Following Content Also Features as a Guest Blog Post from the Loonie Doctor.
Conventional wisdom is to avoid realizing capital gains in order to defer taxation as long as possible. However, there are some times when harvesting the capital gains in a corporate investment account could actually defer tax even more. It can also be useful for early retirees or those with a low-income year, but this article will focus on the Canadian small corporation owner. Learn about how this works and whether it is something that you should consider discussing with your accountant.
What is capital gains harvesting?
Capital gains harvesting is selling a holding (like a stock, mutual fund, or ETF) that has an unrealized capital gain and then immediately re-buying it. That has two effects. First, it makes the capital gain taxable. Second, it then resets the adjusted cost base (ACB) of your holding. That means that future capital gains/losses would be compared against this new price as the benchmark.
Capital gains harvesting is not to be confused with capital surplus stripping. That is a boutique tax law maneuver. This maneuver is basically the inverse of tax-loss harvesting or capital loss harvesting that is commonly described. In fact, it also sometimes referred to as tax-gains harvesting. Tax-loss harvesting is realizing a capital loss now. In the U.S., that can be used as a deduction against income. In Canada, it could be useful to be offset some capital gains from previous or future years to reduce or defer taxes.
One important difference between capital gains harvesting and tax loss harvesting is that you do not need to worry about the “superficial loss” rule. In tax-loss harvesting, you cannot have bought the identical holding (in another account) or re-buy the identical holding within a 30-day window on either side of selling and realizing the loss. That is considered a superficial loss and cannot be deducted against other capital gains. Conversely, there is no such thing as a “superficial gain”.
The reason why the “superficial rule” does not apply to gains is that realizing a capital gain makes tax due now. It is to the government’s advantage. If it makes tax due now, then why the heck would you do it?!?
When would a capital gains harvest be useful?
There are a couple of reasons why you may want to trigger and pay taxes now rather than later.
The speculative harvest.
A gains harvest can be a bet that the tax rate is going to rise drastically in the very near future. Better to pay less tax now compared to pay much more next year. It is a gamble, that the tax hike will occur, and that it will be large enough to justify the smaller pile of capital left to compound over time.
Capital gains are currently taxed with a 50% inclusion rate. That means only half the capital gain is taxed. The capital gains inclusion rate is taxation by design. It is meant to encourage the risking of capital required to innovate and grow the economy, and to account for inflation eroding the “buying power” of capital appreciation.
Raising the capital gains inclusion rate has been bandied around by our cash-strapped government for several years. The NDP had raising the inclusion rate to 75% as part of their election platform. A move to 75% from 50% equates to a 50% tax hike! The expenditures dealing with Covid-19 have surely stoked the governmental thirst for revenue from unsavory types – like savers and investors. Usually, when governments announce a new tax measure, it is effective from the day of announcement forward (even if the bill is passed later). The Federal throne speech looms imminently and a budget soon thereafter…
This is a speculative reason to capital gains harvest and the topic of a future post. It could apply to either a personal taxable investment account or a corporate investing account.
Capital gains harvesting as corporate tax planning.
There is also a mathematically sound tax planning reason for capital gains harvesting. It applies to those using a small corporation, like a Canadian Controlled Private Corporation (CCPC) or Medical Professional Corporation (MPC). While the harvest results in more corporate tax paid now, that can be more than offset by personal tax savings.
When we flow cash from our corporation into our personal hands, we pay personal tax on the dividends or salary. The amount we dispense to ourselves from our CCPC is usually driven by how much after-tax cash flow we need to fund our lifestyles (and usually our RRSP & TFSA if we are trying to optimize!). In essence, we work backward from how much after-tax money we need to live on to determine how much money we must pay ourselves from our corporation. We also need to avoid mental accounting and consider both the corporate and our personal taxes together.
Reducing our personal tax rate means that we can pay out less from the corporation to achieve our cash flow goal. That translates into more tax-deferred money left in the corporation to invest and grow. It maximizes the corporate tax-deferral advantage.
The above, simplified, description of the taxes is an optimal situation. There are a number of nuances that effect how efficiently this works. To fully understand how a capital gains harvest in a corporation can result in net tax savings, we need to review how capital gains are taxed in a CCPC in more detail.
CCPC capital gains taxation: inclusion rate, refundable tax, and capital dividends.
Capital gains inclusion rate
When we sell a holding for more than we paid for it, that gain in value is taxed as a capital gain. Only part of that capital gain is subject to tax. That is the “included part” and the proportion is referred to as the inclusion rate.
For example, my CCPC bought $1K of shares in Apple in 2011. Yeah, I wish! They are now worth $101K. That is a capital gain of $100K. I sell all of those shares and realize that gain. The capital gains inclusion rate is 50%. So, $50K is taxable (included) and $50K is tax-free (excluded).
Tax on the included amount
The included amount is taxed at the corporate rate of 50.17%. Some of that tax is refunded to the corporation via RDTOH when the corporation pays out enough ineligible dividends. Further, personal tax is then due on the ineligible dividend.
The excluded amount build the capital dividend account (CDA)
The excluded amount is added, dollar for dollar, to the CCPC’s capital dividend account. The capital dividend account (CDA) is a notional account. That means it just exists on paper for accounting purposes to keep track of whether a CCPC can pay a capital dividend or not. If there is a positive CDA balance (meaning there are accrued capital gains in excess of accrued capital losses), then the corporation can elect to dispense a capital dividend. There is no personal tax on a capital dividend.
Movement of a $100K realized capital gain from a corporation into personal hands is illustrated in the diagram below.
The astute will notice that the total tax paid (28.857%) is higher than if you were to realize a capital gain personally (26.765%). As in other areas of tax integration, a corporation on its own is not an efficient way to flow earnings. What can make this very efficient is if a corporation is already dispensing more than enough dividends to release the RDTOH (yellow in the chart) from its active business income as part of the usual payment to shareholders. In that case, the use of a capital dividend could reduce the amount of excess ineligible dividends paid from active income required for the shareholder/owner to have the same after-tax personal income.
Factors affecting the efficiency of tax gain harvesting in a CCPC.
Sufficient cashflow out of the corporation.
For capital gains harvesting to be efficient, you must have enough money flowing out of your corporation. That could be to fund your regular spending or it could be a one-off-big-withdrawal-year to top up a TFSA, put a lump sum in an RESP, fund a home renovation, or even buy a motorhome.
If you are not flowing enough money out of your corporation, then realizing capital gains within the corporation is not tax efficient. You are paying tax on the gains now, but not able to offset that with personal tax savings.
Sufficient dividends to release Refundable Dividend Tax On Hand (RDTOH)
When a corporation receives investment income, it is taxed upfront at ~50%. When you pay out ineligible dividends, the RDTOH of 30.67% is refunded to the corporation. So, if you are not still paying out enough dividends to release the RDTOH, then adding more investment income via the taxable half of realized capital gains worsens efficiency. Instead of a 9.5% tax drag on realized capital gains, it is a 25% tax drag in the corporation. Approximately $2.61 of dividends paid out are required to release each dollar of RDTOH.
If you pay out more ineligible dividends just to release the RDTOH, then you pay personal tax on those dividends. That decreases the tax drag in the corp by 15.6%, but the personal tax rate incurred (20-48%) is much higher than that for incomes over about $50K/yr. So, it is usually not advisable to dispense extra dividends simply to get the RDTOH if you don’t actually have a personal use for the money.
Have a large enough capital gain to offset accounting costs.
To dispense a capital dividend requires a special election and paperwork. Some accountants will include that in their overall fees for managing the corporation’s taxes. Others will charge a special fee. That fee could be a flat rate. Alternatively, it could be based on the time required to review the investments and do the paperwork. That can vary greatly based on how complex the investment portfolio is and how organized your records are. Generally, something in the $300-900 range is what I have heard of. It would be great for readers to add their experience to the comments section of this post.
So, you would need to be able to dispense a large enough capital dividend to save enough tax to offset that cost. That would be larger for those facing large accounting fees or in low personal tax brackets.
The capital gains inclusion rate.
The efficiency of a capital gains harvest from corporate investments is driven by the ability to give tax-free capital dividends. As the inclusion rate rises, this opportunity decreases as the excluded gain (that adds to the capital dividend account) shrinks. Currently, it is 50%. However, an increase in the inclusion rate to 75% would cut the amount of a gain going to a CDA and eligible for a capital dividend in half! This may limit the utility in the future if tax rates rise.
Exceeding the active-passive income threshold.
The included half of the capital gain counts towards aggregate investment income for the corporation. If that exceeds $50K per year when added to other investment income, then it will shrink the amount of active business income that the corporation is allowed the lower small business tax rate for at a rate of $5 for every $1 over $50K for the following fiscal year.
The corporate income above the active-passive threshold is taxed at the higher general rate. However, that also generates GRIP which softens the tax-blow by allowing more eligible dividends instead of the higher-taxed ineligible ones. That may even be a net advantage in Ontario and New Brunswick where tax integration got broken by the rule change (until they fix it). One could also increase the salary paid out to decrease the corporate active income as a strategy to come back below the threshold. That is particularly effective if the extra salary can be offset with RRSP contributions/deductions. A third strategy to attenuate this problem would be to spread out the capital gains harvest across two corporate fiscal years. A number of other strategies could be used if the active-passive income threshold is going to become a recurring problem.
Is it time for you to consider a capital gains tax harvest from your corporation?
The answer will be different for everyone depending on:
- How much investment income your corporation has normally. More income means more RDTOH collected that requires ineligible dividends to release. This also relates to the next bullet.
- How much personal cash you can utilize for lifestyle needs or to top up your tax-sheltered accounts. If you start to trap RDTOH in your corporate account by decreasing the ineligible dividends dispensed, it is less efficient. If you require excess ineligible dividends to meet your after-tax cash needs, then offsetting that with capital dividends from a capital gains harvest can be efficient.
- How much capital gains you have to harvest. Is it worth the hassle and accounting fees?
- Whether it will bump you over the passive income threshold and whether you can attenuate the effects of that.
- Whether you think the capital gains inclusion rate will rise in the near future. If that happens, then this may be a narrowing window of opportunity.
Given all of these variables, I recommend consulting with your accountant or financial advisor if you are considering this. I am neither a financial advisor nor an accountant. However, I have also made a capital gains harvest tax simulator (click the image above to link to it) that you can try for educational and entertainment purposes. You should probably get out more if you find it really entertaining…
I will use it to do some illustrative cases in future posts. The only tax harvesting example that I was able to find on the internet was from a CPMB post last year and some more examples to understand this should be helpful. The simulator has multiple tax calculators running, tries to optimally distribute dividends, and even has some flags with possible solutions when the capital gains harvesting is sub-optimal. As usual, please let me know if you find a bug, error, or are otherwise able to break it.
Blog Post Excerpt from the Loonie Doctor.