Following up on last week’s post, we’re not yet done exploring the wild world of capital gains taxation. Today, we’ll take a look at tax gain harvesting.
Say what? Isn’t that supposed be “tax loss harvesting”? Well, that exists too, and is more familiar to most investors. Since harvesting a gain incurs taxable income, it may at first seem kind of crazy to want to voluntarily reap what you’ve sown. But if you’re a corporate investor, it can actually be a smart, “crazy like a fox” thing to do.
Tax loss harvesting: Losing to win some tax breaks
First, a quick reminder of how tax loss harvesting works (a.k.a. tax loss selling). Say you buy an investment like a stock ETF, and a few months later the stock market plummets. Your ETF is now at a significant loss, so you sell it, realizing a capital loss. Even this may sound a bit nutty, like an infamous buy-high, sell-low strategy. But there is a critical difference. Immediately after selling the ETF, you buy back a similar, but not identical fund to retain your original market exposure (because all evidence suggests that the market is expected to eventually recover and continue bearing beautiful fruit if you stay the course).
Think of tax loss harvesting as promptly replanting your harvested “field” with a similar “crop,” instead of leaving it barren. Once the dust settles, you’ve generated a capital loss to offset taxable capital gains (in the current year, past prior three years or indefinitely into the future), without substantially altering your investment landscape.
Tax gain harvesting: Winning to lose some tax burdens
Now to tax gain harvesting. Why would anyone want to pay capital gains taxes earlier than necessary?
As an individual investor, about the only (relatively unusual) time it might make sense to harvest gains early is if you are in a lower tax bracket than you expect to be in the future.
But the corporate landscape is different. Here, the optimal time and place for harvesting gains isn’t as straightforward. It’s going to be easier to show you an example of why that’s so than to tell it to you in theory, so here we go …
Reaping the harvest: An illustration in action
To illustrate the potential tax deferral benefits of realizing corporate capital gains taxes, let’s compare two scenarios.
- Corporation 1 will harvest a $20,000 capital gain and distribute to its shareholders the non-taxable and taxable portion of the gain (after corporate taxes have been paid and refundable taxes have been returned).
- Corporation 2 will not realize any gains. It will instead distribute enough taxable dividends so that their shareholders end up with the same amount of personal after-tax cash as in the first scenario.
Which strategy wins? Not to ruin the suspense but this is, after all, to illustrate capital gain harvesting in action. So, as you might expect, Corporation 1 ends up with more money to invest after the distributions have been made, resulting in a greater tax deferral benefit. If you don’t believe me, here are the calculations involved.
Corporation 1: Harvesting a $20,000 capital gain
This example is identical to the one from last week’s post. The $10,000 taxable portion of the capital gain is subject to $1,950 of non-refundable taxes ($800 federal + $1,150 provincial). That leaves $4,983 of after-tax corporate income, plus $3,067 of refundable taxes to distribute to shareholders and be taxed in their hands at 45.30% (the highest marginal tax rate in Ontario for ineligible dividends). After paying $3,647 in personal taxes ($8,050 × 45.30%), the shareholder has $4,403 of after-tax cash.
But this isn’t the entire story. The corporation can also distribute a $10,000 tax-free dividend to its shareholders ($20,000 × 50%). Quick refresher from last week: The capital dividend account has a positive balance for the same amount, due to the non-taxable portion of the $20,000 capital gain.
In the end, shareholders have received $14,403 of after-tax cash, while the corporation is out $20,000 ($1,950 non-refundable taxes + $8,050 taxable distribution + $10,000 tax-free distribution).
|Taxable portion of capital gain||$10,000||$20,000 × 50%|
Part I tax – non-refundable
|($800)||$10,000 × 8%|
Part I tax - refundable
|($3,067)||$10,000 × 30.67%|
Provincial or territorial tax – non-refundable
|($1,150)||$10,000 × 11.5% (Ontario)|
After-tax corporate income
|$4,983||$10,000 - $5,017|
|$3,067||$10,000 × 30.67%|
Amount available to distribute as a taxable dividend
|$8,050||$4,983 + $3,067|
Personal tax on dividend
|($3,647)||$8,050 × 45.30%|
After-tax cash (excluding the non-taxable portion of capital gain)
|$4,403||$8,050 - $3,647|
Non-taxable portion of capital gain
|$10,000||$20,000 × 50%|
|$14,403||$10,000 + $4,403|
Corporation 2: Distributing all-taxable dividends
The calculations are a lot easier in this scenario, but the costs are a lot steeper. Without realizing the capital gain, the corporation must instead distribute only taxable dividends to its shareholders, which are taxed at 45.30%. In this example, a whopping $26,331 must be withdrawn from the corporation to yield $14,403 of after-tax cash [$14,403 ÷ (1 – 45.30%)]. This leaves Corporation 2 with $6,331 fewer dollars to invest, compared to Corporation 1 ($26,331 – $20,000).
|Amount distributed as a taxable dividend||$26,331||$14,403 ÷ (1 – 45.30%)|
Personal tax on dividend
|($11,928)||$26,331 × 45.30%|
|$14,403||$26,331 - $11,928|
The early bird doesn’t always get the worm
Before you conclude that corporate capital gain harvesting is the bee’s knees every time, let me rush to assure you that you never know. I’ve deliberately cherry-picked this harvest to show you the potential benefits of tax gain harvesting, but there are plenty of other scenarios in which a gains harvest could lead to a higher tax liability and no tax deferral benefit.
So here are two “thou shalt” rules to abide by every time: First, don’t forget to consult with your friendly neighborhood accountant before you implement anything. Second, be sure any plan you embark on is customized to your own corporate and personal tax situation.
Oh, wait. There’s one more rule to add: Whatever works today, may not work tomorrow. In my next post, we’ll look at what the government has in store for corporate capital gains taxation.
Thanks for the article. Question: Do you have to carry forward and apply corporate capital losses to future years? During the current market meltdown, if a security in a CPCC was sold and immediately repurchased to realize a capital loss, subsequent capital gains at the time of market recovery would allow significantly greater “harvestable” taxable gains, but only if the previous loss didn’t need to be applied against that gain. Any thoughts on this?
@John: If you sell a security and immediately purchase it, the loss would be deemed superficial by CRA and denied.
If you realize and acceptable loss, it must first be used to offset gains in the current year. After that, it can be carried forward indefinitely or carried back up to 3 years.
I am retiring and expect to deplete my Corporate account over the next 5 years. I understand the benefits of tax gain harvesting (and have arranged for my first capital dividend payment). Is the reverse also true, i.e. should I avoid selling losers until the end to avoid harming the capital dividend account? When I eventually sell any losers, will the capital losses result in a recovery of some of the taxes paid on the taxable portion of the gains harvested earlier? (All assumes the tax rules don’t change.)
@Russ McGillivray: For this specific question, you should speak to your accountant. If you do decide to realize some losses, you can always sell some of your winners to offset the amount (assuming you have more unrealized gains than losses in the corporation).