How portfolio structure can save tax for clients with private corps

Customized investment management tends to provide better after-tax returns. With Finance’s new rules for passive investment income, which take effect for tax years after 2018, customized solutions will take on even greater importance for clients who own Canadian-controlled private corporations (CCPCs).

The new rules state that if passive income exceeds $50,000 per year, then access to the small business tax rate (10% to 18%, depending on the province) will drop by $5 for every $1 of passive income above $50,000. That means that a company earning $150,000 of passive income would have no access to the small business tax rate and would pay the general income rate (26.5% to 31%) on all active business income. Note that it’s not passive income but rather taxable passive income that counts.

Read: Feds to tie passive income threshold to small business deduction

Thus, where possible, clients should aim to keep passive income below $50,000 per year to preserve access to the small business deduction.

For those clients who already have taxable passive income greater than $150,000 per year or have more than $15 million of capital inside their related companies, the small business tax rate is eliminated, and they pay the higher general rate on active business income. For those in this category, the objective is to design a portfolio to earn lower rates of taxable income without increasing the risk profile of the portfolio.

Before we tackle the design of such a portfolio, let’s see how different types of assets and their returns are taxed—an important consideration for portfolio construction. See Table 1.

Table 1: Effective tax rates for assets held by CCPCs

Asset type	Canadian equities	Foreign equities	Fixed income	Real estate	Alternative strategies	Life insurance
Tax rates	38.3% on dividends 25% on realized capital gains 0% on deferred gains	50% on dividends; otherwise the same as for Canadian equities	50% on interest income received 25% on realized gains	50% on taxable rental income 0% on return of capital 25% on realized gains 0% on deferred gains	25% on realized gains 0% on deferred gains	No tax on any growth in the policy unless the policy is cashed in before death

With these tax rates in mind, here are considerations for an ideal corporate portfolio earning passive income.

Taxation of real estate versus commercial mortgages

To illustrate how taxation can affect asset location strategy, we’ve analyzed taxation of our Canadian real estate pool, SPIRE Real Estate LP, and our Canadian commercial mortgage pool, NWM Balanced Mortgage:

Table 2: Returns for real estate fund versus mortgage fund

Fund	Year	Return from interest or rental income (A)	Return from realized capital gains (B)	Return of capital (C)	Growth or deferred gain (D)	Total return (A + B + C + D)	12-month yield (total return –D)
SPIRE Real Estate LP	2016	0.59%	0.64%	4.57%	4.13%	9.93%	5.80%
NWM Balanced Mortgage	2016	5.18%	0.01%	0%	0.15%	5.34%	5.19%

Even though the real estate return is 9.93%, only 0.91% would have been taxed in 2016 (0.59% + (0.64% × 0.5)), with tax equivalent to 0.46% corporately (based on Ontario’s corporate tax rate of 50.17% for passive investment income). That works out to less than 5% of the total return and results in a net return after tax of 9.47% (9.93% − 0.46%).

Comparatively, 5.18% of the 5.34% total return for NWM Balance Mortgage is taxed as interest. That works out to 97% of the total return and results in a net return after tax of 2.74%.

Thus, real estate funds generally provide greater tax efficiency for corporate portfolios than do mortgage funds.

From a risk management and asset allocation standpoint, mortgages and real estate are not substitute asset classes, and both play an important role in effective portfolio diversification. Therefore, mortgages and similar interest bearing investments should be held in tax-sheltered accounts or within trusts that can flow the income to beneficiaries in lower tax brackets.

Life insurance as an asset class

Life insurance cash values accumulate on a tax-deferred basis (ultimately tax-free at death) unless the policy is redeemed for cash. This can make investing in permanent life insurance a tax-effective way to own assets such as bonds, private fixed income, real estate and commercial mortgages inside a CCPC. This often makes sense for business owners because they have limited access to tax-deferral in RRSPs and IPPs, due to historically utilizing dividends instead of salary in their compensation plans.

Read: Using life insurance under new passive income rules

Further, insurance can be used as collateral for loans (typically at a value of 90% versus 50%-60% for real estate and equities), which creates an opportunity to leverage a tax-free asset to add more tax-preferred assets to the portfolio. A common life insurance recommendation is the use of participating policies. Long-term returns of these policies are based on how assets of the participating pools perform over time. Historically, the policies achieve balanced fund returns with fixed income risk levels.

Tax-efficient asset allocation

Our analysis has found that it’s possible to build a balanced corporate portfolio with a net effective corporate tax rate of less than 5%, when paying out dividends from the capital dividend account and subsequently recovering refundable dividend tax on hand (RDTOH) annually (see Figure 1). This sample asset allocation assumes that the corporate account has $2.5 million of assets with the illustrated asset allocation, annual returns and taxation characteristics. This results in a portfolio return of $150,000—of which $43,500 would be taxable.

On a $2.5-million portfolio, we would expect no reduction in the small business deduction, resulting in a total blended tax rate (corporate and personal) of less than 15% under the new passive income and RDTOH rules. Our assumptions lead to a portfolio eroding the entire small business deduction at about $7 million, resulting in a total blended tax rate of 27.6%.

Figure 1: Tax-efficient asset allocation for private corporations

The government has assumed that $50,000 of passive income would be generated on $1 million of passive capital (a 5% return). Our results show that, with good design, one can reduce that level of passive income so that a company could have as much as $2 million to $3 million of capital before earning more than $50,000 of annual taxable income.

That would be a significant benefit for those focusing on building capital for retirement while still enjoying the small business tax rate. Many people could retire comfortably with that level of corporate savings, combined with registered assets and perhaps the use of family trusts and prescribed rate loans.

Read: How to keep splitting income with family members in 2018 and beyond

For a sample asset allocation for a registered plan or foundation, see Figure 2.

Figure 2: Sample asset allocation for registered plans and foundations

Risk management and therefore diversification remains paramount to ensure the tail (tax) does not wag the dog (financial needs and goals) and thereby increase the risk profile of the overall portfolio.

Kyle Westhaver, CIM, is a financial advisor at Nicola Wealth Management, and John Nicola, CFP, CLU, CHFC, is chairman and CEO of Nicola Wealth Management.