Parting Thoughts for 2023...

The Holiday Season provides many of us with a chance to reflect back on the events of the year as we prepare for the next. With so many businesses closing their doors temporarily to give staff some family time to recharge their batteries, entrepreneurs and corporate leaders often find some much needed "thinking time" to take stock of the frenetic activity of the previous 11 months and plan for the next 12.

I am no exception and for those that follow me, I hope that this Linkedin article will provide you with some useful tips as you reflect on your own life and business - over the Holiday Season.

My Key Thesis in this Article: It should not be about "how hard you work" but rather on "how smart you work".

Many start a new year with a litany of resolutions: "I'll diet! I'll get a gym membership!" I'll do more social media! I'll put on more webinars! etc etc." These intentions are often laudable but may turn out to be ineffectual or even counter-productive if they are not part of a coherent and well-thought overall "game plan". Increased effort and activity does not always translate into greater profitability and enhanced productivity. Increased efforts that are misdirected could simply exhaust the reserves of the person increasing the pressure on themselves.

Let me give you an example: Two business owners are twins. They do everything the same way. Their belief in investing is the same. They are happy with a stable portfolio that generates a constant 5% rate of return on assets over long periods of time. Twin "A" opens up an RRSP and contributes $100,000. Twin "B" opens up a Personal Pension Plan and contributes $100,000. Both twins invest in the same underlying assets. In both cases the twins use the same portfolio manager who charges an investment management fee of 1% on assets under management (eg. $1,000 per annum given the $100,000 investment).

Unfortunately for Twin "A" (RRSP) the $1,000 investment management fee paid to the portfolio manager is not tax-deductible pursuant to paragraph 18(1)(u) of the Income Tax Act. Because Twin "B" is using a PPP, his corporation (normally taxed at 26.5%) can claim the $1,000 investment management fee as a corporate tax deduction thanks to paragraph 18(1)(a). So Twin "B" has an extra $265 that the other is missing out on.

In other words, the retirement assets of Twin "B" are in effect growing faster than those of Twin "A", so that Twin B will reach the total wealth goal sooner.

To continue with this example, now let's imagine that after saving in their respective solutions they have maximized their annual contribution limits (both to the RRSP and PPP) and after 10 years they have the same capital of $1,000,000. Unfortunately, 50% of their portfolio is exposed to public equities and with the invasion of an ally of the United States in Asia, the stock market just lost 50% of its capitalization in a single day. At the end of that fateful day both Twins now only have $500,000 to retire on. Because Twin "A" has maxed out his RRSP contributions, the only thing to do is to hope that the markets will recover. Twin "B" is not in the same predicament. Under pension laws, his company is entitled to do a 'catch up' or 'special payment' of $552,750. This is a full tax deduction for his corporation.

To pay for this special payment, the Corporation of Twin "B" borrows $200,000 from a line of credit (interest cost of 10%). The $20,000 in interest charges due to the lender is an additional tax deduction for the Corporation. Unfortunately, if Twin "A" borrows money to contribute to the RRSP, the interest is not tax deductible. In any event, Twin "A" doesn't have any RRSP room to buy cheap stocks, so even if the interest cost was deductible, this solution is not even possible.

The Corporation of Twin "B" earned pre-tax corporate income in the year and normally it would have set aside 26.5% of that income to pay the tax authorities. However, in this case $100,000 of pre tax income will be contributed to the PPP to help with the total cost of $552,750. Thus, the $26,500 that would have been remitted as corporate taxes is now going into the PPP instead.

The balance of the cash necessary to make the $552,750 contribution is generated by selling capital assets that the Corporation had in its Non-Registered, Corporate Investment Account. These capital assets (shares of companies, units of mutual funds, real estate etc.) were initially purchased at $100 per share, but the sale price is $300 per share, triggering a capital gain of $200/share. Of this $200/share capital gain $100/share is taxable to the corporation. The other 50% of the capital gain is a credit to the Corporation's Capital Dividends Account ("CDA"). If we assume 1,000 shares being sold, and proceeds of disposition of $300,000, the capital gain is $200,000 and the taxable capital gain would be $100,000. The CDA credit is also $100,000.

Looked at from a different point of view, Corporation B, in contributing $252,750 in cash to the PPP is creating an expense that is much larger than the $100,000 taxable capital gain, meaning that the Corporation will not pay ANY tax on having sold these 1,000 shares. In fact, the Corporation might even have some tax losses (that can be carried back 3 years or indefinitely against future taxable income). More importantly, since only $252,750 of the $300,000 cash is contributed to the PPP, the balance ($47,250) could be paid to Twin "B" as a tax-free capital dividend!

Now, let's look at it from an investment point of view. Twin "A" has $500,000 in the RRSP account. Twin "B" also has $500,000 but we are now injecting $552,750 which can be used to purchase shares that were worth 50% more the day before. This is the classic "Buy Low, to sell High" strategy at work. The added twist is that if the cheap stocks purchased in the PPP are eventually sold at a profit in the future, any capital gains triggered by the sale of said shares won't be taxable at all, since this transaction occurs within the confines of a registered pension plan.

Astute readers will be quick to point out that this is not a fair comparison. After all, Twin "A" could also borrow money, sell Corporate assets or take corporate income and invest these different sources of cash in a Non-Registered Corporate Investment Account to approximate what Twin "B" is doing within the pension plan. While this is true, these dollars are 'working' in a taxable environment that erodes their value over time and thus incapable of catching up to B's PPP (who is operating in a tax-sheltered environment).

Enough about pensions - let's go back to our thesis: let's work smart, not harder!

Let's look at the "Enhanced Smith Manoeuvre" a variation on a theme of the venerable "Smith Manoeuvre" first introduced by BC-based financial planner Fraser Smith many decades ago. The context is this: most Canadians own a home (partially) and the value of that residence is encumbered by a mortgage from a lending institution. Under Smith Manoeuvre principles, where a taxpayer borrows money with a view of generating a profit (not just mere speculation like buying a bar of gold) the interest paid as part of that economic activity is a legitimate tax deduction at the personal level.

Simple example: Twin "B" owns a house appraised at $2,000,000 but the bank still has a $1,000,000 mortgage against the title of the house. B's equity is thus $1,000,000. If the mortgage has two segments: (i) a $100,000 Home Equity Line of Credit (HELOC) and (ii) a Conventional 5 year fixed Mortgage for $900,000, it is possible for Twin "B" to borrow the $100,000 and lend that amount to Corporation B, as a shareholder's loan. If the interest rate is 10%, the $10,000 in interest paid back to the bank will become a personal tax deduction. If B is taxed personally on his income at 50%, B will enjoy a minimum tax refund of $5,000 at tax time.

But what is Corporation B to do with this new $100,000 in working capital that is now sitting in its corporate bank account? One possibility is to purchase a corporately-owned insurance retirement plan via a Whole Life policy, and to do so on an "immediate financing arrangement (IFA)" basis. In other words, the $100,000 or such lesser amount is the first premium for the whole life policy, and another lender will lend Corporation B the $100,000 or some lesser amount, having taken the policy as collateral. The whole life policy might also have a 'death benefit' face value of $500,000, and the Corporation would be the designated beneficiary of this policy should Twin "B" pass away. Since life insurance proceeds are tax free in Canada, in the event of B's passing the entire $500,000 would credit the Corporation's CDA account making that money available on a tax-free basis to the children of Twin "B".

But recall that the secondary lender made (say) $90,000 available to the Corporation since this policy was purchased on an IFA basis. This means that if Corporation B wishes to make a contribution to a PPP this is still possible. Such a pension contribution (being a tax expense) would create a $90,000 tax deduction for Corporation B. On the first $90,000 of pre-tax income earned by Corporation B, instead of remitting 26.5% to the tax authorities, Corporation B can hang on to that money (eg. $23,850) in its corporate bank account. Remember that Twin "B" originally lent $100,000 to Corporation B after drawing on the HELOC secured on the home. Corporation B can start paying down this shareholder's loan to B, and do so on a tax-exempt basis. In other words, Twin "B" receives a cheque for $23,850 but doesn't have to pay tax on it. He can then use that cash to pay down the $100,000 HELOC. [At the very least he can pay off the $10,000 interest cost on the HELOC or pay down the principal or both].

The final piece of the analysis is: what will the PPP do with the $90,000 cash contribution that came in from Corporation B ? The usually suspects of stocks and bonds are of course coming to mind. However, nothing prevents the trustee of the PPP to take that $90,000 and purchase a whole life insurance policy, that also comes with its own death benefit component ($250,000 for this example).

If we trace the money throughout the system - what is the result ?

1) $100,000 HELOC created a $5,000 personal tax refund (due to interest deductibility)

2) $100,000 allowed Corporation B to create an asset that, on death will generate $500,000 in tax free benefits to survivors. First whole life has a cash surrender value account as well (but we are ignoring that wealth for now).

3) $90,000 is now part of a second whole life policy that will inject another $250,000 into the PPP for the benefit of the surviving children. (Second whole life policy has a cash surrender value account with assets that we are also ignoring for the time being)

4) $23,850 landed in the pocket of Twin "B" on a tax-free basis to either pay down the HELOC or spend the cash on X-Mas Gifts.

In other words, we have created a guaranteed 28% rate of return on the initial $100,000 "investment" for Twin "B", plus $750,000 of death benefit capital for his family. And none of this was done using operational cashflow from the economic activity of the Corporation. Briefly-put, without having to cut into expenses or deprive himself elsewhere, Twin "B" has made a smarter use of the scarce capital he had in the first place. After all, the $100,000 in home equity is useless unless he sells the house to turn it into cash.

The moral of the story is this: it isn't about how hard you work and what you have to sacrifice to get to the goal, it's all about being able to leverage command of tax, insurance and pension laws to create extra guaranteed value every time & on a consistent basis.

So, in parting, this article is my humble gift to the broader Canadian financial community. While this is not to be construed as legal or tax advice, merely my own thoughts on how to do more with less, I encourage those who knew nothing about the Enhanced Smith Manoeuvre or PPPs to take the time to learn about the myriad of solutions hidden in our statutes & regulations. They can take pressure off your clients and create guaranteed wealth instead of always being at the mercy of volatile stock markets or other riskier investments.

Happy Holidays!!!

JP