Single-Family Offices: A Tax-Deferral Opportunity

Growth in the fortunes of Canada’s “top 1 percent” over time has increased the number of families with wealth of $100 million or more. Such families may create a corporation for the sole purpose of managing their investments: a single-family office, or SFO. Where the family does not want to pay out all of the profits as a dividend, there is an opportunity for significant tax deferral if the SFO can avoid the status of specified investment business (SIB).

One way of escaping SIB status is to avoid being a CCPC by, for example, incorporating in a foreign jurisdiction (for details, see Andrew Plant’s paper from the CTF 2019 Atlantic Provinces Tax Conference, “A Review of Specified Investment Business Rules and the Taxation of Canadian Corporate Investment Income”). However, since there may be concerns about potential CRA pushback and amendments to the tax rules to eliminate this strategy, other alternatives may be more attractive.

The other approach to escaping SIB status, and having income taxed as ABI, is to have a business that employs more than five full-time employees. Changes in the investment landscape have made this alternative more attractive. Namely, such families are beginning to bring investing in-house rather than fully outsourcing, or using a combination of both strategies. Wealthy families often have access to their own direct investment opportunities or want to have control of their own investments rather than go through intermediaries.

In particular, there is a general trend toward an increased allocation to alternative investments—loosely, an asset class that does not include stocks, bonds, or cash, and may include private equity or private lending. This is consistent with how the investment allocation of endowment portfolios of leading universities has changed over time. The motivation is that such investments may provide either higher returns or returns that have a low correlation with stock market returns. Such investments are not widely publicized and require significant human resources to identify, select, and manage.

The analysis above suggests that creating an in-house wealth management group would have two advantages for the SFO: (1) improving returns and (2) gaining the tax advantage of earning ABI. However, to illustrate the advantage of avoiding SIB status on its own, consider two situations that are assumed to have the same pre-tax investment return. A family in Ontario with a $200 million investment portfolio earns $16 million gross interest return annually, with $1 million (50 basis points) investment management costs. The family can pay a multi-family office $1 million annually, or hire its own six-person (five full-time and one part-time) staff for the same amount. In either case, the net pre-tax investment return, and the amount of taxable income, is $15 million.

If the SFO outsources the family office role, it would be a SIB. The annual income tax would be $7.5 million ($15 million times the 50.2 percent rate for SIB income in Ontario in 2021). On the other hand, if the SFO hires its own staff, it would pay income tax of $4 million ($15 million times the 26.5 percent rate for ABI that does not qualify for the SBD). The tax-deferral savings of hiring its own staff are $3.5 million ($7.5 million − $4 million). Hence, the after-tax return has increased from 3.75 percent ([$15 million − $7.5 million]/$200 million) to 5.5 percent ([$15 million − $4 million]/$200 million). Assuming consistent annual after-tax returns, this would double the family’s money in about 13 years rather than about 19 years (since 1.05513 ≈ 2 and 1.037519 ≈ 2).

Jamie Herman
Fruitman Kates LLP, Toronto

Canadian Tax Focus
Volume 11, Number 1, February 2021
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