Op-ed: Why Finance shouldn’t target passive investments in private corps

The March 22, 2017 federal budget hinted at three major changes to private corporations that are part of a discussion paper to be issued later this year.

Read: How Finance might curb tax advantages for private corps

Let’s examine the Liberals’ concern that holding passive investments inside a private corporation “may be financially advantageous for owners of private corporations” compared to otherwise similar investors.

Some experts have suggested this may refer to CCPCs changing their character so they are no longer CCPCs, allowing them to benefit from a larger tax deferral.

But what if this concern relates to deferring income by simply leaving retained earning inside a corporation?

In Ontario, this tax deferral can be as high as 35% at the top marginal tax rate. This means that on $100,000 of active business income, a shareholder would have $85,500 to invest, compared to only $50,500 if the income was personally earned.

How advantageous is it to hold investments inside a corporation?

To answer that question, we must follow the money to come up with the answer.

Utilizing my firm’s financial planning software, my analysis will focus on the after-tax income potential in retirement under four scenarios:

• 100% invested in a private corporation.
• 100% invested personally in non-registered accounts.
• 100% invested personally in TFSA and non-registered accounts.
• 100% invested personal in RRSP, TFSA and non-registered accounts.

First, let’s assume we’re dealing with a 65-year-old single Ontario taxpayer receiving maximum CPP and OAS. In each of the four scenarios, there is a $1-million passive investment portfolio earning 5.0%. For each, I calculated the maximum after-tax annual income the taxpayer could spend each year from age 65 to age 90, assuming 2.5% inflation.

As the above results illustrate, holding a $1-million passive investment portfolio inside private corporation is a disadvantage compared to investments held personally. One reason for this is that drawing dividends from the corporation triggers a partial clawback of OAS, which is factored into the results.

In my second analysis, we’ll look at a 45-year-old single Ontario taxpayer with earned income of $100,000 per year and active business income of $57,696. After paying corporate tax of 14.5%, there is $49,330 in retained earnings. Why those amounts? Assuming inflation of 2.5%, $49,330 is how much needs to be invested annually to age 65 so that the taxpayer would receive the same after-tax income as in my first example: $61,700 in today’s dollars from age 65 to age 90.

For scenarios 2 through 4, the taxpayer withdrew the $57,696 as income and invested the after-tax amount annually†.

Again, the results would suggest that holding retained earnings in a passive investment portfolio inside a private corporation is a disadvantage compared to investments held personally.

Read: How to avoid factual control of a corporation? Avoid influence

Conclusion

The government plans to issue a paper in the coming months outlining the perceived issues in more detail, as well as proposed policy responses. If they are concerned with the 35% tax deferral when investing in a private corporation, we can only hope that they look beyond the initial tax savings before further taxing Canadian businesses.

Also read: Tax headache coming for professional clients

Dave Faulkner, CLU, CFP, is CEO of Razor Logic Systems Inc., and creator of RazorPlan Financial Planning Software.

†Where TFSA and RRSP are used, amounts over the maximum contribution limit are invested in non-registered accounts.