Smarter Corporate Investing: The Benefits of ETFs Inside Your Corporation
This article is sponsored by BMO ETFs.
Those who must save and invest at a rate faster than the TFSA and RRSP room that they generate may have to invest the excess using non-registered accounts. That is a common challenge for professionals and business owners because they usually take a decade or more to reach their income potential while they train and build their business. In addition to a lost decade of compound growth, higher personal income is taxed aggressively.
Fortunately, many self-employed professionals and business owners may have the option to incorporate their business or practice. While still exposed to tax, a well-managed corporation can invest tax-efficiently. Using ETFs to invest can make that easier and more cost-effective.
What Is Incorporation?
Incorporation is a process by which a separate legal corporate entity is formed from the individual taxpayer to conduct business and/or invest. Incorporation helps to smooth personal income and retain money in the business to buffer the more erratic cash flow intrinsic to being self-employed. Excess money earned from business income that is not needed for immediate personal, or business expenses can also be invested within the corporation and drawn upon later when needed or paid out to the owners (typically in retirement).
How Is Corporate Investment Income Taxed?
The main advantage of a corporation is (personal) tax deferral. Not as good as the full tax-deferral of an RRSP or pension, but the next best thing and without contribution limits. Corporations that earn active business/professional income pay a lower tax-rate upfront (approximately 10-30% depending on the province and level of income earned) compared to individuals (approximately 20-54% depending on the province and their marginal tax brackets) on the same earned income. For individuals who are high earners, that means more money upfront to invest and grow inside the corporation. They pay the rest of the tax personally when they access the money later by receiving dividends from the corporation. The combined corporate business taxes plus personal dividend tax is typically more than earning the same income personally. However, if the lower-taxed corporate business income money can be retained within the corporation to invest and grow for many years before accessing it, then that tax-deferred growth can potentially be powerful.
There are mechanisms to prevent too much tax deferral. When a corporation earns passive income — interest, dividends, or taxable capital gains — they are taxed at high corporate investment tax rates upfront (which include refundable taxes). When the corporation pays out a taxable dividend to its shareholder (who then pays personal tax), all or part of that corporate refundable investment tax is refunded to the corporation. Looking at this for an individual subject to the highest personal marginal tax rate, the total of the corporate tax (net of the refund) plus personal tax on the dividend from the corporation is more than you’d have paid receiving the same investment income directly.
That seems to discourage corporate investing. However, if you must draw dividends derived from the corporate investment income to live on anyway, then you would be paying that personal tax regardless. In that case, the net tax on investment income after the refund in a corporation is very low — single digit tax cost on interest income, half that amount on capital gains, and zero cost on dividend income. Foreign dividends, like from the US or non-North American companies are taxed more heavily in a corporation due to how foreign withholding taxes interact with the refundable tax mechanism.
How Can ETFs Help?
If your brain did not explode from the preceding section, you hopefully survived with some important take-aways. Corporate taxation is complicated. It is impacted both by investment income received and the dividends paid out by the corporation. Different types of investment income are treated differently. Using ETFs can simplify the investing and accounting process so that you can focus on optimizing those interactions. I’ll explore some of the ways how below.
Simplifying Compensation Planning For Corporate Owners
Corporate owners have an option to pay themselves salary or dividends. Salary has the advantage of lowering corporate taxes and generating tax-advantaged RRSP room. Salary also comes with contributions to the Canada Pension Plan (CPP). Some equate CPP to a “tax” because it is mandatory and national, but it is actually a small defined benefit pension plan that is indexed to inflation. Not a reason to avoid salary and its benefits. On the other hand, dividends paid out of past business income retained earnings have had the advantage of retaining more money in the corporation to invest. Dividends income paid in the future also keep corporate investment income tax efficient by triggering refunds for the passive income taxes.
To get the best of both worlds, “approximately optimal” compensation uses a mix. Paying dividends roughly equal to the corporate investment income ensures release of refundable taxes. For a corporation with a low investment income, that would usually not be enough to fund the owner’s lifestyle. The difference can be made up using salary and its advantages. The exact mix can be fined-tuned, and it must be tailored to your specific situation, but that is a good starting point for discussion with your accountant. It may not come up if you do not bring it up.
This approach requires you to have a sense of your investment income over the coming year. That is much easier with one or several ETFs than it is with a large number of individual stocks and bonds paying different types and amounts of income at different times throughout the year.
Simplifying Corporate Investing Enough To DIY
The complexity of corporate taxation is often used to discourage DIY investors from also DIY investing for their corporation. A corporation can open a self-directed brokerage account just like other investing accounts.
The same investing principles apply. Choose an asset allocation that suits your risk tolerance, diversify to mitigate risk, rebalance as needed, and keep fees low. Just like elsewhere, an all-in-one asset allocation ETF can be a great solution for those considerations. The BMO Growth ETF (ZGRO) and BMO Balanced ETF (ZBAL) even use discount bonds for some increased tax efficiency relative to regular bonds. The savings of using ETFs versus a high fee advisor could be substantial if you can stick to that plan.
The potential for tax savings by trying to finesse it are minimal before the corporation is large enough to produce significant passive income. That often requires millions of dollars invested. Even then, it is optional and ETFs can make DIY investing more feasible.
Asset Location Optimization
Asset location optimization is attempting to match where you hold different investments to the accounts in which they are most tax efficient, while still maintaining your target asset mix. It gets complicated quite quickly and is not worth the effort for those just using an RRSP and TFSA. Small tax savings could be easily undone by execution or assumption errors. However, it can be worthwhile with corporations in the mix because of larger differences between taxation of different income types and how “too much” passive income can make a corporation less tax efficient.
The downside is the complexity, but ETFs can make it feasible by using ETFs that bundle investment income types. For example, a Canadian equity ETF (eligible dividends), a foreign equity ETF (foreign dividends), and a bond ETF (interest). The magnitude of the interest or dividend yield also impacts taxes. So, splitting foreign equity into US (lower dividend) vs non-North American (higher dividend) could allow for even further optimization.
For example, the Canadian allocation would preferentially be held in the corporation given eligible dividend efficiency there while shifting less tax efficient non-North American equity or bonds in tax-sheltered accounts. US equity ETFs can be efficient in an RRSP, or if the yield is low, a corporation. Even with ETFs, it requires calculations due to the limitations of registered account space and priority of maintaining your overall asset allocation. Given these complexities, a tax professional could help provide further information and guidance.
I have portfolio builder calculators (found on www.looniedoctor.ca) that attempt to make it easier. I can’t imagine attempting tax optimization while also juggling enough individual holdings to be diversified. There would be significant potential for errors.
Keeping Accounting Reasonable
An ETF strategy simple enough that you can manage it yourself can reduce the drag of portfolio manager fees. It can also have an important impact on your accounting costs. Many accountants cringe when their client says that they want to DIY invest in their corporation for good reason.
A good full-service advisor should give the accountant a nice package at tax time showing the transactions and summarizing the investment income received. Discount brokerages may issue a tax package, but it usually corresponds to the calendar year rather than the corporate year end.
If you hand your accountant a tangle of multiple transactions on enough individual stocks to be diversified, that will be a lot of work for them to sort and enter the information. That translates into a higher risk of mistakes. It also means either higher costs for their time or less of their time spent on your tax planning. A buy and hold strategy using one, or a handful, of ETFs keeps you diversified while keeping the bookkeeping simple.
Good Corporate Tax Planning Is Complex. ETFs Keep The Investing Simple.
The advantages of ETFs for corporate investors also apply to personal investors using non-registered accounts. However, the benefit is magnified in a corporation due to the corporate tax complexity (compensation planning, asset location, and accounting costs). Corporations also often have larger portfolios making the dollars saved by making DIY investing feasible larger compared to hiring a %AUM manager. Still, the best option depends on your situation, ability to execute, and whether an advisor is able to add value to that relative to their cost. Whether using an advisor or DIY ETF investing in your corporation, hopefully this article gave you some ideas of where the pay-dirt is and what to learn more about or discuss further with your financial team.
Dr. Mark Soth is a practicing ICU physician. He blogs about career, life, personal finance, and investing for Canadian professionals and small business owners as The Loonie Doctor at www.looniedoctor.ca and co-hosts The Money Scope Podcast at www.moneyscope.ca
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