Victor, age 38, is the sole shareholder of his investment holding corporation which holds a significant amount of cash. In the future, he would 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 is looking for a strategy that could accomplish both of these goals.
Victor meets with his advisor and she suggests that his corporation makes 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 that can be accessed when he retires and serve as a tax effective way to donate in the future.
What is 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 is 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 per cent inclusion rate, the cash flow would still be considered tax efficient.
The donation of 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 is reduced to zero per cent.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 per cent of the capital gain, as opposed to only 50 per cent 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 is an effective strategy that will allow him to accomplish both of these 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 six per cent in annual cash flows this would generate an average after-tax income flow of $9,765³ for 19 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 $185,535, 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 six per cent annual rate of return, the market value of Fund A will still be $200,000. At this point, the corporation can donate the $200,000 in funds from Fund A to a registered charity.
The capital gain realized on the transfer will not be taxed and the corporation will receive a $200,000 deduction, which provides tax savings of $102,000⁵ (depending on the province/territory). Furthermore, $200,000 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 taxfree as a capital dividend from his CDA up to $200,000 – the amount that was added to his CDA as the result of his corporate donation. See Table 1 for how the strategy may look.
Outcome – Win-Win-Win
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 a significant tax savings.
- Avoid triggering capital gains tax on the donated securities.
- Generate a 100 per cent bump in its CDA which can be paid out to Victor tax-free.
Table 1 – Corporate donation strategy
1 For corporations, donations are generally deductible against income subject to certain limits. Subsection 38(a.1) of the Income Tax Act (Canada) (“ITA”) provides that there is no tax on capital gains on publicly-traded securities donated to a charity. 2 Subsection 89(1) of the ITA 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 per cent annual rate of return, corporation’s tax rate is 51 per cent, and taxable distributions of $1,500 per year and ROC distributions of $10,500 per year. 4 Assumes a 6 per cent annual rate of return on an annual investment of $9,765 compounded over 19 years. 5 Assumes corporation’s tax rate is 51 per cent. Refundable Dividend Tax on Hand (RDTOH) account will be reduced by $61,340 ($200,000 x 30.67 per cent).
For more information on Manulife’s corporate class mutual funds and how they can help, speak to your advisor or refer to our related piece Tax Managed Strategy #21: Ideal Candidates For Mutual Fund Corporations (MK2529).
The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the fund facts as well as the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. The payment of distributions is not guaranteed and may fluctuate. If distributions paid by the fund are greater than the performance of the fund, then your original investment will shrink. Distributions should not be confused with a fund’s performance, rate of return, or yield. You may also receive return of capital distributions from a fund. Please consult with your tax advisor regarding the tax implications of receiving distributions. See the prospectus for more information on a fund’s distributions policy. Manulife Funds and Manulife Corporate Classes are managed by Manulife Investment Management Limited (formerly named Manulife Asset Management Limited). Manulife Investment Management is a trade name of Manulife Investment Management Limited. Manulife, Stylized M Design, and Manulife Investment Management & Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and its affiliates under license.