Victor, age 38, is the sole shareholder of his investment holding corporation, which holds a significant amount of cash. In the future, he’d like to use some of the money to help fund his retirement income, as well as to donate a sizable amount to a local charity. He’s looking for a strategy that will accomplish both goals.
Victor meets with his advisor, and she suggests that his corporation make an investment in Manulife’s corporate class mutual funds with a Series T payment option. An investment in a Series T fund can provide a tax-efficient income stream that can be used to fund another investment within his corporation, which can be accessed when he retires and serve as a tax-effective way to donate in the future.
What’s a Series T fund?
A Series T fund can provide a regular stream of tax-efficient cash flow from monthly distributions. All or a significant portion of the distribution received is likely to be considered a tax-free return of capital (ROC). Each time the fund distributes ROC, the adjusted cost base (ACB) of the investment decreases. In addition, since ROC is considered after-tax money, there’s no tax payable on this cash flow in the corporation. However, there may still be taxable distributions similar to those of a mutual fund.
Once the ACB reaches zero, additional ROC distributions are taxable as capital gains. Since capital gains are only subject to a 50% inclusion rate, the cash flow would still be considered tax efficient.
Donating publicly traded securities to a registered charity allows for a deduction in the corporation equal to the value of the securities donated and a capital gains inclusion rate that’s reduced to 0%.¹ In other words, the tax on any capital gains arising from the disposition of publicly held securities donated directly to a charity is eliminated—a significant tax savings. An additional benefit is that 100% of the capital gain, as opposed to only 50% in the case of a regular capital gain, is added to the corporation’s capital dividend account (CDA).² This can result in substantial tax savings given that the amount in the CDA can be paid out to the corporation’s shareholder tax free.
Here’s how it works
Victor’s goal is to be able to utilize some of the cash in his corporation to help fund his retirement income while also donating a significant amount to charity. So, what’s an effective strategy that’ll allow him to accomplish both objectives?
Let’s say Victor invests $200,000 in a Manulife corporate class mutual fund (Fund A). If Victor invests $200,000 in a Series T version of Fund A that generates 6% in annual cash flows, this will generate an average after-tax income flow of $11,312³ for 20 years. The corporation can then reinvest these funds in another Manulife corporate class mutual fund (Fund B). The total income his corporation will receive after tax over that time period is $229,141, and when reinvested in Fund B, would grow to $329,666.⁴
At that point, the ACB in Fund A will reach zero. However, assuming a 6% annual rate of return, the market value of Fund A will be $193,492. At this point, the corporation can donate the $193,492 from Fund A to a registered charity.
The capital gain realized on the transfer won’t be taxed and the corporation will receive a $193,492 deduction, which provides tax savings of $98,681.⁵ Furthermore, $193,492 will be added to the corporation’s CDA, which can then be paid out to Victor tax free. As the corporation begins to trigger income from Fund B, or if the corporation has excess cash from other sources, Victor can flow these amounts out to himself tax free as a capital dividend from his CDA, up to $193,492—the amount that was added to his CDA as the result of his corporate donation.
This strategy has allowed Victor’s corporation to:
- make a sizable donation to a registered charity of his choice while also allowing for a deduction in the corporation, resulting in significant tax savings
- avoid triggering capital gains tax on the donated securities
- generate a 100% bump in its CDA, which can be paid out to Victor tax free.
1 For corporations, donations are generally deductible against income, subject to certain limits. Paragraph 38(a.1) of the Income Tax Act (Canada) provides that there’s no capital gains tax on publicly traded securities donated to a charity. 2 Subsection 89(1) of the Income Tax Act (Canada) allows for the full amount of the capital gain to be added to the corporation’s capital dividend account and can be distributed to shareholders tax free. 3 Assumes a 6% annual rate of return and the corporation’s tax rate is 51%. All normal fund distributions are reinvested in month 12. The return of capital distribution equals gross cash flow. In month 12, the normal fund distribution is reinvested prior to the return of capital payment for that month. 4 Assumes a 6% annual rate of return on an annual investment of $11,312 compounded over 20 years. 5 Assumes the corporation’s tax rate is 51%. The non-eligible refundable dividend tax on hand (NERDTOH) account will be reduced by $59,344 ($193,492 x 30.67%).
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