IMPORTANT: The information contained herein reflects general tax rules only and does not constitute, and should not be construed as, tax advice. Investors’ situations may differ from those illustrated. Investors should consult with their tax advisors before making any investment decisions.
Incorporating a private business, particularly for professionals like physicians and dentists, has been a longstanding practice of high-net-worth financial planning.
The tax benefits for business owners who choose to organize their business affairs via a Canadian-controlled private corporation (CCPC) are numerous, including the ability to deduct business expenses and access the lower corporate tax rate on active business income.
In the 2018 federal budget, the federal government introduced legislation to fundamentally change the system of taxation for private companies, their shareholders and family members.
The legislation affirmed the usage of an attractive threshold for “active income”, that is to say, income earned by the corporation’s business activity. It added new legislation to increase the potential tax payable on income generated from the passive income portion of the corporation, which would include investment portfolios held within the corporate structure.
This whitepaper addresses how investors can potentially use certain ETF structures, that are not expected to pay taxable income, to significantly improve the tax effectiveness of building an investment portfolio within the CCPC structure.
The changes in 2018 reduce some of the tax effectiveness of building an investment portfolio of stocks and bonds within a corporation, but they do not completely eliminate its value as an important tax-planning tool for professionals and business owners, particularly if there is a way to reduce the level of income generated by passive income within the corporation.
The CCPC structure can be a powerful way for a client to reduce their total tax burden. Income earned from the professional activities of the corporation (professional service fees etc.), referred to as “active income”, is taxed at the corporate rate, which is lower than the marginal tax rates of individuals. This alone makes the CCPC a more tax-efficient structure for small businesses and professionals.
In Ontario, for example, active business income is taxed at a combined rate of 26.5%1 (which is not dissimilar to the capital gains for rate a high-income earner). Investors can take any net, after-tax income retained within the CCPC and invest it in a ‘passive’ investment (such as a stock, bond, mutual fund or ETF) within the CCPC structure.
Most professional corporations and small businesses should be able to take advantage of the preferential tax rate on a material portion of the ‘passive income’ they earn on the investment portfolio within the CCPC. If a business generates active income of less than $500,000 a year, it is eligible for the Canadian Small Business Deduction, which in Ontario, would result in a combined federal and provincial rate of 12.5%.1
If a corporation and its associated corporations, with active income of less than $500,000, earn more than $50,000 of passive investment income in a given year – the equivalent of a 5% annual return on a $1 million portfolio – the amount of income eligible for the small business tax rate would be gradually reduced. This effectively means that any passive income earned per annum below $50,000 would be taxed at the 9% small business federal tax rate1 (12.5% in Ontario, as an example, when combined with the provincial rate).1
The small business deduction limit would be reduced by $5 for every $1 of investment income above the $50,000 threshold, such that the business deduction limit would be reduced to zero at $150,000 of investment income (equivalent to $3 million in passive investment assets at a 5% return). Effectively, beyond $150,000 in investment income, the 50%+ full tax rate would kick in. Any income earned beyond the $150,000 threshold would be taxed at much higher passive income rates – roughly 50.2%1 in most provinces. However, even in this scenario, the investor is still able to save the difference between the CCPC tax rate and the higher individual rates, which for many higher-net-worth investors, is also in excess of 50%.1
1Based on combined provincial and federal rates, as disclosed for the 2021 tax year. This rate does not contemplate any non-resident withholding tax that may be withheld by the relevant foreign jurisdiction(s) or any resulting foreign tax credits.
TRI ETFs: A Tax-Efficient Enhancement to CCPCs
Horizons ETFs’ family of Total Return Index (“TRI”) ETFs can be used within the CCPC structure to reduce the potential tax liability of investing in equities and fixed income securities. Typically, any investment gains generated from these ETFs would be taxed as a capital gain (or loss), only in the year in which they are sold. This means a CCPC investor in Ontario, for example, could take advantage of low levels of taxation on income earned from other investments (ranging from 12.5% to 26.5%)1 and then pay capital gains tax on any net gain realized upon the disposition of the TRI ETFs it holds in its portfolio. For an investor in Ontario, this is about 26%.1
Investors can take advantage of the favourable taxation of income within the CCPC structure to build an investment portfolio and defer paying tax on any gains generated from that investment portfolio without receiving taxable passive income through the use of TRI ETFs.
Horizons’ family of Total Return Index (“TRI”) ETFs comprise index ETFs that offer potentially significant tax advantages compared to traditional ETF structures. None of the TRI ETFs are expected to pay taxable distributions to their securityholders. TRI ETFs could substantially reduce the tax liability of earning income from investments held either within the CCPC, or in non-registered accounts generally, due to the fact they are not expected to pay out taxable income or dividend distributions.
TRI ETF Corporate Class Structure
Each of the Horizons TRI ETFs is a series of shares in a corporate class structure, the Horizons ETF Corp. This simply means the ETFs are collectively structured as a single corporation, rather than individually as trusts, which was the traditional structure used by Canadian-listed ETFs and mutual funds.
While the corporate class structure used by Horizons TRI ETFs is generally referred to as a mutual fund corporation, that is a reference to how it is classified for tax authorities. All of the products offered by Horizons ETFs are exchange traded funds, and not mutual funds offered via FundServ.
First established in 1987, mutual fund corporations are structured similar to traditional corporations. Under one corporate structure, many different investment fund mandates (series or classes) can exist. In the case of Horizons ETF Corp., the different Horizons TRI ETFs are all held within the corporate structure, where each is a separate series of the corporation.
Within a Canadian mutual fund corporate structure, only capital gains and Canadian dividends can be distributed to investors. From a tax perspective, any other income and foreign dividends generated within any one series of the corporation can potentially be offset by income losses and expenses incurred in other classes, which can, in certain circumstances, make the corporate class structure more tax-efficient than a traditional mutual fund trust.
The major difference between the Horizons TRI ETFs and other corporate class funds is that most of our ETFs primarily hold derivatives to achieve their investment returns, although physically replicated Index ETFs are also held within Horizons ETF Corp.
Unlike a physically replicated ETF, which typically purchases the securities found in the relevant index in the same proportions as the index, most TRI ETF utilize a synthetic structure that never directly buys the securities of an index. Instead, the cash portion of the ETF is placed in an interest-earning cash account.
The synthetic-based ETF then provides the investor with the total return of the index by entering into a total return swap agreement with one or more counterparties, typically large financial institutions, which will then provide the ETF with the total return of the index in exchange for the interest earned on the cash deposit. Any distributions paid by the index constituents are reflected automatically in the net asset value (“NAV”) of the ETF.
Within the Horizons TRI Family of ETFs, there are a few ETFs that are physically replicated, instead of using the derivatives structure. These include the Horizons NASDAQ-100 ETF (HXQ), the Horizons US Large Cap Index ETF (HULC), The Horizons Cash Maximizer ETF (HSAV) and the Horizons US Cash Maximizer ETF (HSUV.U). These ETFs are physically replicated within the corporate structure, but built up losses and expenses within the corporation are expected to be used to offset any taxable liability by distributions made by these ETFs.
Whether the TRI ETF is synthetic or physically replicated, the investor only receives the total return of the index, which is reflected in the ETF’s share price, and is not expected to receive any taxable distributions directly. This means that an investor is only expected to be taxed on the capital gain (if any) that is realized if, and when, holdings are sold.
No Tax Re-Characterization
The TRI ETFs do not engage in any tax re-characterization. Any income or distributions received by the TRI ETFs — whether income realized from the settlement of a total return swap (pre-settlement of a portion of the total return swap upon redemption), or income and dividends received by HXQ, HULC, HSAV and HSUV.U — are expected to be fully offset within the corporate structure used by Horizons, through the use of offsetting corporate expenses or carry-forward income losses built up in other series of the corporation.
For the end security holders that purchase these ETFs in the secondary market, any returns are expected to be taxed as a capital gain (or loss) once such position is sold, since only the NAV of the ETF has increased (or decreased), and no distributions are expected to have been received by that security holder.
Illustrative Example on Investment Income for a CCPC Investor
The following hypothetical example compares the difference between an investor who would buy a Canadian fixed income ETF that pays interest income and the Horizons Cdn Select Universe Bond ETF (HBB). For this example, we use the less-attractive passive investment income tax rate of 50.2%, and capital gains tax rate of 25.10% used for CCPCs based in Ontario under the assumption that none of the income is eligible for the small-business tax deduction.
In this hypothetical example, HBB and the competitor strategy that pays out distributions would be held for a three-year period. It makes the assumption that HBB and the hypothetical competitor would be sold at the end of this period which could incur a capital gains tax liability. Any distributions received by HBB are reflected in its net asset value and reinvested immediately upon being received, whereas the physically replicated ETF would receive distributions quarterly and then reinvest them. The comparison also makes the assumption that any distributions paid will be taxed at the marginal tax rate of the investor in the calendar year they were received. Such tax payment is funded through the redemption of units of the hypothetical competitor fund at each year end. *Where a Canadian ETF holds U.S. securities, non-resident taxes will be withheld from payments that are subject to U.S. withholding taxes (such as most dividends). Depending on the ETF, some Foreign Tax Credit may be passed on to certain security holders. No Foreign Tax Credit is contemplated in this example.
In this example, we compared HBB to a physically replicated bond ETF. The two leading physically replicated bond ETFs that invest in the broad Canadian bond universe both have management fees of 0.09%; HBB, meanwhile, has a management fee of 0.09% and a swap fee of approximately 0.15%, for a total fee cost of approximately 0.24%.
Even with this fee differential in this hypothetical example, HBB generates approximately an additional 0.64% after-tax return per year, which results in about $19,401.92 in tax savings on a $1,000,000 investment over three years, assuming there are no real differences in capital returns for the bonds (in a rising interest rate environment, it’s doubtful there will be much difference).
This is a simple way to enhance the tax efficiency of passive income generated in the CCPC structure.
TRI ETFs also provide significant tax advantages for passive income generated from holding foreign securities which pay dividends. In the following hypothetical example, we use the tax rate for foreign dividends of 50.2%1, and compare the use of the Horizons S&P 500® Index ETF (HXS) to a physically replicated ETF that invests in the same index. In addition, any physically paid U.S. dividends are subject to a 15% withholding tax, which may or may not be recoverable based on the ETF and various tax circumstances.
The above hypothetical example highlights the expected after-tax performance benefits of holding HXS versus another Canadian domiciled physically replicated S&P 500 ETF in a taxable corporate account (in CAD), assuming both ETFs earned/reflected a net 2% income and track the exact same universe of equities. It also assumes no change in the market value of the index constituents. This example does not take into account any commissions, fees, or expenses that would be associated with the purchase or sale of units/shares of the ETFs. The example does contemplate the sale of the ETF units/shares and the potential tax liability.
*Where a Canadian ETF holds U.S. securities, non-resident taxes will be withheld from payments that are subject to U.S. withholding taxes (such as most dividends). Depending on the ETF, some Foreign Tax Credit may be passed on to certain security holders. No Foreign Tax Credit is contemplated in this example.
In this hypothetical example, HXS and the competitor strategy that pays out distributions would be held for a three-year period. It makes the assumption that HXS and the hypothetical competitor would be sold at the end of this period which could incur a capital gain tax liability. Any distributions received by HXS are reflected in its net asset value and reinvested immediately upon being received, whereas the physically replicated ETF would receive distributions quarterly and then reinvest them. The comparison also makes the assumption that any distributions paid will be taxed at the marginal tax rate of the investor in the calendar year they were received.
In this hypothetical example, we compared HXS to a physically replicated S&P 500 ETF. The two leading physically replicated ETFs that provide exposure to the S&P 500 Index both have management fees of 0.10%, while HXS has a management fee of 0.10% and a swap fee of approximately 0.30%, for a total fee cost of approximately 0.40%. Even with this fee differential in this hypothetical example, HXS generates approximately an additional 0.56% after-tax return per year, which results in about $17,012.84 in tax savings on a $1,000,000 investment over three years, assuming there are no real differences in capital returns.
Again, if an investor is already invested in large-cap U.S. equities, they aren’t doing anything different from an index exposure perspective by owning the respective TRI ETF; it’s the same investment exposure! However, their after-tax performance can potentially be noticeably better compared to using a less-tax-efficient, physically replicated ETF.
*Plus applicable sales taxes.
† Annual management fee of 0.07% rebated by 0.03% to an effective management fee of 0.04%, until at least December 31, 2021.
†† Annual management fee of 0.18% rebated by 0.10% to an effective management fee of 0.08%, effective April 1, 2020, until further notice.
Commissions, management fees and applicable sales taxes all may be associated with an investment in any of the Total Return Index ETFs (TRI ETFs) managed by Horizons ETFs Management (Canada) Inc. The TRI ETFs are not guaranteed, their values change frequently and past performance may not be repeated. The associated prospectus for each ETF contains important detailed information about each ETF. Please read the relevant prospectus before investing.
Horizons Total Return Index ETFs (“Horizons TRI ETFs”) are generally index-tracking ETFs that use an innovative investment structure known as a Total Return Swap to deliver index returns in a low-cost and tax-efficient manner. Unlike a physical replication ETF that typically purchases the securities found in the relevant index in the same proportions as the index, most Horizons TRI ETFs use a synthetic structure that never buys the securities of an index directly. Instead, the ETF receives the total return of the index through entering into a Total Return Swap agreement with one or more counterparties, typically large financial institutions, which will provide the ETF with the total return of the index in exchange for the interest earned on the cash held by the ETF. Any distributions which are paid by the index constituents are reflected automatically in the net asset value (NAV) of the ETF. As a result, the Horizons TRI ETF receives the total return of the index (before fees), which is reflected in the ETF’s share price, and investors are not expected to receive any taxable distributions. Certain Horizons TRI ETFs (Horizons Nasdaq-100 ® Index ETF and Horizons US Large Cap Index ETF) use physical replication instead of a total return swap. The Horizons Cash Maximizer ETF and Horizons USD Cash Maximizer ETF use cash accounts and do not track an index but rather a compounding rate of interest paid on the cash deposits that can change over time.
The information contained herein reflects general tax rules only and does not constitute, and should not be construed as, tax advice. Investors’ situations may differ from those illustrated. Investors should consult with their tax advisors before making any investment decisions.
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