Understanding Corporate Investment Income Tax Part 1 –  Capital Gains and the Capital Dividend Account

 

Apologies for the long hiatus. I felt hesitant to write any further advice since the corporate tax change proposals have created a climate of uncertainty. While the uncertainty will persist for a while longer, the last announcement found here talks specifically about corporate passive investment income with a threshold of $50,000/year before more onerous taxation kicks in. As I scrambled to review my corporate holdings to see if I currently exceed the threshold, I realized investment income tax treatment is likely an area that is poorly understood by many. It will be important to understand for any professional with a corporation moving forward how to structure their corporate holdings in the most tax efficient method.

The 3 main forms of investment tax treatment are: capital gains, dividends, and interest income. Part 1 will review capital gains tax and the CDA, while part 2 will discuss the RDTOH and the proposed tax changes implications. I will discuss tax sheltered investment taxation like RRSP, TFSA, and RESP in a separate post.

Capital Gains – Basic Definitions

The concept of a capital gain is fairly straightforward. When you buy any asset for a price “x”, a capital gain with occur when you finally sell the asset at any value above “x”. The value above “x” will be the profit.

A capital loss will occur if you sell any asset at below the original purchase price of “x”. Capital losses can be used to cancel out capital gains/profits from future asset sales to reduce the amount of tax owed.

The holding period is the duration of time between the purchase of the asset and the sale of that asset. In some countries, the tax treatment of a capital gain may depend on the length of the holding period. For example, America has a minimum holding period of 1 year for an asset before its sale can register as a typical capital gain. In Canada, there is no difference currently if you hold an asset for 1 day or 50 years – if you sell for a profit the tax treatment is identical.

There is an exception to this holding period concept when selling an asset at a loss called the superficial loss rule. This rule states that if an asset is sold at a loss and then the same asset is re-purchased within 30 days it is a superficial loss. This superficial loss will not be deemed a real capital loss for tax purposes. If repurchased after the 30 day time limit, then the capital loss will be valid and applicable for reducing future tax owing on capital gains.

The type of asset (asset class in finance terms) is another important point to discuss. It doesn’t matter if you purchased stocks, bonds, real estate, gold, art, or bitcoin – if any of these assets are sold at a higher amount then the purchase price “x”, a capital gain is supposed to be declared for tax treatment. During the holding period, some of these assets may produce some form of additional investment income, such as dividends or interest. This will not change the fact that a capital gain or loss will register upon the sale of that asset.

Passive investment income is the term used for the additional cash flow such as dividends, interest or rent as discussed above. These cash flows are often predictable and paid out on a defined regular interval (monthly, quarterly, yearly) Once an asset is sold for a profit, a capital gain will occur which can add to the yearly passive income. This is unique to the other forms of passive income in that the individual may choose the timing of when to receive this income.

In reference to the recent corporate passive income discussion by the government, it is important to distinguish corporate passive investment income from corporate active business income, which is the income generated from the primary purpose of the business or professional. Any reference to the $50,000/year cap on passive investment income has no bearing on the amount of active business income you can choose to leave in a corporation on any given year to be taxed at the small business corporate tax rate.

Things can get complicated when you buy or sell portions of the same asset many times over a given holding period. You may buy 100 shares of a stock at a price of $5, $7 and $12 on different occasions. In this simple example, the average purchase price over the 3 different purchases is $8. This would serve as the “x” in our example to determine if the final sale is done at a profit or loss. The fancy term for this average purchase price is the adjusted cost base (ACB). ACB is generally tracked through most investment advisors or retail investment brokerages for index or mutual funds, stocks and bonds. For more obscure assets, the purchaser has to track the ACB with documentation for when a sale occurs.

A fundamental concept of capital gains tax treatment is the potential tax deferral on the long term growth of the investment asset. Capital gains tax is only triggered when there is a realized gain, which means the owner decides to sell. An unrealized gain is the increase in the value of an asset that has not been sold. There is no requirement to pay tax on the unrealized gain, but it is tracked on the yearly financial statements of the CCPC. This is fairly important to understand properly, so I will use an example.

Example 1: Capital Gains Tax – Holding Long Term vs Frequent Buying and Selling

Jen buys a $10,000 asset that compounds at a 7% annual rate uninterrupted for 25 years that has a final value of ~ $54,000. Assuming a personal marginal tax rate around 50%, she will have ~$43,000 left after tax. I will show the actual calculation for this in latter examples.

Phil buys a $10,000 asset that also compounds at a 7% annual rate uninterrupted. He chooses to sell the asset fully at the 10 year mark. He repurchases a new asset immediately which also gets a 7% annual compound rate. He repeats this sale again at the 20 year mark and holds for 5 more years at a 7% annual return until the total 25 year period is up. I will spare you the calculation, but final after tax balance will be $38,800 for Phil.

Phil has a 10% lower overall return than Jen despite having identical starting amounts and identical overall compound growth rates. Phil’s amount is lower secondary to tax leakage, which is taxation that interrupts the compound growth effect. The magnitude of tax leakage depends on the rate of asset turnover within an investment portfolio and the investment time horizon. You can imagine if Phil bought and sold a new asset every year, his tax leakage would be far more dramatic.

Stock portfolios have two factors working against them to promote tax leakage – to sell the asset requires just a click of a button and the overall volatility is higher than most people are comfortable with. When compared to real estate, which takes actual effort to sell and has a lower volatility profile, you can see why investment real estate benefits from a longer uninterrupted period than most investment stock portfolios.

Capital Gains Tax Treatment

Investment taxation always has unique variables depending on what type of account it is in: tax advantaged accounts (RRSP, RESP, TFSA), corporate, or personal non-registered. I will start with the base case of personal non-registered accounts as it is the simplest to explain. Typically, an individual would only consider investing in a non-registered account once they have invested the maximum available within their tax-advantaged accounts mentioned above and they do not have the option of a corporate investment account.

Example #2 – Personal Non Registered Account and Capital Gains

Julie personally buys 1000 shares of an index fund at a price of $10 for a total purchase price/ACB of $10,000. The investment does not distribute any annual passive investment income during the entire holding period of 5 years.

Julie sells 500 shares at $15 and 6 months later sells the other 500 shares at $17. The total amount received upon sale = (500 x$15) + (500 x $17) = $16,000

Julie’s capital gain is $16,000 – $10,000 (ACB) = $6000 capital gain.

The tax treatment is that 1/2 of this capital gain can flow through directly to the owner tax free and the other 1/2 capital gain gets taxed at Julie’s marginal tax rate. This is called the 50% capital gains inclusion rate.

Julie receives $3000 directly tax free and pays ($3000 x 35% marginal tax bracket) = $1050 tax with $1950 leftover.

The total amount from the capital gain in Julie’s hands after tax is $4950 from the original $6000 which is an effective tax rate of 17.5%. At the high end of a 50% personal marginal tax rate, the effective capital gains tax rate will approach 25% of the total capital gain of the asset sale. It is important not to forget that the original ACB of $10,000 has no taxation on it and is back in Julie’s hands upon the sale. The final dollar amount in her hands from the $16,000 is $14,950 after tax.

Pretty easy right? Looking at the corporate tax process will seem like a nightmare to this!

Example #3 – Corporate Investment Account and Capital Gains

Jonathan owns a professional corporation and has leftover retained earnings after corporate tax of $50K/year. He purchases an index fund once a year for 20 years and then retires with a plan to withdraw these funds in retirement. It performs an average of 6%/year over the investment timeframe. The fund has no passive investment income that is distributed during the holding period.

The total amount invested is $50K x 20 years = $1 million purchase price (ACB)

The total accumulated corporate investment portfolio value is $2.11 million after 20 years.

The total profit at that time is $2.11 million – $1 million ACB = $1.11 million.

If Jonathan decided to sell the whole portfolio in his first year of retirement, the following tax treatment would occur under current tax laws:

$1.11 million capital gain has a 50% capital gains inclusion applied. Similar to the non-registered example above, ½ of the capital gain can be paid out directly to a shareholder tax free.

This is of critical importance to recognize that this is a corporate asset moving into the personal hands of a shareholder tax free. This is quite a unique benefit as very few rules allow for tax free removal of funds from a corporate account for personal use. It occurs via the Capital Dividend Account and deserves its own specific discussion.

Capital Dividend Account (CDA)

The CDA is a special notional account (fancy term for bookkeeping account) that will be tracked by your accountant throughout the existence of your professional corporation. The 50% capital gain inclusion portion will be added to the CDA from each asset sale that generates a gain. Any capital loss incurred on an asset sale will be subtracted from any capital gains already in the CDA account. The CDA account is a significant benefit in the structure of a CCPC when used correctly.

The calculation would be 50% x (total capital gains – total capital losses) = amount available as a capital dividend. This calculation is simplified to remove other financial variables such as insurance proceeds and inter-company capital dividends that don’t pertain to this example.

A CDA can have a negative or positive value. There is only a benefit to pay out the CDA when the value is positive as the capital loss can’t pay out anything personally. To pay out the CDA, a capital dividend election is made by the accountant/lawyer and an official filing is sent in to CRA. I would suggest only doing the capital dividend election with professional advice as an error can have significant penalties. Given that professional fees will be incurred to make an election, it often only makes sense to file an election when the CDA has accrued a meaningful amount such as $25,000 or greater.

Example #3 (cont’d)

Jonathan had $1.11 million in realized capital gains. He has $555,000 available in the CDA to pass tax free to himself.

The remaining $555,000 of profit/capital gain will be taxed at the highest rate of ~50% (varies per province between 45-50%).

This equals $277,500 of taxes owed within the CCPC or an effective tax rate of 25% on the original $1.1 million capital gain.

So when the dust settles, Jonathan has the original $1 million ACB from the money he put up to make the investments and $832,500 of the profit left after paying the corporate capital gains tax = $1.8325 million in corporate cash after tax.

He can pay out $555,000 tax free if he makes the capital dividend election, which would still leave $1.2775 million cash in the corporation.

The remaining balance of $1.2775 million can be paid out as well, but it is important to remember that to remove this cash from the corporation into Jonathan’s personal hands, he will be taxed at the marginal rate of that withdrawal. This would be similar to when drawing active business income on a yearly basis for personal salary. There is one slight difference, which leads to the next level of understanding corporate tax – the Refundable Dividend Tax On Hand (RDTOH), which will be discussed in Part 2.

Final Thoughts

The CDA will be a substantial part of tax planning assuming none of the proposed tax changes adjust use of it. In regards to the Liberals proposed tax changes, it was discussed in the initial paper in July to eliminate the CDA as a way of balancing out the initial benefit of tax deferral in corporations vs. investing personally in a non-registered account. The elimination of the CDA and the Refundable Dividend Tax On Hand (RDTOH) is how the theoretical 73% corporate tax on passive income came about. I have made excellent use of the CDA already to draw corporate funds out personally. I will be watching the final tax interpretation carefully and hope the CDA is left alone on both the grandfathered assets and the passive investment income below the $50,000 proposed cap.

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7 comments On Understanding Corporate Investment Income Tax Part 1 –  Capital Gains and the Capital Dividend Account

  • wonderful explanation. Thank you

  • Thanks so much!
    Still trying to digest the last example. I’m good until ‘The remaining balance of $1.2775 million can be paid out as well, but it is important to remember that to remove this cash from the corporation into Jonathan’s personal hands, he will be taxed at the marginal rate of that withdrawal.’ If taken out in total, wouldn’t the taxed rate be lower than the highest marginal rate, as the original 1 mil would have already paid the 15% small bus rate, and the 277k would have paid the capital gain of 50%? Does that not decrease the tax burden removing all the rest because some was already paid?

    • Great question Anna!

      Your thinking is spot on that tax has already been paid on on the capital gains in the corporation so you shouldn’t be taxed twice.

      This leads wonderfully into the next post to explain the RDTOH, because it exists so the corporation can get back the tax it paid once the income is sent out to shareholders. Look out for this next week.

      In regards to the ACB payout to shareholder, it is another great question. You are correct that the SB tax rate would already have been paid here.
      My understanding (disclaimer that I’m not an accountant) is that the ACB would be paid out as a non eligible dividend to the shareholder and not as typical salary.
      Non eligible dividends are typically paid from after corporate tax retained earnings. Non eligible dividends will factor in the corporate tax as you pay less on non eligible dividend than the equivalent salary in your marginal bracket.

      Hope that helps!

      FFMD

  • Hi. Great post, Thanks for explaining the CDA. I also read your part 2 on the RDTOH. I had a question about how the non-taxed portion of the capital gain is treated. For example: if you have a $20,000 realized capital gain by selling stocks (only 50% is subject to capital gains tax) you would have $10,000 in the CDA, would owe $5,000 taxes (and I recognize you would also have $2667 in the RDTOH), but the other $5000 that was not directly paid to the CDA and not used for the tax bill goes where? Does it also flow to the CDA and eligible for tax-free payout, or does it flow to the corp bank account along with invested principle (ACB) and not treated preferentially in any way like the CDA?
    Thanks!

    • Hi Julian

      I think you might be confusing the idea of the notional account for the CDA and the RDTOH.
      These are just book-keeping accounts that the accountant tracks but no actual money gets deposited into them.

      In your example, the $20K capital gain gets sold. If it is in an investment account, all $20K sits in your account to reinvest right after the sale.

      When tax time comes, you will owe $5K as you suggested. You can withdraw that from the investment account or pay it from cash in your corporate chequing account.

      The CDA only gets triggered as a tax free flow out to the shareholder when you and the accountant elect to. You would then obviously need that physical amount ($10K in your example) somewhere in your corporate chequing or you can remove the $10K from the investment account.

      I choose to never take anything out of the corporate investment account since it is all long term retirement money and often use general cash flow from work to deal with the taxes and CDA pay out.

      Hope that helps!
      FFMD

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