How to keep passive income to proposed $50K threshold

Editor’s note: A version of this article, which was written before Budget 2018, was originally published on Canadian Portfolio Manager Blog.

Do you do the limbo? How low you can go reflects your flexibility. Limbo skills will come in handy to plan for Finance’s tax proposals.

In particular, on October 18, 2017, the government announced that its proposed tax measures wouldn’t apply to the first $50,000 of annual passive investment income earned within a corporation.

So if a client earns 5% annual interest on a $1-million passive investment portfolio, there should be no impact on their bottom line. And if clients can keep their earnings under that level moving forward (current corporate passive investments are expected to be grandfathered), they should remain in the clear.

Proposal details are yet to be revealed, which leaves plenty of questions. Business owners and incorporated professionals will likely receive little clarification until the government announces its 2018 federal budget, generally around February or March.

In the meantime, let’s test our flexibility. Here’s how the new rules could potentially play out, and how they might require administrative limbo skills for corporate investors.

Under the limbo bar

For this illustration, I use 2016 tax breakdown figures (from CDS Innovation Inc.’s tax breakdown service), and assume that the client’s corporation has purchased a taxable $1-million balanced model ETF portfolio at the beginning of the year (using net asset value per share figures from 2016). I also assume that the 50% taxable portion of capital gains is included in passive income, rather than the total amount of capital gains realized, which Finance may decide against. Interest, eligible dividends and foreign dividends are also considered passive investment income.

Income received during the year is shown in Table 1. Capital gains, interest, eligible dividends and foreign dividends total $22,274—well below the proposed $50,000 annual threshold. If this were the portfolio’s only source of income, the corporation could probably invest more than $2 million in passive investments and still pass under that $50,000 limbo bar without breaking a sweat.

Table 1: Annual income earned on balanced ETF portfolio of $1 million

Fund	Market value (beginning of year; total = $1 million)	Interest	Eligible dividends	Foreign dividends	Taxable capital gains
BMO Discount Bond Index ETF (ZDB)	$400,000	$7,648			$64
Vanguard FTSE Canada All Cap Index ETF (VCN)	$200,000	$12	$5,547
iShares Core S&P U.S. Total Market Index ETF (XUU)	$200,000			$3,860
iShares Core MSCI EAFE IMI Index ETF (XEF)	$150,000			$3,798	$295
iShares Core MSCI Emerging Markets IMI Index ETF (XEC)	$50,000			$1,050
Income		$7,660	$5,547	$8,708	$359

Total income = $22,274

Sources: CDS Innovations tax breakdown service (2016), BMO ETFs, Vanguard Canada, BlackRock Canada

Be a limbo star

Although the income in the example above is nowhere near the $50,000 threshold, a significant portion of a portfolio’s income also comes from realizing capital gains over time.

Continuing our example, three of the ETFs have year-end unrealized gains (VCN, XUU and XEC), while two have unrealized losses (ZDB and XEF), as shown in Table 2. If the client sells the winning ETFs at year-end and leaves the losers untouched, capital gains of $53,990 would be realized ($36,828 + $15,143 + $2,019). The taxable portion is $26,995 ($53,990 × 50%).

Total passive investment income now equals $49,269 ($22,274 + $26,995), squeaking under the $50,000 threshold. By realizing some or all capital gains each year, your client can avoid building up deferred (unrealized) capital gains that could exceed the threshold.

Table 2: Annual unrealized capital gains (losses) on balanced ETF portfolio of $1 million

Fund	Market value (beginning of year)	Market value (year-end)	Unrealized capital gain (loss)
BMO Discount Bond Index ETF (ZDB)	$400,000	$397,817	($2,183)
Vanguard FTSE Canada All Cap Index ETF (VCN)	$200,000	$236,828	$36,828
iShares Core S&P U.S. Total Market Index ETF (XUU)	$200,000	$215,143	$15,143
iShares Core MSCI EAFE IMI Index ETF (XEF)	$150,000	$142,795	($7,205)
iShares Core MSCI Emerging Markets IMI Index ETF (XEC)	$50,000	$52,019	$2,019
Total	$1,000,000	$1,044,602

Sources: CDS Innovations tax breakdown service (2016), BMO ETFs, Vanguard Canada, BlackRock Canada

Suppose the portfolio grows to $2.5 million after 20 years, and no gains have been realized. Eventually, the annual interest and dividends will exceed the threshold. When the client finally realizes capital gains, they’ll be subject to the new, less favourable tax treatment.

There’s one caveat: it’s unclear if the government will still allow clients to route the non-taxable portion of capital gains to their corporate capital dividend accounts, even if total passive investment income remains below the $50,000 threshold. This means that the non-taxable portion of these capital gains could be treated as a taxable dividend when it’s ultimately distributed to shareholders.

The pain of estimating gains

Although the income in the examples stays nicely under the threshold, that’s mostly luck. In practice, it’s challenging to estimate the amount of capital gains to realize each year. Here are four potential hurdles:

• CDS Innovations tax breakdown service report timing. CDS updates its tax breakdown service annually—in February, after year-end. Even if your client’s corporation has a December 31 year-end, exact income won’t be known before the December 31 cut-off point for realizing capital gains.
• Foreign dividend income calculations. For Canadian-listed foreign equity ETFs, distributions are net of withholding taxes. For tax reporting purposes, gross foreign dividend income figures are required. These would need to be estimated by grossing up the net figures.
• Return of capital (ROC) adjustments. The ROC portion of ETF distributions might not count as income. If that’s the case, clients might have to manually back out ROC from the income on monthly brokerage statements.
• Phantom or reinvested distribution surprises. As their ghostly name suggests, reinvested distributions don’t show up on monthly statements, but the income is still taxable. If a significant phantom distribution occurs, clients might realize more capital gains than expected.

Additional capital gains may have to be realized, and estimated income figures may have to be calculated, to ensure that together they don’t exceed the $50,000 threshold. That’s assuming the threshold itself doesn’t change.

Until the government releases more information, business clients remain in limbo.