether they receive income personally or through a corporation. 

Without knowing the particulars of your situation, let’s assume for the moment that it makes sense to leave your investment funds inside your corporation. The Income Tax Act provides a few mechanisms to ensure that integration works for you when you are investing and, eventually, taking money from your corporation. These include:

Refundable Dividend Tax on Hand Account (RDTOH)

The RDTOH account is a special notional account which ensures that although investments in the corporation are subject to tax at a high rate, some of that tax is “released” back to the corporation when you pay out dividends to yourself. 

Withholding tax from you at the corporate level initially achieves the goal of eliminating any advantage you might have by growing your investment capital inside the corporation vs. personally. It also creates fairness in that you are not double taxed on that investment income when you take the money from your corporation as a dividend.

Capital Dividend Account (CDA)

In the year that an individual taxpayer earns capital gains as an individual taxpayer, 50% of the capital gain is included in your income, and the other 50% is tax-free. Capital gains earned inside of your corporation are taxed the same way. In your corporation, the non-taxable 50% will be dropped into another notional account called the Capital Dividend Account (CDA). You then have the option to pay out any balances in the CDA to the shareholders of your corporation on a tax-free basis. 

It would not be fair for you to need to pay tax on 50% of capital gains that you earned on your corporate investment account, and then need to pay tax on that amount when you take those funds from your corporate account. Again, this is integration at work. 

Note that Canada has 10 provinces and 3 territories, with different provincial tax regimes in each. These differences mean integration works slightly differently from jurisdiction to jurisdiction. But, overall, it works very well to create tax fairness for owners of investments inside of private corporations, so that if you earn $10,000 corporately and pay out $10,000 personally, you’ll pay the same, or a very similar, tax bill as if you earned the $10,000 personally. 

The importance of getting good guidance

While passive investing in ETFs can be very easy, setting and maintaining your tax strategy can be complicated. Proper tax filing and compliance are crucial when dealing with notional accounts like the RDTOH and CDA accounts. While this article focuses on a few investing and tax considerations, keep in mind that there are also a host of estate planning steps for you to consider while you maintain investments in a holding corporation and possibly plan to pass them on to the next generation. Spending some time working with a good financial planner to help you lay out a strategy that serves you will be a worthwhile investment. A planner can help you make sure your tax, legal and investment objectives all work in harmony with your overall life plan so you can enjoy a prosperous retirement with peace of mind.

This response was provided by FPAC Member Mark Walhout, CFP, CIM, a Financial Advisor with Walhout Financial and Investia Financial Services, Inc. Mark provides financial planning and evidence-based investment management services to families in Ontario. 

Qualified Advice is written by members of FPAC (the Financial Planning Association of Canada), a MoneySense content partner. Working closely with governments, regulators, financial planners, academia, vendors and the general public, FPAC’s goal is to set standards and principles that will allow financial planning to evolve into a knowledge-based profession which ultimately commands the credibility, public awareness and respect afforded to other advisory professions. 

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