In the last episode, we introduced how investment taxation using a Canadian Controlled Private Corporation (CCPC) works. Different types of income are taxed differently in a corporation. We reviewed different types of investment income flow through a corporation and how that interacts with the corporation’s active income. Plus, how you pay yourself.
Today we’ll start talking about how that fits into your investing strategy. There are also different strategies and products aimed at different aspects of corporate investing. You want to make sure that you understand them to be the big dog. So that you don’t get wagged by the tax-tail. You must also learn more about those products and strategies to see if they pass your sniff test. We’ll dig into that today because you must be often bridge the gap between your long-term investing and your annual tax planning. Or know the value your advisors can provide in that realm to choose ones that do.
[00:00:02] BF: Welcome to the Money Scope podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka The Loonie Doctor.
[0:00:16] MS: Great. Welcome back. In our last episode, we covered some of the details of how investment income flows through corporations, and all the notional accounts that are used to track that. Now, we want to spend some time unpacking how that should or should not impact how we invest using a corporation, and how that fits into our overall portfolio strategy, which is going to have multiple accounts.
[0:00:39] BF: Yes, that’s right. A corporation is a great tax deferral vehicle, but there can be a tax drag on growth between now and when you get access to the money in the future. So understanding the basics of how to minimize that tax drag helps you to have the right conversations with your accountant and your financial planner.
[0:00:56] MS: That’s right. Like anything complex, investing tax efficiently through a corporation also incites the interest of those selling complex products or strategies. We’re going to cover those in much more detail in other episodes as well. But I thought it was prophylactically important to introduce a few of them today, which we’re going to do. We’ve got the Money Scope water pump all refilled up, and ready to go to start washing some of the gunk off the screen, so we can see what’s underneath some of these products.
[0:01:27] MS: We’re going to come back to that and try to put this all into perspective with our corporate investment strategy. We talked about these notional investment accounts. There’s some heavy math in there, but some big concepts that hopefully you have a bit of a grasp of. How does that actually impact your investment strategy?
We’re going to spend a bit of time unpacking how this should or should not impact how you invest in a corporation. We’ve kind of started already doing that with some of the discussion we just had. Then, how does that fit into our overall strategy, which we’re also kind of mentioning. You have to have a kind of a cohesive plan. It’s really important for you to understand the key points in this section, because even though you likely use an accountant and probably a financial advisor of some type.
Accountants are great at dealing with the taxes. They’ll take whatever you hand them, and do the best they can with it. Financial advisors are generally great at planning strategies over a long period of time. That’s what they’re good at. Great advisors and accountants consider both and match those together, but that’s definitely not a given.
I’ve seen many cases with my colleagues where they are making poor investment decisions based on some tax nuance. I’ve even seen people with massive notional account balances that they haven’t used. They haven’t used them because they never asked about them. Ben, I’m sure you’ve probably have some selection bias. But what’s been your experience when you take on new clients that have come in de novo, having dealt with some of this?
[0:02:51] BF: We do see all kinds of messes when we onboard new clients. Not always, because like you said, we do attract clients who listen to our podcast, to the Rational Reminder podcast or maybe to the Money Scope podcast. Those types of people are going to be more engaged, and they’ve heard a lot of this information, so they might be making better decisions in general.
But we’ve definitely seen large notional account balances that are not being drawn on. We’ve definitely seen the whole-life policies that were sold on their tax benefits. In situations where the RRSP, and TFSA accounts had not been used at all, and money had been put into a permanent insurance policy, which in my opinion, is inappropriate.
We’ve seen other missed tax planning opportunities. We’ve definitely seen some stuff. But you got to understand, this stuff is complicated. Even we think about accountants, it takes a level of expertise to deal with incorporated clients. Like you mentioned, the case of somebody who had large notional account balances, because they never asked, but you shouldn’t have to ask.
[0:03:42] MS: No, you shouldn’t.
[0:03:44] BF: Ideally, that’s advice that you’re getting from an accountant. But not all accountants are super familiar with how all this stuff works, honestly. Even more so, with specific niches. An incorporated physician, client is going to have different needs and planning opportunities than somebody who owns a software business. They’re going to have different nuances. We definitely do see the occasional new client where it seems like they must have been seeing like a podiatrist to treat their heart condition. We try to unwind that as much as we can.
[0:04:12] MS: There’s some scary stuff. I’ve seen that too. A CDA, which I said is probably your most valuable notional account. I’ve seen a couple of them, at least, with a few million dollars. And the owners paying themselves a salary every year. You mentioned the podiatrist and heart condition. I mean, it’s like a heart condition. This is serious business. It’s big money and it’s also time sensitive too.
One of the other issues, which we’ll dive deeper in on the episode on corporate compensation is that these notional accounts are actually priced in nominal dollars. That means that the buying power that they represent from the refunds or giving out tax-efficient capital dividends is eroding if they’re left unused, because they are nominal dollars. If you learn about this and make it part of your discussion with your accountants and your advisors. The CDA in particular represents major buying power, that erodes rapidly with inflation when it’s not being used.
[0:05:04] BF: That’s super important. If you have a CDA, and you take out the tax-free dividend personally. I mean, you have that personal money. You can invest it, and it will grow and hopefully outpace inflation. If you leave it inside the corporation, the value that you are able to take out, in real terms declines over time. The purchasing power of the amount declines over time.
[0:05:22] MS: That’s big. As we’ve mentioned, personal investing is often actually pretty tax-efficient. The hard part is getting the money out of the corporation to your personal accounts in a tax-efficient way, and the CDA is the way to do it. Let’s come back to the taxes again, with investing.
This is the first point to make about corporate investing, which we’ve made already, but I’m going to make it again. Is that, your priority should be to make a diversified executable investment strategy that suits your goals and your risk tolerance. The tax considerations come secondary to that. That’s important, because as you’ve may have figured out, some kinds of investment income are extremely efficient in a corporation, like capital gains, and eligible dividends. While others are less efficient like interest and foreign dividends.
That tax quirk can lead people to focus really on Canadian equity portfolios for their corporation. Basically, their corporation is full of Canadian equity to get capital gains, and eligible dividends, and nothing else because they’re afraid of having to pay taxes on interest in foreign dividends. Using a lot of Canadian equity in a portfolio is not necessarily a bad thing. As long as you’ve done that as you’ve chosen your asset allocation of Canadian equity versus other asset classes deliberately first, and you’re making sure that you’re achieving that as your priority.
Trying to balance your risk tolerance, diversifying away uncompensated risks, and then deciding on that home country bias how much of that’s reasonable, which we talked about in episode six. It is probably reasonable to be overweight, somewhat in Canadian equities. But you don’t want to make that the total focus within your corporation, because your corporate account is likely going to be one of your largest accounts. If that was your focus, you’d have a massive Canadian equity allocation.
I’m just mentioning that quirk, because I’ve seen a lot of people who do that, and they just point to the tax efficiency, but they don’t realize the uncompensated risks they’re taking from over concentrating in Canada, and on dividend-paying stocks in particular. Fortunately, there are simple ways that we can keep our corporation relatively efficient, and meshed overall with an efficient portfolio. By understanding how it all works, we can minimize their tax drag, manage your tax deferral using some easy moves. Let’s spend a few moments talking about tax drag and tax deferral with corporate investing. Those two concepts.
[0:07:43] BF: All right. Let’s start with corporate investment tax drag. Tax drag is the drag on your portfolio’s growth rate, the annual growth rate due to the fact that you have to pay taxes on investment income every year. If you pay tax from a non-investment account, that’s money that you could have otherwise invested. We can’t say that just because you’re not selling from the portfolio, you don’t have tax drag. It is still tax drag from the opportunity cost of not investing the money that used to pay the taxes.
With the corporation tax drag is pretty complicated. It can vary depending on the investment income, the active income, and how you move money out of your corporation to fund your living expenses. As you mentioned at the beginning of the episode [episode 10], corporate tax law has measures that discourage passive income. They don’t want people hoarding money inside of their corporations to invest on a tax-deferred basis.
When you’re investing with global diversification, there’s also going to be a range of income types. We have eligible dividends, interest, foreign dividends, and capital gains. We talked about the different tax treatment of those as a flow through to the shareholder earlier.
You can’t really help that, the fact that you’re going to get the different types of income unless you start making investment strategy trade offs, like only investing in Canadian stocks, for example, which comes with its own, well, trade offs.
You can minimize the impact by paying yourself optimally. So that means, enough dividends to release RDTOH. Plus, when you have enough in your CDA to justify the associated accounting fees.
We didn’t mention that earlier. When you pay a CDA, your accountant will usually charge a fee. It varies vastly. I’ve seen accountants charge $500, and I’ve seen them charge $5,000 or more to do a CDA election.
[0:09:19] MS: And some even just roll it into your overall corporate and tax preparation.
[0:09:25] BF: Yes, it’s a specific filing. You have to do a specific election to pay yourself capital dividend. Anyway, you may not always pay it out. just because it’s there. You may wait until there’s whatever, I don’t know, $10,000, $50,000, whatever amount makes sense.
[0:09:37] MS: I think it’s a good litmus test if your accountant wants to charge you a $5,000 capital dividend election fee, it’s time to start looking for a new accountant. Seriously.
[0:09:45] BF: Five thousand is extreme. That’s not a personal experience, that one. That’s a second-hand account of someone telling me about that. I’ve heard of it too though. I was actually talking to someone about how to model CDA in a financial model, and at what point we should release it. Then, we started talking about different levels of cost we’ve seen from different accountants. He actually told me he’s seen up to $10,000, which is like, what are you doing?
[0:10:08] MS: Wow. I get asked about this all the time, how much would you have before you’d give out? Because I try to model this too. You don’t know, it’s so variable.
[0:10:15] BF: Worth asking. Like you said, it could be a good litmus test, where if someone’s going to charge you $10,000 for a CDA election, it might be time to go.
[0:10:22] MS: I would say, though, the caveat to that is how big of a mess you’re handing the account. But if you give them everything nice, and bundled, and it’s simple, it should not cost much. If you pass them a big mess to sort out, then yeah, you should expect to pay more, because it’s going to be a big amount of time to sort out that mess.
[0:10:38] BF: That’s a very fair point, because they do have to figure out how much they can file for in the election, which does require some accounting. When we do it, we give the accountant a capital gains and losses report up to that point in time, which is something that we just have a report that we can generate. It’s super, super clean. But you’re right.
[0:10:54] MS: I do that too, with all the adjusted cost base and everything. The actionable point, I’d say for everybody from that little tidbit of discussion is that, when you are tracking your business expenses, and dealing with your account, make everything as clean, and easy and well documented as possible for them to deal with. It may not only is going to mean there’s less chance of mistakes happening, because they’re humans just like everyone else. But it’s going to cost you more if you hand a big mess to somebody.
[0:11:20] BF: Totally. I don’t want to give a shameless plug, but I’m going to. One of the things that we provide as a service for our clients that have corporations is that we prepare a corporate tax package that’s a really clean document of all of the information that the accountant needs. We just ship that off to them in a PDF, and it’s like, that’s it, you’re done for what you have to ship to your accountant.
[0:11:40] MS: That’s what should be happening for everybody. I can tell you it doesn’t.
[0:11:42] BF: I know it doesn’t and it can be pretty messy. Back to CDA elections. When all this can become a dilemma? We’re talking about using CDA and RDTOH to smooth your tax drag over time. Where this can become a dilemma though is when the corporation has a lot of passive income, or if you spend very little for your personal consumption. The investment income is taxed at close to the top rate upfront, like we talked about earlier. If you need less dividends than would be required to release all the RDTOH, you’re left with a choice.
You can either take extra money out, and pay the personal tax. Effectively, inflate your lifestyle intentionally to get more dividends out, which means paying more personal tax. Or you leave it in the corporation and accept that you’re going to pay this 50% tax on passive income until you eventually do take it out personally. If the personal taxes are more than the corporate refund, the RDTOH is effectively trapped until you do need money personally.
[0:12:41] MS: The tax drag of investments in a corporation that can be very efficient. When the [investment] income is low, and you’re spending a lot personally, it keeps everything flowing. Just some of the extra drag that you get from those imperfections of tax integration. That change is not for the better when the passive income becomes larger relative to your spending. We’re going to model some of that in the accompanying case conference, when we’re going to use the Money Scope to decompress the case of corporate bloat. That has the unpleasant effects of corporate bloat that can become actually quite severe if you develop an active-passive limit problem.
The issues with the active-passive income limit are very similar to the refundable dividend tax issue you just mentioned. I mean, it’s a non-issue for many people, but can cause major tax drag if the corporation has a high active and passive income. If you spend more money by taking more salary to live on, or eligible dividends to use the extra grip that’s generated, that can blunt that overall effect from that passive income tax. But it’s still there, except possibly in Ontario and New Brunswick due to that tax integration break that I mentioned.
The passive income limit also becomes a non issue when the corporation doesn’t earn active income anymore, like in retirement. This is really only an issue that affects you during your working years, essentially.
[0:13:53] BF: The bottom line here is that, when a corporation grows more passive income, it can become less tax efficient. You’re forced to either move money out and pay personal tax, or accept high tax rates inside of the corporation on your investment income. Effectively, you’ll be forced to take money out, and pay the rest of the tax at some point. Like you said earlier, in the episode market, you have to pay it at some point. All we can do is defer. Using a corporation to invest is only tax deferral, not tax elimination. Whether that’s good or not, it depends. Let’s jump into corporate tax deferral on investments.
[0:14:27] MS: This big advantage of corporate investing. Really, they hinge around this tax deferral. The tax deferral reduces the tax that you defer now at this higher tax rate and take it out lower tax rates in the future. That’s the idea behind it. When you do that, that ultimately means more money in your pocket, because you’ve moved from a high tax rate, and defer that to a low one. What people don’t realize is that, the inverse also applies. Leaving partially taxed money in the corporation now, and then taking it out at a higher tax rate in the future could increase the overall tax bill to access that money for personal consumption.
Now, the tax rate for any given income level, that could also change in the future. The government could change the tax rates at any time. That’s totally unpredictable. However, you can plan to try to smooth out your income and your consumption to try to keep yourself in lower tax brackets overall over time.
That concept of having an exit plan for the money in your corporation is really important. It’s very common advice to just leave as much investments in the corporation as you can to grow it as big as you can with tax deferral. As I mentioned, capital gains, and the growth of that capital is a big advantage. However, you have to make sure that you’re planning an exit strategy for that money at some point.
I even heard it be advised that you just don’t bother using your RRSP, your TFSA, or other tax shelters. Just leave it all in the corporation. But the problem is that, eventually, it does have to come out of the corporation. If it becomes very large, that’s going to be potentially in a higher tax bracket.
[0:15:59] BF: We mentioned earlier some accountant stories and CDA election stories. This is one of the big ones, where some accountants fixate. I don’t mean to disparage accountants, that’s definitely not my intention, but I’ve seen this. Some accountants do fixate on dividends for reasons that I personally think are pretty silly, like wanting to avoid paying into CPP is one common example. But as mentioned, when a corporation works well, is when you’re moving the money out at a lower tax bracket in the future. That’s when the tax deferral of a corporation is powerful, to also reduce tax. You’re deferring, but you’re deferring to the future where you’re paying tax at a lower rate.
That often works out well with how people earn and spend in their peak during their working years, compared to less in retirement, like it just makes sense. Your expenses in retirement typically lower too. You don’t have to take out as much money from the corporation for personal mortgage payments, and child-related expenses, and things like that. If you’re using enough dividends to live already, and it’s also enough to keep the RDTOH flowing, then corporate tax drag is pretty reasonable.
During your working years, that means a gradual shift from salary to dividends as the corporate passive income grows. Then in retirement, you’d be using all dividends to live on. You wouldn’t pay yourself a salary from a corporation that doesn’t have active income. It just wouldn’t make sense. If the income that you need to draw in the future is lower than it was during your working years, then you get to stay in the lower tax brackets. If tax rates are unchanged, then that means a tax savings compared to if you had taken it all at once.
[0:17:28] MS: I think there are a couple situations with a corporation where the income and taxes could be higher in the future. I mean, most commonly, and the hope is that they’ll be lower, but there are ways that it may not work out. I mean, the obvious one is that you decide in the future you’re going to consume more, and then you need to draw more income to meet that need. Maybe when you retire, you finally have all this time, and the ability to do all the expensive things that you put off while you’re working. That’s totally possible. That’s kind of an obvious one.
I think the less obvious one is that if the corporation has become really large with a lot of passive income. If that happens, you may need to draw more income to keep the RDTOH flowing, or accept that high tax rate. Anyway, the way to deal with this potentially is, instead of taking small amounts out now, and letting the corporation grow as massive as possible until you’re forced to take it out at a higher tax rate in the future. You may want to strategically move money out of the corporation at lower rates over time when you have those opportunities. We’ll talk a bit more about that later.
[0:18:28] BF: We were working on this at the same kind of time, Mark. But we modelled this earlier this year. We were trying to look at how to optimally take money out of a corporation over time. Should you take salary or should you take dividends? We both kind of find the same thing in our separate models, which is that, you probably want to do a mix of both.
Taking salary has benefits because it creates RRSP room and IPP room. Taking dividends has benefits because it releases RDTOH. But we called this – our little nickname for it was, take a dynamic salary, which is basically to take out salary in varying amounts from year to year depending on how RDTOH is available in the corporation at that time. It’s just kind of looking at that every year and your mix between salary and dividends might change from year to year.
[0:19:09] MS: The other thing that might confuse people having listened to us talk about RRSPs. Where people are afraid of using an RRSP because they’ll be forced to take money out in the future, and it might be at a higher tax rate because it’s tax deferral. I just want to point out, there is actually an important difference there, and that an RRSP is not only tax deferral. It’s actually tax sheltering at the same time. The difference between that, and a corporation is, a corporation has tax deferral, but the income growth over there over time is actually taxed. It doesn’t get to make up for that the same way that an RRSP does.
[0:19:42] BF: Yes. We’ll talk about that in one of our cases in the case conference too.
[0:19:45] MS: Perfect.
[0:19:47] BF: Let’s talk a little bit about tax planning for a corporate account. We’ll talk a little bit about decompressing from the corp to tax shelters. One is whether to slow the growth of the corporate passive income by using other account types. We briefly alluded to this earlier. This means, taking money out of the corporation to invest personally, like in your registered accounts, or potentially in your personal taxable account, depending on the situation.
Not only does that decompress current money and future growth in the corporation, future growth from the corporation. That future growth also has the tax sheltering and other benefits that registered accounts offer. We described that in in a lot of detail on episode eight.
You basically just described this, Mark. That if you leave money inside of your corporation, we know as we’ve just discussed, you’re either paying tax at a relatively efficient rate or not, depending on your RDTOH, and your personal dividends situation. But in the case of the RRSP and the TFSA, you’re not paying tax on investment returns from year to year. That’s a big deal.
Another option that’s related to the work that we did earlier this year that I mentioned a second ago that’s available to corporate business owners is something called an IPP, an individual pension plan. Now, that is a tax deferred tax-sheltered account, kind of like an RRSP. It feels like a little bit like an RRSP. Although, the legislation that lets it work, and the rules that let it work are very different. It is more complex than an RRSP, for sure, but it does also have some pretty interesting properties from the perspective of getting money out of the corporation and into a tax-sheltered vehicle.
We’ll do a deeper dive on IPPs in a future episode, but it is worth mentioning here, that they are an option to complement to corporate investing strategy. Because it’s a registered pension plan, it actually falls under the same legislation as the type of defined benefit pension plan that some employers provide. It’s a pretty interesting vehicle.
But as a corporate professional, who’s an employee of their own company, they can set one up for themselves. One of the requirements to do this is you have to have been paying yourself salary and have to be continuing to pay yourself salary to make contributions. If you’ve only ever taken dividends out of a corporation, and only plan to take dividends out of the corporation, you do not get the option of using an IPP.
In that salary versus dividends discussion, there’s the tax efficiency stuff that we talked about a moment ago, but there’s also the optionality of creating IPP and RRSP rooms. Now, an IPP has advantages and disadvantages. But either way, all things considered, it’s a pretty interesting tool. Not for all cases, but for the right cases.
[0:22:10] MS: That decision about moving some money out of the corporation to decompress it and put it into tax shelters seems like a pretty smart one to make. It’s pretty straightforward. Other consideration is, if your tax-sheltered accounts are all full, and then all you have left is a personal taxable account. Whether to take excess money out to put into that. Most of the time, it doesn’t make sense to do that.
However, there can be opportunities where you can strategically move some money out really tax efficiently. If you can get those opportunities and take advantage of it, and you don’t need the money, Then, you had the opportunity to invest that in a personal account. That essentially removes that corporate tax liability and starts you over fresh with a new one.
As mentioned, future investment growth would flow personally, and tax integration generally favours that. Plus, building what I liked about it, as well, is you build this pot of personal money. It has less tax liability baked into it, because you remove some of that. Usually, it’s just some capital gains. Those got reset when you have the money. That’s also useful to plan for personal cash flow splurges, and where you draw your pots down in retirement.
This can be particularly useful if you can move money out really efficiently, and into the hands of a low-income spouse, like we talked about with capital dividends. Without getting ensnared by the attribution rules that we talked about in episode nine.
Now to do that, I mean, these opportunities have to present themselves. It’s usually be done slowly over time, because it only makes sense in low-tax brackets and when you have those opportunities, I mean, for us, we’ve done it over the course of about 10 years now. But it’s come in quite handy. It spreads out our tax risk beyond our corporation. I mean, we started to really pay attention to it in 2018, when they’re talking about really digging corporations. And we thought, “Well, if all our eggs are in this one basket, and they changed the rules on us, we’re going to be a big trouble.” So it spreads out that risk a bit.
I think what we’ve found the most useful for it is, it helps us to have some of this invested money that has a small tax liability. If we do have big splurges like an RV, or vacation, or renovations, or something. We can access some of that money without having a big tax hit taken from it. As opposed to having to take out a bunch of money from the corporation at a higher tax rate. Now, there are ways if you’re planning for big splurges that you can smooth it out, and we’ll talk about more of that in the compensation episode. But it’s given us a bit of flexibility for some of those less planned splurges that we’ve done.
That brings us to the topic of more complex products and strategies. So those are pretty easy ways to use the accounts you’ve got, manage your cash flow. But as we mentioned, prevention of passive income and the corporation is also a target for more complex financial products and strategy.
When you talk about those, it is important to recognize the risks and costs of those strategies. Those costs and risks could be really hard to spot. So, we’ll use the Money Scope water pump to wash off some of the financial bullshit, which you’ve talked about as an actual academic term to get a clearer look at that in some future episodes. Still, before then, we should make some high-level comments as a bit of a preventative measure. Because I think this is one of those things we just can’t leave sitting.
[0:25:12] BF: It’s definitely worth addressing. I think if some of these products are really aggressively marketed, permanent life insurance, which you mentioned earlier is definitely one of them. One of the attractive features used to sell corporately held whole life, or universal life insurance is that it can be paid for with lightly taxed pre-personal tax corporate dollars like I mentioned earlier, instead of personal money. Then, a lot of the eventual death benefit can be paid through the capital dividend account. That’s a big part of the sales pitch.
If done long before death, the adjusted cost basis of the overfunded investment part of the policy can be ground down to allow much of the payout to eventually be tax-free capital dividends. That’s kind of the pitch. During the accumulation years, it’s often sold as having no tax on the income earned in the policy to the corporation. What gets missed in that sales pitch, and what most people don’t realize. To be honest with you, I didn’t realize until relatively recently, because this is not easy stuff. No one gives it to you on a brochure, and shows you, “Look at all the fees and taxes you’re going to pay.” It took a whole lot of digging to figure this out.
When I did the Quebec financial planning licensing course, in their textbook, which I found the Quebec financial planning exams were incredible. They were very difficult. In the textbook on insurance, I had the textbook translated from French to English using Google Translate. I don’t know if this is actually what the textbook says in French, but it said very bold language in the English translation. It said that saying that growth inside of insurance policy is tax free is a misrepresentation, and then it walks through why. So that caught my attention. Then I went and did a bunch of my own research and figured out how all this works. Anyway, a bit of a digression there.
With permanent insurance, there are provincial taxes on deposits into the policy. So on premiums, but also on overfunding deposits in the policy. You’re going to pay, in Ontario, it’s 2%., but it varies from province to province. The insurance company is taxed on the policies investment growth. This one, just nobody talks about it. It’s called the investment income tax, or the IIT. Now, that’s a cost that makes it right back to the policyholder through fees or premium costs. The insurance company is not just going to eat that tax for free, and do you a favour. So that’s two. Premium tax and investment income tax on growth in the policy.
Then, if you do need to access the policy during life, there can be further potential costs and taxes. It’s not a tax-free vehicle. You might defer some tax. You might pay a lower tax than you would if you were earning investment income inside of your corporation. But it is most certainly not tax free and it comes with a bunch of other costs. If you’re paying for the cost of insurance, for insurance that you don’t need, I would consider that to be a cost. Insurance premiums for a term insurance policy that you do need, so that’s a good investment. But paying premiums to get access to an investment vehicle, I would call that just part of the cost of getting access to this vehicle.
Then, there’s also a lot of uncertainty around the so-called policy dividends that a lot of these participating life insurance policies get sold on. You’ll see some pretty compelling, what are called illustrations, which is like a projection of how valuable this insurance policy can be in the future, and they use policy dividends to show that. I don’t know. They’re not guaranteed.
The insurance companies don’t say that they are and the agents won’t either. But they’re risky, and they never get illustrated as risky. I would maybe like to see it with a Monte Carlo simulation to show a range of possible outcomes. Or what I always do if someone’s looking at these, as I illustrated at current dividends scale minus 2%. Let’s see how that looks. They never look as good as the illustration that gets shown to the client.
Then the cost of those policies, and this is one of the big problems here. The cost of those policies is about 10 times the rate for – at least 10 times the rate for an equivalent amount of term insurance. So if you have an insurance need, use term insurance, that’s way less expensive.
This also is not really insurance that you need when you’re retired. That’s the other thing, is you’re buying a permanent insurance policy, which your insurance needs by the time you’re retired is probably not very significant. But a lot of people do get sold on these products positioned as insured retirement plans, which does sound pretty compelling. I want an insured retirement.
[0:29:15] MS: Yes, the language that’s used is really phenomenal with these products. I can tell you, as a confession, I do have a small, permanent life insurance policy that I got sold earlier in my career before I knew about all this. But I tried to look at what was going on under the hood and I couldn’t find it. Even some of the things that actually are taxes were actually called fees. Calling it a tax doesn’t sound good when you’re selling a tax-saving product, but a fee is okay.
[0:29:41] BF: Yes, that’s hilarious.
[0:29:42] MS: It sucked me in and I got it.
[0:29:44] BF: It’s really crazy stuff. I did a Twitter thread on this earlier, and a lot of people who are pretty competent in tax messaged me saying that they didn’t know any of this stuff. It’s not easy information to find. Since we’re doing confessions, I don’t have it anymore. I ended up canceling it and taking the small amount of cash value that it had. But when I started my career in financial services, I did work for an insurance firm. I sold myself a permanent insurance policy. It was like maybe six years into the policy. I ran the numbers on continuing to pay premiums versus canceling the policy, and I ended up deciding to cancel the policy. But I’ve been there too.
[0:30:18] MS: We all make mistakes. It’s hard, because that’s a hard landscape to navigate. I know we’ve talked about this life insurance policy issue, probably several times now. We’re going to talk about it again, but it’s worth repeating. Because as you mentioned, even people that know about these things, don’t actually know about all these details. It takes a few times to hear about it to really kind of consider it. I think it’s time well spent.
[0:30:43] BF: Then, there’s all kinds of funny things that happened with the way these are illustrated. They’ll compare, “Look, how much this permanent insurance policy could grow to versus earning 100% interest income in your investment portfolio.” Nobody earns 100%, right?
[0:30:56] MS: Who does that? I shouldn’t laugh too hard, because I know a lot of people are like, “Hey, I know that interest rates are so high, why would I invest? I’m just going to buy GICs.”
[0:31:04] BF: But it’s super sensitive to that. If you go and model it against earning eligible dividends, and unrealized capital gains as the alternative, then the insurance doesn’t look so good.
[0:31:14] MS: Yes, it’s going to get smoked.
[0:31:15] BF: It’s going to get smoked, exactly. If you illustrate the insurance at the dividend scale minus 1% or minus 2%. Or if you introduce some uncertainty that to the future dividends that the policy could receive, that’s another crazy thing. I don’t want to go too deep on insurance, because we’ll do an episode on this. But with the participating policies, they’ll calculate the participating dividend every year for all the participating block. But then, within the participating block, there are cohorts of unit holders who will get different dividends scale of treatment.
[0:31:43] MS: They make adjustments. I actually tried to look up the adjustment formula once.
[0:31:48] BF: No, it doesn’t exist.
[0:31:49] MD: No.
[0:31:50] BF: It’s proprietary. Fair enough, they can’t give that information away, because that’s how they price their products, and that’s part of their competitive advantage as the insurance company. But yes, it’s super, super opaque. The point there is that, even if you go and look at the past dividends scale of a participating product, that doesn’t mean that’s what you would have gotten. Because of your section, if your block of the participating block of policies, your sub block, I guess. If it’s like whatever, White males aged 30 to 40, or whatever that block is. If they have performed particularly poorly for the insurance company, the dividends scale will be reduced for that portion, that group of people. Anyway, super opaque, and it never gets illustrated with the amount of risk that’s actually in there.
On the idea of insured retirement plans that I just mentioned, there has been a recent regulatory crackdown. That’s been pretty – I mean, scary, honestly, to watch to see what the regulators have been finding with some of the audits that they’ve been doing. Regulators are not happy with how these things have been sold. Unfortunately, in the cases that they’re cracking down on it, it looks like it’s mostly lower income people as opposed to high income people. But they’re being sold permanent insurance policies instead of having money in their RRSPs and their TFSAs.
[0:33:00] MS: I can understand why you get so fired up about the insurance. It’s fires me up too. The vulnerable people get actually hit with this pretty badly. It’s crazy. It’s not financial sophistication, they’re selling a sophisticated product, and appropriate, and that’s the person who shouldn’t be doing that. Makes me mad too. It’s crazy.
[0:33:15] BF: Super frustrating. High income people and professionals, they can still get screwed on that, but at least they’ve got high incomes to recover from it. But in a lot of cases, it’s people who maybe will have a lot more trouble recovering.
What you really want to look at is the total after tax return of an insurance policy, when you’re considering it as an investment. When you actually need insurance is a different calculation. But you want to look at the total after-tax expected return, net of all the fees, and costs, and taxes, and comparing with some level of uncertainty.
Because we don’t know what future stock returns are going to be, but we also don’t know what future participating dividends are going to be. You got to make that comparison kind of apples to apples. We’ll talk more about that in a future episode.
The main takeaway on insurance is that it’s good for insuring against low probability catastrophic events, like an untimely death. Low cost, index-type investments, like ETFs, and low-cost mutual funds – those are going to be better for investing most of the time.
[0:34:09] MS: that brings us to another type of way that we can try to deal with the passive income issue in a corporation, which is actually with some of those ETFs and funds. There’s a group of special type of funds called corporate class funds, that can be aimed to reduce passive income in a corporation. It essentially, it defers tax. When it does provide returns, those are going to be as tax efficient capital gains, instead of the usual income capital gain mix. Which, as we’ve already mentioned, capital gains in a corporation are very, very tax efficient.
These are corporate class funds, and what that means is they’re mutual funds or they’re ETFs that have a corporate instead of a trust structure. Most ETFs or mutual funds are trusts, which means they collect income, they pass it all through, and it’s all attached as one clean line of money movement.
What happens in corporate class type of fund is that all the different ETFs, or funds that cover different asset classes are all part of one big company. They all are different share class within that company. The effect of that is, is that the income in one fund, you can use the expenses and usual trading costs and management fees from another fund to offset that income, making the net income zero.
If there’s no net corporate income, then there’s no tax during that year for that fund. That means that, it translates it into practice when it’s working well, as it means, no taxable distributions to your corporation either. You don’t get dividends, or interest, or anything like that. What happens is the value of the shares just go up by the total return of what you would get from the income plus the capital gains. That makes it all a capital gain, essentially, which differs until you sell it, and then it’s super tax efficient.
This sounds like a great way to invest, especially in a corporation where passive income is bad, and capital gains are good. It can be very attractive for people. But there are some potential issues that kind of lurk under the surface with this.
One of them is that the actively managed corporate class mutual funds have the same drag on performance as other mutual funds due to their high management fees. In a corporate class mutual fund that’s actively managed, it’s likely to be even higher, because you have the cost of running the business of the corporation in addition to the costs of the investing. Those of course can be used to offset so you don’t get distributions, but you’re also losing on your total return by having those high fees paid.
Now, there are other lower cost corporate class ETFs, which those are going to have lower fees and lower cost structure by the way that they’re made. But they also have another potential problem, because they don’t have as many management and trading expenses to offset the income. There is potential over time that the corporation could start to develop some net income that they can’t offset with their expenses. It is a corporation, so it’s subject to corporate taxation. And this gets a little bit complicated, which we’ll talk about in a future episode on them. But they can actually become very tax inefficient very quickly if there is corporate income that’s being realized within the mutual fund corporation.
I recently wrote a series of blog articles to unpack that with pictures, and models as examples, because it is actually a bit complicated. But it’s important if you’re considering using these types of corporate class funds, which can have really good tax benefits when they’re functioning as attention, that you also are aware of what the potential risks are that are there, to see whether it’s worth that tax savings for you or not.
[0:37:38] BF: Yes. That series of blog posts were just incredible. That level of detail on something like this for free on the Internet, it is just unbelievable value for people.
[0:37:47] MS: Free is my favorite price.
[0:37:50] BF: It’s a good price. I did want to mention on corporate class funds. We talked earlier about the flow through treatment of foreign dividends in a corporation. Corporate class funds, not the low-cost index ones, because they’re using a swap structure to get their total returns. So that’s a different animal. But a lot of mutual fund companies do still have traditional corporate class mutual funds that hold securities directly to deliver the returns of an asset class, or an actively managed strategy or whatever. But if you were earning foreign dividends in your corporate class fund, they’re still going to get the overall Ugly Tax treatment. There are all sorts of pitfalls.
It’s kind of like the permanent insurance thing, actually, where you’re not actually reducing your tax, you’re just making it less visible. Because a lot of the tax ends up happening inside of the corporate class fund. You might receive an eligible dividend or capital gains or whatever, instead of interest income, or instead of foreign dividend. And you think, “Great, I paid less tax.” But when you trace it back and think where did that eligible dividend come from.
[0:38:46] MS: Yes. It really depends on the type of income, how it flows in, and then the net corporate income, how its structured. If it’s structured really, really well, and it’s functioning like that, it can be amazing. That’s tricky to do. A lot of these corporate class mutual funds have been closing down over time, because they’ve been having issues.
The big family of corporate class ETFs is relatively new on the scene, and still functioning pretty well, actually. But I think it’s important understand what’s going on under the surface, because it’s not readily apparent.
[0:39:15] BF: Totally. They’re almost two separate discussions. Traditional corporate class mutual funds and the Horizons total return swap.
[0:39:22] MS: Yes, because they’ve got that swap structure, which changes the income type completely.
[0:39:27] BF: We’ve got the swap structure, and they’ve got their suite of ETFs that are almost literally designed to lose money. Not literally, but they’re like speculative vehicles that have historically been very good at losing money. But vehicles like that, it’s interesting when you think about ETF products, a lot of products that lose money consistently may actually exist because people use them as some kind of hedge. Somebody needed a hedge against whatever, the price of oil changing. So they bought this ridiculous looking – to an investor that wants to earn positive expected returns, it looks ridiculous. But someone who needed a hedge, maybe it served a purpose for them.
[0:40:03] MS: I think I heard that you talk about this recently in an episode. A lot of people still aren’t sophisticatedly thinking about it as a hedge. They’re looking for this –
[0:40:10] BF: Well, that’s the thing.
[0:40:11] MS: Market timing, speculative investing, and get the big skewed return on it. That’s the thing. Human nature being what it’s going to be, I think those products are always going to exist because people serve their inner animal by using them.
[0:40:24] BF: I was trying to throw a bone and be nice to the people losing money in these products, that maybe they’re being smart in hedging. But you’re right, we had a guest who has studied thematic ETFs, and he finds that, well, that could be an explanation for why people use them. It’s actually not. People are just performance chasing.
[0:40:37] MS: That’s funny, because it’s like this conflict of interest that I have, because I do use some corporate class ETFs. I’m trying to stop people from investing stupidly, but at the same time, they’re helping to offset and save me taxes on my index type of investing strategies. It’s kind of like this inner tension that’s there.
[0:40:53] BF: Yes, that is funny.
[0:40:54] MS: Stopping people doing stupid stuff still wins out.
[0:40:57] BF: We looked at those products a while ago, and that was one of the things that kind of made us flinch, I guess. Is that, okay, so this works as long as a bunch of people are losing money. I don’t know. Not sure how we feel about it.
[0:41:06] MS: All markets are going to be that way, though. There’s going to be people on two sides of the trade.
[0:41:11] BF: That’s true.
[0:41:12] MS: I’d rather be on the winning side.
[0:41:14] BF: Well, we’ll do a whole episode on corporate class funds, because lots of interesting stuff to talk about there.
[0:41:18] MS: Yes, we can have fun with that.
[0:41:19] BF: The next one I’ll mentioned is asset location. This is another one that gets thrown around as a way to be smart with taxes, and it can work. But the idea is trying to match the investments with more efficient eligible dividend income and capital gains to the corporate account. And then putting the less efficient investments that pay interest income or foreign dividends to other accounts like the RRSP, TFSA, or personal taxable account.
Now, we did mention this in the last episode. That can get pretty complicated pretty quickly. Remember that a corporate account is tax deferred. So, you have to adjust for the baked in tax liability to get a true sense of your overall after-tax asset allocation if you’re trying to optimize for asset location. We’ll get into that in some of the other challenges in an episode on tax planning specifically.
But the main message, I think, with asset location, and we do have actually one of our case conference topics on this as well. But the main message I have on asset location is to be really careful increasing your execution risks and your costs. In some cases, really obscuring what your actual asset allocation is, it can get pretty confusing. All those downsides can easily exceed the tax savings if you’re not careful.
[0:42:28] MS: What I would say about that is, for the average person who’s personally investing the potential tax benefit is minuscule, and the potential risk execution and costs for doing that could easily outpace that.
I think with a corporate account, because of the high taxes on passive income, I think there’s more potential that’s there for you to get a bit of a bigger tax savings. But at the same time, it really has to be done very cost effectively, simply, and you have to be able to follow that plan. Which I think is probably going to be hard for a lot of people. But there’s those two sides, I think the corporation has a bit more of an opportunity for that. But those other risks are still very real, and probably would stop most people from doing it.
[0:43:09] BF: It introduces real objective measurable risk too. I’ve modelled this a while ago, not with the corporation. That’s something that we’re going to do at the personal level. I think that in broad terms, the lesson still applies, where I went and built the optimal asset location strategy based on expected returns. So based on like PWL’s expected return assumptions, I went and build the optimal asset location strategy across, I think RRSP, TFSA, and a personal taxable account.
Then, I went and looked at whether that strategy was actually optimal with a real series of 10 year returns from the previous 10 years, I think. That ended up being significantly suboptimal relative to just having the same mix in all account types. You can actually end up worse off if reality ends up being different from your assumptions when you make the optimal location decisions.
[0:44:00] MS: Totally. It’s very sensitive to a whole bunch of inputs. That was a great paper. I’m hoping to see one with a corporate account too. That’d be awesome.
[0:44:07] BF: It’s coming.
[0:44:08] MS: Great, that’s good. I just want to finish off this discussion about tax planning and how to manage your corporate investments with another way of looking at it. We’ve talked about the approach is to spread income out across other accounts, strategic opportunities to do that. Sometimes using complex products, or strategies, or not. That’s all part of tax planning, and we’re going to focus on that in our next few episodes.
But I do want to make one more point before we wrap this up. That is that, really, the inefficiencies that can happen with corporate investing result from having a lot of income and not spending much personally. For many people, even high-income professionals, that will never be an issue. If it is an issue, that’s often later in your career or closer to retirement.
If that is the case, then another approach to this problem is to consider scaling back your work and spending time developing some of your non-work interests and relationships. When you have this issue, you’re obviously going to be – you’re in a sound financial position or you wouldn’t be having a too much corporate passive income problem.
However, I would say that retirees can often struggle, not just because of any financial issues that are in a strong financial position, may struggle because they don’t have interests and relationships outside of work to retire to. Those non-work-related sources of wealth require investment and time to grow as well.
If you’re finding yourself in these situations where there’s passive income problems with a corporation, just also remember that that’s also a time for you to step back and think about what it is you want to do.
Maybe if it’s happening early in your career, or mid career, then it may be good to have a bit of a midlife crisis, because you’re killing it financially. But you should reflect on how you’re going to use that financial power to do the most for you, and your family, your community, and everybody else that’s important to you.
That maybe – a lot of us love our jobs. It’s a big part of our identity and our purpose. So, it doesn’t mean necessarily stopping working or cutting back per se. It could mean, just refocusing your work on areas that you find a bit more non-financially satisfying, but you can dedicate some time to that. Or you can spend a bit more and or give a bit more to charity.
Spending and giving are actually important financial skills, and they actually require practice to improve at it. So it’s not one of those things that you should just leave all of these aspects of your overall financial life, and wellness to some day later in retirement. These are all things that you need to work on building your human and social capital over time, as well as your financial capital.
Yes. We can deal with corporate taxation and investment strategies with all of these ways that we’ve talked about. But the whole reason why we’re doing all of this is as part of our lives overall, so just keep that perspective.
[0:46:44] BF: Super important. To tie back to what we covered in the early episodes on values, and objectives, and living a good life as opposed to just focusing on minimizing your overall tax liability or maximizing your lifetime after tax wealth, which are worth thinking about. But the end is living a good life, not maximizing wealth.
[0:47:05] MS: It is important to pay attention to, though, because one of the things I would say is we are stewards for the wealth that we’ve got. If we pay attention to the taxes and invest well, we can grow a bigger pot of money to do more good things with. If we don’t pay attention to that, then that money goes to other people who may not do as much with it as we would.
[0:47:24] BF: Yes, for sure. That’s a great point.
[0:47:25] MS: Great. That wraps up the second episode that we’ve done on investing using corporation. This is a complex topic. We know you’ll probably have to listen to the episodes more than once to get the material. There’s also a number of concepts that we’re going to come back to again beyond this.
[0:47:42] BF: That’s the thing. We’ve kind of built a foundation to talk about these relatively complex topics. Now, we’re going to be equipped to address it from a bunch of different angles in future episodes. Because of the complexity and different taxes involved here, there are a lot of strategies and products that get aimed at it. Those include things like permanent insurance, corporate class funds, and asset location strategies. We’re going to unpack those in future episodes, including their pros and cons. Because you don’t want to simply exchange some tax savings for increased fees, or other risks.
Now, there are some simple things that you can do, which is the good news. You can keep flowing money out of your corporation to fund your lifestyle and make good use of your registered tax shelter accounts. Like your RRSPs and your TFSAs.
You can ask your accountant about your notional account balances and be sure to pay yourself from your corporation in a way that efficiently uses them up. The money has to come out of the corporation eventually, and an efficient plan meshes the investment income with how you compensate yourself.
As you’re earning investment income, that’s taxed at that higher rate in the corporation, you want to be able to release some of those refundable taxes by making sure that you’re paying yourself with the right mix of salary and dividends.
We are going to do a full episode on the optimal compensation strategy for people with corporations. In the meantime, we hope that you’ll join us for the case conference supplemental episode, where we’re going to illustrate some of the concepts from these last two episodes.
