The Corporate Reserve

A corporation holds money it does not intend to spend this month. The amount is rarely decided on purpose. It is whatever was left after the last strong quarter, sitting where it landed, in the account payroll runs out of, because nobody moved it.

Then a quarter forces the question. A receivable due in March arrives in June, a compressor fails, an insurer applies a deductible, and the institution that reviewed the file in a calm year reviews it again in a nervous one. The money is reachable that week or it is not.

This page compares the places a corporate reserve can sit. It compares them one feature at a time and names no winner, because they do not answer the same question. Every tax statement below belongs to the Chartered Professional Accountant who files the corporation's return. It gives no percentage, because a percentage produced by a website is produced from nothing.

Why does a corporation need a reserve at all?

Because a corporation's costs arrive on a schedule it does not control and its revenue arrives on a schedule somebody else controls. Payroll, source deductions, rent and insurance fall due on fixed dates. Receivables, contracts and seasons do not. A reserve bridges the distance between those two calendars.

A profitable corporation can be short of cash, and frequently is. Profit measures work performed against costs incurred. Cash measures what has arrived against what has left, and only the second of those two measurements pays anyone on Thursday. A good year can contain an empty month.

Growth widens the gap. A larger contract means more labour and material bought before any of it is billed, and a bigger float carried on the corporation's own money. That pattern is set out for one trade in contractors, holdbacks and working capital.

What is a corporate reserve actually for?

For a short list of ordinary events that arrive without warning and cannot wait. Payroll through a slow quarter. A receivable that arrives late. An insurance deductible on a claim the corporation did not choose. An equipment failure. And a covenant that must be met at a fiscal year end.

Payroll and the late receivable are one event seen from two sides. The work was done, the cost of doing it has left the corporation, and the money sits with somebody who has no reason to hurry. A reserve buys the ability to keep the crew while it waits.

The deductible and the equipment failure are different, because that money is gone for good. A compressor, a delivery vehicle or a machine on the floor fails on its own schedule, and the insurer's participation begins above the deductible. A corporation without a reserve meets that with a card.

The covenant is the one on the list with a date printed on it. A lender requiring a minimum working capital position, or a ratio measured at the fiscal year end, has said in advance which day the reserve will be looked at. Meeting it depends on where the money sits.

What does an operating line of credit cost, and what does it give up?

An undrawn operating line costs nothing at all, which no other place on this list can claim. What it gives up is permanence. The limit belongs to the lender, is reviewed on the lender's schedule, and can be reduced or withdrawn in the quarter the corporation most needs it.

The cost of keeping it is the attribute that makes an operating line attractive. Undrawn, it costs nothing beyond whatever standby fee the agreement sets, and many set none. Speed is nearly as good. Once the facility exists, a draw is a transfer and the money lands the same day.

Who can take the access away is where the line differs from everything else here. A facility is a promise from a financial institution, subject to review, and it is reviewed most carefully when that institution has become nervous. A permission is a different thing from money the corporation owns.

What it earns is nothing, because it holds no money. It holds the right to money. The passive income rule described below therefore has no application to an undrawn facility. Interest paid on a drawn balance is generally deductible where the borrowed money was used to earn income, which the corporation's CPA confirms.

Using it creates a debt at a floating rate, secured by whatever the general security agreement covers and often by a personal guarantee. The balance is visible to every other lender. And a facility reviewed with a balance on it is a different conversation from the one held while it was empty.

What does cash on deposit cost, and what does it give up?

Cash in a deposit account is available the same hour and answers to nobody. What it gives up is purchasing power and tax efficiency. The interest it earns is taxed inside the corporation at investment income rates, and whatever survives that tax then meets inflation, which takes the remainder slowly.

The cost of keeping it is the gap between what the deposit earns and what prices do, and that gap is often negative once tax comes off the interest. Speed is the attribute nothing else matches. There is no request and no settlement period. The money is already liquid.

Who can take the access away is nobody, in the ordinary case, and that is the whole argument for holding cash. A deposit at a federally regulated financial institution or at a credit union is the corporation's property, protected within published limits set per institution and per category by the applicable deposit insurer.

What it earns is interest, and interest is the least favourably treated income a private corporation can receive. It is taxed as investment income in the year it is earned, and it enters the measure that reduces the small business limit under section 125(5.1) of the Income Tax Act. The CPA calculates both.

Using it reduces it, and that is the end of the story. There is no interest to pay and no advance outstanding. The corporation spends its own money, the balance falls, and the only work remaining is deciding when to rebuild it. Nothing else here behaves that simply.

What do term deposits and certificates cost, and what do they give up?

A term deposit or a guaranteed investment certificate pays a little more than a deposit account and asks for a term in exchange. The term is the attribute that disqualifies it for part of a reserve, because money that must be reachable on an unknown date has been promised for a known one.

The cost of keeping it is the same inflation gap as cash, narrowed slightly by the higher rate. Speed depends entirely on one word in the contract. A cashable certificate can be broken, usually with a reduced rate on the period held. A non-redeemable one cannot be broken at all.

Who can take the access away is the corporation itself, on the day it signed. Nobody reviews a certificate and no institution withdraws it. What removes the access is the maturity date, and a ladder of maturities reduces that problem without removing it, because an emergency does not consult the calendar.

What it earns is interest, treated exactly as deposit interest is treated. It is investment income in the year it is earned, and it enters the same measure under section 125(5.1) that reduces the business limit. A certificate paying more therefore contributes more to that reduction, which is arithmetic the CPA performs.

Using it before maturity means breaking it, and what breaking costs depends on the contract nobody reread. Some issuers pay a reduced rate on the period held. Some pay nothing. A certificate broken in the second month of a one year term can return less than the deposit account it left.

What does a participating contract cost, and what does it give up?

A participating whole life contract accumulates a value inside it that grows without an annual tax bill on that growth while the contract stays exempt. What it gives up is time. This is the slowest place on the whole list to build, and a corporation that needs a reserve this year will not find one here.

Here's the cost. The premium funds two things at once and is not a fee. Part of it buys insurance that pays on a death whether or not the reserve was ever needed, and part builds the accumulated value. Those costs fall heaviest early, which is why a contract in its third year holds less than has been paid in. Speed, once there is value to reach, is a written request and a few days, with no credit decision.

Who can take the access away is nobody outside the contract. The loan provision is written into the contract at issue, and the insurer is obliged to honour it while the contract is in force and holds value. No committee reviews the file and no third party reduces the amount available. That single attribute is why a contract appears in this comparison at all.

What it earns is credited inside the contract, and while the contract remains exempt under Regulation 306 of the Income Tax Regulations, that growth is not taxed annually in the corporation. It therefore does not enter adjusted aggregate investment income as defined in section 125(7) of the Income Tax Act. Exempt status is maintained and never inherited, and the CPA confirms the treatment.

Using it means taking an advance from the insurer against the contract's value. Interest accrues from the day it is made, at the rate the contract sets, whether the corporation has a strong year or a poor one. While the advance is outstanding it reduces what the contract pays out on a death. The money arrives in the corporation, so moving it to a shareholder is a second transaction.

What does the passive income rule do to interest in the corporation?

It reduces the ceiling on income taxed at the small business rate. Section 125(5.1) of the Income Tax Act grinds the business limit downward as adjusted aggregate investment income rises above a threshold set in the provision, so active business income taxed at the lower rate meets the general corporate rate.

The measure is defined in section 125(7) of the same Act, and interest sits squarely inside it. A reserve held as cash or as certificates produces interest every year it sits there. An undrawn facility produces none. Growth inside an exempt contract is not taxed annually, so it does not enter the measure.

Two features surprise owners. The reduction is computed on the combined figure for the corporation and every corporation it is associated with, so holding a reserve in a second company does not divide it. And it uses taxation years ending in the preceding calendar year, so this year's limit was settled last year.

None of that makes any one place correct. It makes the tax cost of holding interest bearing money inside a corporation a real number, belonging on the same page as the liquidity it buys. The threshold, the ratio and the rates are legislated and they change, so the CPA reads the current ones.

What does a lender see on the balance sheet in each case?

A lender reads the reserve as security and as evidence of how the corporation is run. Cash on deposit is the cleanest thing it can see. A guaranteed certificate is nearly as good. An undrawn facility is no asset at all, and accumulated value inside a contract is an asset the lender must be taught to read.

Cash and certificates are counted at or near face value in most working capital tests, which is why a corporation with a covenant measured at year end holds more cash in December than it needs in June. A certificate maturing after the measurement date can be classified differently from one maturing before it.

An undrawn facility helps a lender's comfort and does nothing for the ratio. Availability is disclosed in the notes and is not working capital. A corporation counting its unused limit as its reserve has counted a permission as an asset, and the institution that granted the permission never makes that mistake.

Accumulated value inside a corporate owned contract appears as a long term asset, and treatment varies widely. Some lenders advance against it on a collateral assignment, some discount it heavily, some disregard it. What settles the question is the lender's own policy. Ask for it in writing, in a calm year.

What does a buyer see when the reserve is on the balance sheet?

A buyer sees assets that have to be priced, extracted or left behind. Cash and certificates are usually stripped out before a share sale and paid to the vendor. An undrawn facility disappears with the change of control. A corporate owned contract has to be dealt with deliberately, and years ahead.

Passive assets accumulating inside an operating company can affect whether its shares qualify for the lifetime capital gains exemption on a sale. A large cash balance does this. So does a portfolio of certificates. So, over enough years, does accumulated value inside a contract. The test is applied over defined periods, and the CPA and the tax lawyer measure it.

Extraction carries its own cost. Moving a contract out of the corporation before a sale is a disposition, far easier to plan a year ahead than in the weeks before a closing. Leaving it in means the buyer acquires an asset with its own value and its own insured life.

On a death while the corporation still owns the contract, the amount of the death benefit exceeding the policy's adjusted cost basis is credited to the Capital Dividend Account under section 89(1) of the Income Tax Act, from which a capital dividend may be elected. The credit is the excess and never the whole benefit, and the accountant calculates it.

How should the size of the reserve be decided?

By a method and never by a figure a website can supply. Measure what the corporation actually spends in a month that produces no revenue, count how many such months the business has had to survive, and add the largest single obligation that could arrive without notice.

Start with the fixed monthly outflow. Payroll and source deductions, rent, insurance, equipment leases, loan payments, and the minimum the corporation spends to stay open with nothing coming in. That number is already on the general ledger and almost nobody has added it up.

Then count the months. How long between doing the work and collecting for it, at the slowest, across three years. How long a holdback has actually taken to be released. How long the corporation went, during its worst stretch, without a collection large enough to matter. Three years of records answer all three questions in an afternoon.

Then add the largest single event. The insurance deductible on the claim the corporation has not yet had. The replacement cost of the one machine whose failure stops the work. The covenant figure that must be on the statements at the fiscal year end. The reserve is the sum of those three.

Then decide where each layer sits, by when it might be needed. Money that could be called for this week has to be reachable this week. Money unlikely to be needed, and ruinous to be without, belongs somewhere durable. A corporation holding it all in one place has answered one question.

Which of these wins the comparison?

None of them, and a page naming one would be describing a corporation that does not exist. The four places differ on two questions only: when the money is needed, and who can take the access away. Those two questions have different answers for the same corporation in the same year.

Read down the attributes and the pattern is plain. The operating line is free and conditional. Cash is immediate, taxed and eroded. A certificate pays slightly more and sells the day back. Accumulated value is durable and slow. No item on that list is cheap, immediate, permanent and untaxed at once.

The slowness of a contract deserves saying twice, because it is the attribute most often skipped. Accumulated value takes years to build, the costs fall heaviest early, and a contract funded in March holds very little by September. A corporation needing a reserve this year builds it in cash.

And a participating whole life contract is insurance. It is not an investment, and compared on rate of return against a market portfolio it compares poorly, correctly and always will. What it pays is a death benefit, dependent on the continued solvency of the issuing insurer. Dividends are not guaranteed.

Who this suits, and who it does not

It suits a corporation that already holds a cash reserve, that already has or could arrange a facility, and that is asking where the layer underneath those two should sit. It suits an owner with durable surplus in an ordinary year and a horizon measured in decades.

It does not suit a corporation that may need the money back within a few years, because an early exit from a contract is a permanent loss and never a postponement. It does not suit one carrying expensive debt, because clearing a high rate balance is a certain outcome. Saying so costs sales.

It does not suit an owner inside a decade of handing the business over, and it does not suit any corporation whose accountant has not seen the structure first. Who owns the contract, who pays the premium and who is named as beneficiary are three decisions made together.

The corporate structuring underneath all of this, including ownership, beneficiary designations and the Capital Dividend Account, is set out on the business owners page. A Financial Security Advisor can explain what the contract does. The accountant who files the return decides whether it belongs there at all.