Earning investment income in a corporation

March 29, 2017 Michelle Seymour, CA - Director, Tax and Business Succession Planning
Earning investment income in a corporation

It’s fairly common for clients to hold a portion of their investment portfolio in a corporation. The reasons can vary, ranging from estate freezes (discussed in our August 2016 volume 6 of Navigate), income splitting, US estate tax planning and creditor protection, to the tax deferral associated with retaining profits from an operating business within the corporation.

What happens when a corporation earns investment income?

While there are a number of valid reasons for holding investments in a corporation, it‘s important to know that there is a tax cost of earning investment income through a Canadian controlled private corporation, as opposed to earning investment income personally. This is due to the fact that the combined corporate and personal tax rates (where after-tax corporate funds are distributed as dividends in the year) are higher than personal tax rates alone.

For Alberta taxpayers in the top marginal tax bracket, the tax costs for 2017 are outlined as follows:

                        Interest income         Capital gains             Eligible dividends
Tax cost                                      5%                      2.5%                            -

Where after-tax corporate funds are retained in the corporation, there is also no tax benefit achieved from deferring the personal tax component for investment income. In fact, due to the refundable corporate taxes charged, a prepayment of tax would occur in this situation. The tax prepayment percentages for Alberta taxpayers in the top marginal tax bracket are outlined below:

         Interest income         Capital gains            Eligible dividends
Tax prepayment                     2.7%                     1.3%                         6.6%

 

Four options to reduce overall taxes

If you’re a taxpayer with investment income being earned in a corporation, you may want to consider the following options for reducing the investment income earned in the corporation, while increasing your personal investment income to reduce your overall taxes.

1. Repayment of shareholder loans. Consider repaying loans to shareholders who have loaned funds to the corporation. Funds that were previously invested in the corporation could then be invested personally. Disposition of the investments by the corporation, however, could trigger capital gains or losses. The corporate taxes resulting from a capital gain and the potential application of the superficial loss rules should be considered before proceeding with this alternative.

2. Converting non-interest bearing shareholder loans to interest bearing shareholder loans. Where the shareholder has loaned funds to the corporation on an interest-free basis, these loans could be converted to interest bearing loans. The result would be an interest expense in the corporation and corresponding interest income to the individual, without having to dispose of the investments held in the corporation.

3. Payment of capital dividendsIf capital gains have been realized in the corporation over time, it may be possible to pay a tax-free capital dividend. The dividend could be paid in cash with funds then being invested personally (similar to option 1) or via an interest bearing shareholder loan (similar to option 2).

4. Wind-up of the corporation. Before proceeding with this option, careful thought should be given to the reasons the corporation was put in place and any benefits that exist for maintaining the corporation. The corporate tax costs resulting from the disposition of any investments held by the corporation and the personal tax costs associated with dividends received on the distribution of funds from the corporation should also be determined prior to a wind-up decision being made.

Don’t overpay and get advice!

If you’re currently holding a portion of your investment portfolio in a corporation, it may be time to seek professional tax advice to ensure you’re not overpaying on your taxes if you don’t have to.

This article was originally published in Navigate Magazine, February 2017.

 

The information provided in this article is a simplified general summary and is not intended to replace or serve as a substitute for professional advice. Professional tax advice should always be obtained when dealing with taxation issues as each individual’s situation is different. This information has been obtained from sources believed to be reliable but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. This information is subject to change and ATB Securities Inc. and ATB Investment Management Inc. reserve the right to change the information without prior notice, and do not undertake to provide updated information should a change occur. ATB Financial, ATB Investment Management Inc. and ATB Securities Inc. do not accept any liability whatsoever for any losses arising from the use of this document or its contents.

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