# Investing retained earnings within holdco



## vi123 (Oct 29, 2015)

Hi everyone. My opco has just paid a couple of decent dividends up to my holdco, and im considering what to do with this money.

My first thought was to stick with a Canadian equity ETF, as dividends and capital gains seem to get the best treatment. Dividends can effectively flow through to the shareholder, and half of the capital gains can be paid out tax free. Much better then interest. 

Then I started thinking that having 100% Canadian stocks (or preferreds) in the holdco would end up distorting my overall asset allocation (holdco + personal investments). So I'm wondering if there's a way around this while remaining tax-efficient?

I know there are corporate class mutual funds, but they seem to have very high fees.

How about using swap-base ETFs (like HBB which someone mentioned yesterday)? These would seem to be well suited to corporate investments because they use a Swap to roll all earnings into the ETF price. So growth is tax sheltered and then you are only taxed on capital gains.

Am I right in thinking that swap-based ETFs are a good solution? And where can I find a selection of them? Are there swap-based ETFs that cover international equities? Thanks in advance!


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## andrewf (Mar 1, 2010)

I like HBB, but keep in mind that you are paying a swap fee in exchange for some of the tax savings. Some people view the uncertainty of the counterparty risk as too great, but in my non expert opinion, the risk is quite modest.


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## vi123 (Oct 29, 2015)

andrewf said:


> I like HBB, but keep in mind that you are paying a swap fee in exchange for some of the tax savings. Some people view the uncertainty of the counterparty risk as too great, but in my non expert opinion, the risk is quite modest.


I don't view counterparty risk as important. Swaps have to be marked to market anyway, so the exposure faced by either counterparty will never exceed 10%


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## larry81 (Nov 22, 2010)

vi123 said:


> How about using swap-base ETFs (like HBB which someone mentioned yesterday)? These would seem to be well suited to corporate investments because they use a Swap to roll all earnings into the ETF price. So growth is tax sheltered and then you are only taxed on capital gains.
> 
> Am I right in thinking that swap-based ETFs are a good solution? And where can I find a selection of them? Are there swap-based ETFs that cover international equities? Thanks in advance!


I am that someone and this is what i personally do, i hold all my fixed income in a non-reg (holdco) account. Best of both worlds !

Horizon is the major provider of swap-based ETF in Canada, FYI they don't have any international swap-based ETF and even if they had one, it might not be a good alternative to existing non-swap based ETF. For international holding, i prefer the diversity of VXUS to anything else (6000 holdings!). Even if there was an international equities swap-based ETF, it would certainly dwarf VXUS in regard to diversification. 

US market is a good example, i prefer to hold VTI with his 3800+ individual stocks (Total US market) than the swap-based HXS with his mere 500 individual stocks (SP500).

HBB and VAB are quite similar and there is a distinct tax advantages in holding HBB in non-reg account so this one is a no brainer, even when we factor the higher MER. 

Never pick an investment vehicle only for tax reasons, you need to look at the actual holding.


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## vi123 (Oct 29, 2015)

Thanks Larry. So you're saying that the extra diversification offered by total market US ETFs outweighs the tax deferral benefit offered by HXS. That sounds like a good point. 

In our case, we already have substantial investments in our own names. So we'll probably just continue to hold US stocks personally. Canadian stocks and preferreds (which I know you don't like!) can go in the holdco.

I might consider putting some HBB in the holdco too, but Plan A right now is to stick to short duration bonds. VSB has a duration of 2.8 years vs around 10 years I think for HBB. That's why I'm a bit reluctant to use it.

Question for you:
When you look at your overall asset allocation (holdco plus personal), do you apply some kind of discount factor to account for the fact that 20-30% of of holdco portfolio or so is going to go to the govt when you eventually dividend it out? I guess the same applies to RRSPs. I know it's impossible to know what that number will eventually be...


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## larry81 (Nov 22, 2010)

vi123 said:


> Thanks Larry. So you're saying that the extra diversification offered by total market US ETFs outweighs the tax deferral benefit offered by HXS. That sounds like a good point.
> 
> In our case, we already have substantial investments in our own names. So we'll probably just continue to hold US stocks personally. Canadian stocks and preferreds (which I know you don't like!) can go in the holdco.
> 
> ...


I don't apply any kind of discount factor since i don't sell my holdings. I see my HoldCo is my future pension and i am decades away from retirement. Also, there are advanced tax strategies to further minimize the tax hit of transferring assets from HoldCo to Holder (you or close family).

Regarding duration VSB vs. HBB, i used to briefly hold VSB and switched to HBB. HBB duration is ~7 years and at current rates, VSB will provide a negative post-tax return in a non-registered account.

Quite frankly i used to go through the same questions a couple years ago (ex.: should i use pref-shares in my holdco, sould i use swap based HBB even if duration is higher). My situation might be different than yours but i ended up using HBB and no preferred shares for me


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## makemerich (Oct 1, 2015)

Two things I would consider (from a purely tax standpoint):

1) RDTOH/part IV tax.
2) Succession planning - designation as a QSBC

The third thing that may or may not apply depending on how big your corporate structure is would be taxable capital i.e. clawback of small business limit.


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## CPA Candidate (Dec 15, 2013)

makemerich said:


> Two things I would consider (from a purely tax standpoint):
> 
> *1) RDTOH/part IV tax.*
> 2) Succession planning - designation as a QSBC
> ...


In my experience here, few know about Part IV tax on dividends and believe holdcos have many tax benefits.


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## vi123 (Oct 29, 2015)

makemerich said:


> Two things I would consider (from a purely tax standpoint):
> 
> 1) RDTOH/part IV tax.
> 2) Succession planning - designation as a QSBC
> ...


Thanks makemerich. Answers to your points:

1. I plan on allocating my HBB position to the holdco. There will be no dividends or interest, only capital gains (at some point). If I choose to take the capital gains, I'll pay the non-taxable half directly out to me.
2. I'm far too young to worry about succession issues. Separately, the opco is not really the kind of business that I could sell either. We would be much more likely to sell the assets rather than the business itself. So qualifying for the LCGE is not really a consideration. However, I believe the opco will be purified anyway because all retained earnings are dividend up to the holdco. 

3. For the last couple of years we've 'bonused down' to the 500k limit.


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## makemerich (Oct 1, 2015)

Sounds like you've got your ducks in a row! Now time for me to read up on HBB some more...


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## tdiddy (Jan 7, 2015)

larry81 said:


> I am that someone and this is what i personally do, i hold all my fixed income in a non-reg (holdco) account. Best of both worlds !
> 
> Horizon is the major provider of swap-based ETF in Canada, FYI they don't have any international swap-based ETF and even if they had one, it might not be a good alternative to existing non-swap based ETF. For international holding, i prefer the diversity of VXUS to anything else (6000 holdings!). Even if there was an international equities swap-based ETF, it would certainly dwarf VXUS in regard to diversification.
> 
> ...


I'm also using swaps for corporate investing, agree lots of savings to be had. I would counter Larry's point re: VTI vs HXS. One could complement their US HXS position by adding a portion of VXF (US total stock market- SP500) perhaps in personal RRSP for a very similar level of diversification and significant tax savings


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## vi123 (Oct 29, 2015)

tdiddy said:


> I'm also using swaps for corporate investing, agree lots of savings to be had. I would counter Larry's point re: VTI vs HXS. One could complement their US HXS position by adding a portion of VXF (US total stock market- SP500) perhaps in personal RRSP for a very similar level of diversification and significant tax savings


Very interesting idea. Any idea what ratio of HXS/VXF would replicate VTI?

*Edited to add:*
Just wondering if the swap fee + counterparty risk would make it worthwhile for me. I already have a chunky position of HBB, so I'm not sure I want to add more swap-based ETFs for now unless its a slam dunk.


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## tdiddy (Jan 7, 2015)

vi123 said:


> Very interesting idea. Any idea what ratio of HXS/VXF would replicate VTI?
> 
> *Edited to add:*
> Just wondering if the swap fee + counterparty risk would make it worthwhile for me. I already have a chunky position of HBB, so I'm not sure I want to add more swap-based ETFs for now unless its a slam dunk.


I believe the ratio is just over 3:1, mine has fallen to around 5 or 6 :1 as I ponder the value of the extra diversification and the need to do Norbert's Gambit for US listed fund. 

I think distributions for VTI are around 1.5-2% typically, which you'll pay full corporate tax rate on, so that is probably worth at least 75 basis points/year (some of this will be erased when you cash in extra capital gains). Plus you get currency hedging thrown in haha. Someone on one of these money forums did a much more detailed calculation with HXS + VXF in corporate account and was confident he came out well ahead, don't remember where it was exactly though


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## vi123 (Oct 29, 2015)

tdiddy said:


> I believe the ratio is just over 3:1, mine has fallen to around 5 or 6 :1 as I ponder the value of the extra diversification and the need to do Norbert's Gambit for US listed fund.
> 
> I think distributions for VTI are around 1.5-2% typically, which you'll pay full corporate tax rate on, so that is probably worth at least 75 basis points/year (some of this will be erased when you cash in extra capital gains). Plus you get currency hedging thrown in haha. Someone on one of these money forums did a much more detailed calculation with HXS + VXF in corporate account and was confident he came out well ahead, don't remember where it was exactly though


I think I just found the thread that you're referring too - http://www.financialwisdomforum.org/forum/viewtopic.php?t=104316&start=500#p528364

In this guy's example, the HXS/VXF portfolio comes out 3% ahead after 20 years. He also assumed an MER of 0.24% for VTI, which is much lower now. So I think the gain from holding HXS/VXF is marginal at best, and probably doesn't outweigh the counterparts/regulatory risk. I might run the numbers myself to make sure.


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## tdiddy (Jan 7, 2015)

Did you end up running the numbers?

That's the one I was referring to, however, looking at it again I'm not sure its correct. His calculations show a return that is a bit higher (looks like 6.5% out of 7% gross) than I would expect given the tax on investment income within the corporation. I am no accountant but my understanding would be that dividends from VTI would not be considered eligible (foreign), so subject to ~45% tax, of which ~1/3 is refundable when dividend finally paid out personally. So while compounding VTI should lag about .75%/year behind HXS from a tax perspective. Correct me if I am wrong.

Edit: I also believe even though its a taxable account the foreign withholding tax is only partially recoverable so that would be another 9 basis points/year ding on VTI.


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## OptsyEagle (Nov 29, 2009)

Is my memory failing me or didn't Jim Flaherty put an end to this swap business where a fund effectively turns dividends and interest income into capital gains? Does anyone remember what I am talking about here?


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## andrewf (Mar 1, 2010)

They disallowed one particular kind of transaction, but they have not attacked all total return swaps. And it would be very difficult to do without causing some unintended consequences in the financial industry, as it is a very commonly used tool for institutions.


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## andrewf (Mar 1, 2010)

tdiddy said:


> Did you end up running the numbers?
> 
> That's the one I was referring to, however, looking at it again I'm not sure its correct. His calculations show a return that is a bit higher (looks like 6.5% out of 7% gross) than I would expect given the tax on investment income within the corporation. I am no accountant but my understanding would be that dividends from VTI would not be considered eligible (foreign), so subject to ~45% tax, of which ~1/3 is refundable when dividend finally paid out personally. So while compounding VTI should lag about .75%/year behind HXS from a tax perspective. Correct me if I am wrong.
> 
> Edit: I also believe even though its a taxable account the foreign withholding tax is only partially recoverable so that would be another 9 basis points/year ding on VTI.


Don't forget the swap fee embedded in these funds, which offsets some of the tax benefits.


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## OptsyEagle (Nov 29, 2009)

andrewf said:


> They disallowed one particular kind of transaction, but they have not attacked all total return swaps. And it would be very difficult to do without causing some unintended consequences in the financial industry, as it is a very commonly used tool for institutions.


The ones they did attack caused many consequences in the financial industry. Many funds had to be closed to new purchases and of course the form of taxation changed dramatically. I think the Finance Minister thought that there was a reason why the tax code taxed the various forms of income the way they did and since the financial community was simply bypassing it with their engineering, it decided to bring down the hammer. Which in all fairness, was the right thing to do.

I have to assume here that the Finance Department is simply asleep at the switch and perhaps gave up caring when Jim Flaherty passed on and Horizon's decided to take another run at it. In my opinion, if they take another run at this, I will be all for imposing penalties...to Horizon of course. They were warned.


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## tdiddy (Jan 7, 2015)

OptsyEagle said:


> In my opinion, if they take another run at this, I will be all for imposing penalties...to Horizon of course. They were warned.


I wonder what it would look like for investors if they were to do this


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## OptsyEagle (Nov 29, 2009)

I doubt you would see a penalty as an investor. One might be expected to pay the tax that they avoided but I doubt they would call that a penalty and even that is doubtful.

Now for the financial engineering companies like Horizon. If I was the Finance Minister I would show them no mercy and once and for all tell the investing industry to "Stop Trying To Be So Cute". It's not funny anymore.

All of this is just my opinion, of course. The only finance minister I ever knew that seemed to care at all about tax fairness was Jim Flaherty, and I am pretty sure he is not going to issue any complaints. The rest will do whatever is politically correct.


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## vi123 (Oct 29, 2015)

OptsyEagle said:


> I doubt you would see a penalty as an investor. One might be expected to pay the tax that they avoided but I doubt they would call that a penalty and even that is doubtful.
> 
> Now for the financial engineering companies like Horizon. If I was the Finance Minister I would show them no mercy and once and for all tell the investing industry to "Stop Trying To Be So Cute". It's not funny anymore.
> 
> All of this is just my opinion, of course. The only finance minister I ever knew that seemed to care at all about tax fairness was Jim Flaherty, and I am pretty sure he is not going to issue any complaints. The rest will do whatever is politically correct.


Why so angry? Why not just take advantage of it?

Total return swaps are a foundation of our modern financial system and are not likely to be touched. Even if they find a way to target these funds without affecting other businesses, the worst that will happen is that the funds eventually get wound down.

As a reminder, HXT has been in existence since 2010. If it was going to be shut down, it probably would have happened by now.


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## OptsyEagle (Nov 29, 2009)

vi123 said:


> Why so angry? Why not just take advantage of it?


Do you really think that you have the ability to take advantage of every loophole that these high priced tax accounting firms can dream up? Do you really like paying a little more tax so that some corporation can evade their share. Do you really think that you will take enough advantage of any loophole to pay back the amount of extra tax you are currently paying due to these types of activities by others. I seriously doubt it. That being said, if one of these funds can give you some tax advantage, by all means you should participate in while it is still legal. Even I have used them in the past.

All I am trying to do is point out that it is simply a loophole designed to evade taxation. A loophole that the previous government attempted to close and I am surprised that Horizon had the gaul to reopen it.


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## vi123 (Oct 29, 2015)

OptsyEagle said:


> Do you really think that you have the ability to take advantage of every loophole that these high priced tax accounting firms can dream up? Do you really like paying a little more tax so that some corporation can evade their share. Do you really think that you will take enough advantage of any loophole to pay back the amount of extra tax you are currently paying due to these types of activities by others. I seriously doubt it. That being said, if one of these funds can give you some tax advantage, by all means you should participate in while it is still legal. Even I have used them in the past.
> 
> All I am trying to do is point out that it is simply a loophole designed to evade taxation. A loophole that the previous government attempted to close and I am surprised that Horizon had the gaul to reopen it.


I think you have your timelines mixed up. HXT was in existence before the changes introduced by the previous government. They had the opportunity to close down TRS-based ETFs back then, and they chose not to.

And yes, in the interests of fairness I think many tax loopholes should be closed. However, I do use plenty of techniques myself to avoid taxes. Maxed out registered accounts, deferral in a holding company, swap-based ETFs, dividend sprinkling, etc etc. If all tax loopholes were closed, I would undoubtedly end up paying more.

If anyone chooses not to use tax loopholes out of a sense of duty or fairness, that's up to them. But here's a great quote all the way from back in 1947: 

"Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant." ~ Judge Learned Hand, 1947


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## vi123 (Oct 29, 2015)

OptsyEagle said:


> All I am trying to do is point out that it is simply a loophole designed to *evade* taxation. A loophole that the previous government attempted to close and I am surprised that Horizon had the gaul to reopen it.


I think you mean AVOID, not 'evade'. Its perfectly legal.


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## OptsyEagle (Nov 29, 2009)

vi123 said:


> I think you mean AVOID, not 'evade'. Its perfectly legal.


It is what it is...a loophole. From the speech given by Flaherty when he was closing them, this was exactly what he was talking about.

Your neighbour owns a bond and pays tax as interest and you own a bond and pay tax as a capital gain sometime in the future when it is sold. I am sure you enjoy the tax savings, as would I, but you really cannot call it fair. That is all I am saying.


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## vi123 (Oct 29, 2015)

OptsyEagle said:


> Your neighbour owns a bond and pays tax as interest and you own a bond and pay tax as a capital gain sometime in the future when it is sold. I am sure you enjoy the tax savings, as would I, but you really cannot call it fair. That is all I am saying.


It is fair because my neighbor has the opportunity to buy the exact same product. HBB is available to anyone who can afford a single $43 share. You don't need to create any funky corporate structures, use an accountant or employ a lawyer. Its available to anyone.

You're also forgetting the extra risks that I'm taking when I buy HBB. There's the risk of a regulatory change that triggers early capital gains. And there's the risk of losing up to 10% if National Bank defaults on the underlying TRS. Many people choose not to use swap-based ETFs for just those reasons.


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## OptsyEagle (Nov 29, 2009)

If the government wanted interest income to be taxed like capital gains they would simply change the tax law. Until then this will always be classified as unfair ... no matter how badly you or I can justify it.

Anyway, I think we have digressed on this one enough and both our points have been clearly laid out.


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## humble_pie (Jun 7, 2009)

i stumbled into this thread by accident, what a lovely find.

both vi & optsy make excellent points in the discussion, but in the end they approach the same page, as vi says she (he? vi sounds like a good female lawyer to me each is assuming regulatory risk when she buys a horizons betaPro swap product.

my wrinkle is that, when it comes to the horizons betaPro swap products, i don't believe that national bank is truly carrying all of the default risk. I don't believe the bank's risk from underwriting horizon swap funds belongs to its tier 1 capital.

what i do believe is that national bank would have sliced up the fund company's swaps & sold the risk onwards to their network banks in tiny slivers, the way all banks & insurers parcel out risk, often among overseas institutions, so that in the end the planet becomes completely wrapped up in billions of tangled risk filaments, like a ball of wool.

on a related issue, i love this eloquent quote from Learned Hand. His sounds like a first nation name but i'm pretty sure he was not. Vi, if you have a moment, might you be able to refresh my memory? i could google the venerable judge but i'm sure your take would be more interesting.




vi123 said:


> here's a great quote all the way from back in 1947:
> 
> "Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant." ~ Judge Learned Hand, 1947


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## vi123 (Oct 29, 2015)

humble_pie said:


> what i do believe is that national bank would have sliced up the fund company's swaps & sold the risk onwards to their network banks in tiny slivers, the way all banks & insurers parcel out risk, often among overseas institutions, so that in the end the planet becomes completely wrapped up in billions of tangled risk filaments, like a ball of wool.


As far as I can see, it doesn't really matter whether the risk has been passed on by NB or whether it remains on the books. The TRS needs to be marked to market at the end of each day (a very simple thing to do given the liquidity of the underlying), and collateral needs to be posted against it. Under Canadian rules, the credit exposure of the fund to National Bank cannot exceed 10% of its assets. In reality, it will be much lower than that.

Its also important to note that NB will have similar mark-to-market collateral and netting agreements with all its other counterparties. The systemic threat of all these exposures is hugely mitigated by this. There are also arrangements in the industry to periodically net off and cancel swaps that are on the same underlying. 



humble_pie said:


> on a related issue, i love this eloquent quote from Learned Hand. His sounds like a first nation name but i'm pretty sure he was not. Vi, if you have a moment, might you be able to refresh my memory? i could google the venerable judge but i'm sure your take would be more interesting.


Look up some of his other quotes. Fantastic stuff.
https://en.wikiquote.org/wiki/Learned_Hand


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