Investments owned by private corporations—some considerations
This article highlights some of the things that need to be taken into account when a corporation owns a Manulife Investments GIC, a Manulife segregated fund contract, or other investment.1 It addresses issues applicable to both operating companies and holding companies. It’s highly technical and should generally be used in consultation with the client’s professional advisors. It’s not a substitute for advice from the client’s accountant or lawyer.
Many corporations are looking for ways to invest their cash or to replace current investments. Manulife Investments Guaranteed Interest Contracts (GICs) and Manulife segregated fund contracts may be attractive vehicles for this investment, and in fact, a corporation may even consider the Manulife segregated fund leverage program.
Due to the various personal and corporate tax rates on investment income, it’s not generally useful to transfer additional investments to an existing corporation or to establish a new investment holding corporation unless there are persuasive non-tax reasons for doing so (for example, an investment holding corporation is often an important part of implementing an estate plan; they may also be used to reduce other estate costs, such as probate fees or U.S. estate tax).
That being said, there are often situations where the funds are already in a corporation — either in an operating company or in an investment holding company. The tax cost of withdrawing those funds from the company may be high, and as such, the corporation is looking to purchase investment assets.
Taxation of corporate income — investment income vs business income
In Canada, the active business income of a Canadian-controlled private corporation (CCPC) is eligible for the preferential small business tax rate, up to an annual limit. The tax rate for the first $500,000 ($600,000 in Saskatchewan) of active business income is approximately 12 per cent, depending on the province. Active business income over the threshold is taxed at a higher rate (approximately 27 per cent, depending on the province).
Investment income, or passive income, earned by a corporation would be taxed at approximately 51 per cent (this varies by province and includes the 30.67 per cent of federal refundable tax on corporate investment income).
Products like Manulife Investments GICs, Manulife segregated fund contracts, or other investments would be considered passive investments and, as such, any income earned from these investments would be subject to a high tax rate. Any refundable tax paid on investment income is returned to the corporation when it pays out taxable dividends to a shareholder.
Impact on a shareholder’s ability to claim the capital gains exemption
Shares of a qualified small business corporation (QSBC) may qualify for the $883,384 lifetime capital gains exemption (LCGE). For the shares to qualify as QSBC shares, there are several complex tests that must be met with respect to the type of assets owned by the corporation and how long the shares are held.
The shares must be shares of a small business corporation. A small business corporation is a CCPC in which all or substantially all (i.e., 90 per cent or more) of the assets, on a fair market value basis, are used principally in active business carried on primarily (i.e., 50 per cent or more) in Canada by the corporation or a related corporation. Alternatively, the assets meeting the “all or substantially all” test may be shares or debt in another small business corporation, either controlled by the CCPC or in which the CCPC owns at least 10 per cent of the voting shares and value.
The first test that must be met to qualify as QSBC shares is that at the time of disposition, at least 90 per cent of the fair market value of the corporation’s assets must be used in active business carried on in Canada or as an investment in other corporations that are themselves small business corporations.
The second test is a holding period test. To meet this test, the shares must be owned by the shareholder (or related persons) for two years, and during this period, at least 50 per cent of the fair market value of the corporation’s assets must have been used in active business. These tests become very complicated where holding companies are involved.
A corporate-owned investment may impact whether shares held in a corporation qualify as shares of a QSBC. The QSBC share test is based on how a corporation’s assets are used. An investment would be considered a passive asset and not used by the corporation to carry on active business. In a leverage situation, the debt from borrowing wouldn’t affect the QSBC test.
Accordingly, at the time of disposition or crystallization, when the sum of the fair market value of the investments and other passive assets exceeds 10 per cent of the fair market value of all the corporation’s assets, the corporation would cease to be a small business corporation and its shares wouldn’t meet the conditions for a QSBC. For the two years before disposition, when the sum of the fair market value of the investments and other passive assets exceeds 50 per cent of the fair market value of all the corporation’s assets, the corporation would stop being a small business corporation and its shares wouldn’t meet the conditions to be shares in a QSBC. A shareholder disposing of shares that don’t qualify as shares of a QSBC wouldn’t be entitled to claim the LCGE.
Corporations must consider keeping a running total of passive assets in comparison to the value of the company. It’s possible that if this becomes an issue (i.e., investments are approaching 10 per cent of the value of the assets), corporations can plan to remove tainted assets (purification transactions) to make sure the shares qualify as shares of a QSBC. Corporations should also consider setting up the investment assets in a separate holding company, if this is a concern from the start. However, if the assets of the holding company include the shares of the operating company, another reorganization would be needed, as the total assets of the holding company are considered in determining whether those shares are QSBC shares.
Impact on the small business deduction
The small business deduction (SBD) is available to corporations that are CCPCs throughout the year and entitles them to a tax reduction on their active business income carried on in Canada, up to the threshold of $500,000 ($600,000 in Saskatchewan). That is, their threshold of active business income is taxed at a lower rate than the remaining active business income. The SBD is shared among an associated2 group of companies.
Active business income generally includes all business income, except income from a specified investment business or personal services business and includes an adventure or concern in the nature of trade. A specified investment business generates income from property — including interest, dividends, rent from physical property (land and building), and royalties — and employs less than six full-time employees. A personal services business is basically an incorporated shareholder.
The SBD for a particular year will be reduced under these circumstances:
- Where the corporation’s passive investment income in the preceding year exceeds $50,000 annually, on an associated basis, the SBD will be reduced by $5 for every $1 of passive income above this threshold. If a corporation’s passive income exceeds $150,000, a corporation’s SBD will be fully eliminated for that year.
- Where the corporation’s taxable capital employed in Canada for the preceding year exceeds $10 million, on an associated basis, the SBD will be reduced by $1 for every $10 of taxable capital above this threshold. If a corporation’s taxable capital exceeds $15 million, a corporation’s SBD will by fully eliminated for that year.
The reduction in the SBD is equal to the greater of the reduction based on passive investment income and taxable capital employed in Canada. In general, the SBD will be fully available to many sizable corporations (i.e., those with passive investment income of $50,000 or less and taxable capital under $10 million) carrying on an active business.
Impact on taxable capital
A corporation’s taxable capital is essentially the total of the corporation’s debt and equity minus an investment allowance. The investment allowance includes items such as shares in another corporation (including a mutual fund corporation like Manulife’s corporate class mutual funds), long-term loans to other corporations, bonds, and long-term debt in financial institutions. Canada Revenue Agency (CRA) says that an investment in a mutual fund trust doesn’t qualify for the investment allowance. Although not specifically addressed, a segregated fund contract is also excluded from the investment allowance.
In a leverage situation, the additional debt created when a corporation borrows will increase the taxable capital. However, the interest paid on the debt should be deductible and, as such, will decrease the retained earnings and reduce the taxable capital.
Impact on the financial statements of a corporation
Initially, the corporate investment would be reflected on the balance sheet of a company at the cost of the transaction (its book value). Each year, the taxable income allocated to the corporation would initially be included in income and would increase the book value. This will also affect the retained earnings (or deficit) of a company.
If an investment is purchased through a leverage program, the bank loan will be shown as a liability on the company’s balance sheet. Assuming the interest is deductible, it will be shown as an expense on the income statement and will correspondingly reduce the retained earnings. Disclosure in the notes of the financial statements may indicate that the investment has been pledged as security for the bank loan.
Some adjustments may be required as Manulife segregated fund contracts allocate income on a calendar year basis. The T3 reflects the following income: interest, dividends and foreign income realized by the fund, capital gains or losses realized from fund transactions, and capital gains or losses realized by a corporation’s trades (i.e., redemptions, fund switches). Therefore, if a corporation has a year-end other than December 31 and realizes any capital gains or losses on its trades, it will need to add these amounts into the financial statements and deduct it from the income reported on the T3 in the next fiscal period. Income allocations on the T3 are included in the fiscal year that includes December 31. Adjustments may also be required for other investments, such as mutual funds and guaranteed interest products.
Insurance investments — account set-up and impact on potential creditor protection
With an insurance investment, whether a guaranteed interest contract or a segregated fund contract, it’s important to consider the role of the owner, the annuitant, and the beneficiary and who should fill each role.
The owner is, of course, the person or entity with control over the contract and can manage it as wanted (deposit funds, withdraw funds, switch funds, etc.) in accordance with the contract provisions and subject to any title restrictions, such as a collateral assignment. The owner is also responsible for reporting any taxable income on the contract. In this case, the owner is the corporation.
The annuitant is simply the measuring life for the contract. This means that on the death of the annuitant, the contract is terminated and the proceeds are paid to the beneficiaries. A Manulife Investments GIC or Manulife segregated fund contract may also allow the policy owner to name a successor annuitant or joint life.3 In the event of the annuitant’s death, the successor annuitant or joint life steps in as the measuring life. This prevents termination of the contract on the first death. Generally, in a corporate situation, a successor annuitant or joint life would be named, as the corporation doesn’t want to terminate the contract on the death of the annuitant. The corporation needs to consider who the annuitant should be. Should it be one of the shareholders or should it be an employee? If it’s a leverage program, the individual guaranteeing the corporate loan will also need to be the annuitant.
The beneficiary of an insurance investment contract is the party that receives the funds on the death of the annuitant (or on the later of the death of the annuitant and successor annuitant or joint life, if applicable). In all cases, the beneficiary should be the corporation so that the funds are retained in the corporation. In some cases, in an attempt to obtain creditor protection in provinces other than Quebec, the company shareholder’s spouse or child is named as beneficiary of the contract. It’s important to realize then that, on the death of the annuitant, a corporate asset is being given to a related party. In this type of situation, there’ll probably be a shareholder benefit under section 15 of the Income Tax Act (ITA). It is unclear how the CRA would quantify the shareholder benefit in this case, including whether there would be an annual benefit during the annuitant’s life or a benefit at death. Note that when it comes to corporate owned life insurance policies with a beneficiary other than the corporation, the CRA currently takes the position that there is an annual shareholder benefit. In addition, the corporation will probably not be able to claim the expense to reduce its income under section 9 of the ITA because it wasn’t incurred for the purpose of producing income from business or property. Due to the complexity and uncertainty in this area of the law, it is essential that a professional tax advisor be consulted.
One of the advantages of an insurance investment contract is the potential creditor protection available during the lifetime of the owner when the beneficiary is of the family class. In provinces other than Quebec, a family class beneficiary is the spouse, parent, child, or grandchild of the annuitant. In Quebec, a family class beneficiary is any of the married or civilly unified spouse, descendants, and ascendants of the owner. This means that creditors of the owner may not be able to gain access to the contract if a family class beneficiary is chosen. However, as indicated above, the beneficiary of a corporate-owned insurance investment contract should be the corporation. Obviously, this isn’t in the family class, and as such, the insurance investment contract is exposed to the creditors of the corporation.
Segregated fund contracts — impact on the capital dividend account
The definition of capital dividend in subsection 89(1) of the ITA allows for an addition to the capital dividend account (CDA) of a private corporation for the non-taxable portion of the corporation’s capital gain. A capital dividend, free of tax, may be paid to a shareholder of such a corporation.
Subsection 138.1(3) of the ITA states that a capital gain or loss of a segregated fund trust is deemed to be a capital gain or loss of the owner. This means that the entire capital gain or loss is allocated to the owner. As such, a corporate owner (that is, a private corporation) can add the non-taxable portion of the allocated capital gain to the CDA.
Also, the non-taxable portion of any capital gains or losses realized by the corporate investor on trades of the segregated fund contract can be added to the CDA.
1 The comments contained in this article generally apply to all investments held inside a corporation, unless otherwise indicated, whether Manulife segregated fund contracts, Manulife Investments GICs or other guaranteed interest products, mutual funds, stocks, bonds, or the cash value of a life insurance policy. They are collectively referred to as “investments” in this article. 2 Discussion of when corporations are associated is beyond the scope of this article. 3 A joint life option is a guaranteed income stream based on the lives of both the annuitant and the joint life. The joint life must be the spouse or common-law partner of the annuitant, as defined by the Income Tax Act (Canada), at the time of choosing the joint life option. Only one person can be named as the joint life and may not be changed. With the joint life option, the contract won’t terminate until the later of the death of the annuitant and the joint life.
The tax rates contained herein are enacted or considered to be substantively enacted as of the publication date.
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. Borrowing to invest is appropriate only for investors with higher risk tolerance. You should be fully aware of the risks and benefits associated with investment loans since losses as well as gains may be magnified. The value of your investment will vary and is not guaranteed, however, you must meet your loan and income tax obligations and repay your loan in full. Please ensure you read the terms of your loan agreement and the investment details for important information. The dealer and advisor are responsible for determining the appropriateness of investments for their clients and informing them of the risks associated with borrowing to invest. The Manufacturers Life Insurance Company is the issuer and guarantor of Manulife segregated funds contracts. Any amount that is allocated to a segregated fund is invested at the risk of the contract holder and may increase or decrease in value. Manulife Funds and Manulife Corporate Classes are managed by Manulife Investments, a division of Manulife Asset Management Limited. 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. Investment returns are not guaranteed, their values change frequently and past performance may not be repeated. Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.