Corporate class mutual funds in a corporation

Case Study


For the past 10 years, Mike has owned and operated a local construction company that has become highly successful. Due to this success, Mike has built up significant after-tax profits within his corporation and finds himself facing a decision: withdraw these funds now and invest them personally or leave the funds in the corporation and find an attractive corporate investment.

Although Mike believes withdrawing the funds and investing them personally is a viable alternative, his advisor warns him he’d have to deal with the immediate personal tax consequences of removing excess cash from the corporation, which leads to having less cash in hand to make a lump-sum investment.

As a result, Mike is interested in exploring corporate investment options that would allow him to have a higher upfront lump sum to invest. However, corporate tax rates on investment income are generally higher than the top marginal tax rate for individuals. Also, once a corporation’s annual passive income is $50,000 or more, its small business deduction (SBD) can be reduced by $5 for every $1 of passive income and would reach $0 when passive income reaches $150,000. This effectively increases the amount of tax a corporation would pay on its first $500,000 of active business income (ABI). Therefore, reducing the amount of investment income a corporation reports becomes a key objective in determining an appropriate investment vehicle.


Having Mike’s corporation invest in corporate class mutual funds can defer taxes owing, minimize the amount of investment income that’s subject to the high, passive corporate income tax rates, and reduce exposure to the potential clawback of the SBD.

How does it work?

The tax efficiency that a corporate class mutual fund can provide comes from the fact that a corporation can’t flow-through income to investors—only Canadian dividends, capital gains dividends, or return of capital. From a tax perspective, it’s generally beneficial for a corporation to realize capital gains rather than income. Furthermore, when capital gains dividends are received by a corporate investor, the non-taxable portion will be added to the corporation’s capital dividend account (CDA), where money can be extracted by the shareholders tax free.

What’s the capital dividend account?

The CDA is a notional account that assists in integrating the taxes payable between private corporations and individuals. The CDA allows a private corporation to accumulate certain tax-free receipts, which can then be passed on to its shareholders tax free.¹

When a private corporation realizes a capital gain, only 50% of that gain is taxed. The untaxed portion can be added to the corporation’s CDA. Similarly, 50% of a capital loss would reduce the balance in the CDA. Since a private corporation can elect to pay out any positive balance in the CDA to its shareholders by way of a capital dividend, it’s advisable to pay out a capital dividend soon after the account has a positive balance.

While some business owners recognize that life insurance proceeds may be paid out to shareholders tax free through the CDA, they tend to be less aware of the opportunity to pay out the non-taxable portion of capital gains added to the CDA.

How do shareholders of a private corporation benefit from investment in a corporate class mutual fund?

Since interest income doesn’t qualify as an eligible addition to the CDA, business owners may be losing an opportunity to build their capital dividend account.

The ability of corporate class mutual funds to distribute income by way of capital gains dividends allows shareholders to include only 50% of realized capital gains in income for tax purposes. A private corporation investing in corporate class mutual funds will benefit from the lower tax rate associated with capital gains, as well as flowing through the non-taxable portion of capital gains to its shareholders tax free by way of the CDA.

Example: Fixed income investment vs corporate class mutual fund

The following example illustrates the after-tax cash to Mike, comparing a fixed income investment vs a corporate class mutual fund.

 Fixed income investmentCorporate class mutual funds²
Estimated rate of return2.5%2.5%
Annual income$25,000$25,000
Tax treatmentInterestCapital Gains
Corporate taxes3$12,750$6,375
Cash available for taxable dividend to shareholders of private corporation$12,250$18,625
Capital dividend declared$0($12,500)
Dividend refund$7,668$3,834
Total available cash to be paid as taxable dividend to shareholders of private corporation$19,918$9,959
Personal taxes4$7,967$3,984
Net cash to shareholders before CDA$11,951$5,975
Tax-free dividend from CDA$0$12,500
Net cash to shareholder after CDA$11,951$18,475
Difference/percentage increase$6,525 or 54.6%

The example illustrates how $25,000 of annual income is taxed differently in each scenario. In the case of the traditional fixed-income investment, the income is taxed as interest, while the income generated by a corporate class mutual fund is taxed as a capital gain.


Since the non-taxable portion of the capital gains dividends received from the corporate-class investment can be added to the CDA and paid out as a tax-free capital dividend, the amount available as a taxable dividend to Mike is reduced by $12,500 before calculating the applicable dividend refund. This leaves $9,959 available as an ineligible dividend to be paid to Mike as the sole shareholder of the private corporation. In the scenario where the corporation invests in a traditional fixed-income investment, there’s no opportunity to add funds to the CDA.

Once personal taxes on the resulting dividend are considered and the $12,500 tax-free capital dividend from the CDA is included, the result is a net distribution to Mike from the corporate class mutual fund investment that is 54.6% higher than the net distribution that would’ve been received from a traditional fixed-income investment.

Why invest in corporate class mutual funds?

Some benefits to consider when investing in a corporate class mutual fund:

  • Pooling of expenses – A mutual fund corporation can offset the income and capital gains of one fund with the expenses and capital losses of another, thereby potentially reducing or deferring taxable distributions to investors.
  • Tax-efficient income – Since a corporation can’t flow-through ordinary income (i.e., interest or foreign income), any net income or capital gains generated in a corporate fund may be paid out as tax-efficient distributions to investors, either in the form of an ordinary Canadian dividend or a capital gains dividend (which is taxed at 50% as a taxable capital gain).

1 The CDA can be used to track the following: a) the excess of the non-taxable portion of capital gains realized by a corporation over the non-deductible portion of its capital losses, b) capital dividends received by the corporation from other corporations, c) non-taxable capital gains and capital dividend distributions from a trust, d) proceeds of life insurance received by the corporation in excess of the adjusted cost base, and e) the non-taxable portion of the gains realized by the corporation on the disposition of eligible capital property (i.e., goodwill). 2 Assumes corporation is invested in a corporate class mutual fund that’s not expected to distribute ordinary Canadian dividends 3 Assumes 51% corporate tax rate 4 Assumes 40% personal tax rate on ineligible dividends paid from corporation to shareholder