CE Course: Tax-efficient Investing: Part 2

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The questions for this course were written by John Campbell, Tax Group Leader and CA with Hilborn Ellis Grant LLP in Toronto. Reach him at 416-364-6398 or jcampbell@heg.on.ca.

Part 1: Accounting for Tax

Some tax-efficient investments aren’t worth the risk

By Brynna Leslie

Tax should never be the primary driver for decision-making on a portfolio, but a properly structured portfolio always takes tax into account.

Regardless of asset class—money market funds, fixed income, or equity—clients can find ways to earn money in a tax-efficient way. Planning to reduce the tax burden must first coincide with the risk objectives and risk tolerance of your client, says Matthew Harvey, owner of Harvey Financial Solutions Inc., in Kincardine, Ont. “Investment strategies that take tax into account can be complicated and risky,” says Harvey. “Many of them are designed for the financially mature individual—affluent, high-income, and high-net-worth. Clients should not sacrifice expected rates of return just for a tax benefit.”

Understanding LSIFs

Nowhere is this truer than with labour-sponsored investment funds (LSIFs). Through LSIFs, federal and provincial governments use tax incentives to encourage investment in small- to medium-sized Canadian start-ups. Federal rules allow investment up to $5,000 per year in these funds, and that investment is eligible for a 15% federal tax credit, and an additional 15% provincial tax credit in some provinces.

Ontario recently increased the investment cap to $7,500 per year, and it offers an additional 5% tax credit on investments in research-oriented LSIFs. Like flow-through shares, the idea is these funds will grow over time. But they have initial investment risks that would deter most individuals. Typically, there is a lock-in period of eight years for these funds, so selling early means shareholders will not be eligible for the tax benefits. LSIFs are also known as labour-sponsored venture capital corporations (LSVCCs), or simply retail venture capital.

When they emerged a decade ago, fund managers salivated at the prospect of offering clients an investment fund that would see up to 35% in annual tax credits per year. Managers initially had a two-year window to invest the funds however they liked, contributing to the early euphoria.

“LSIFs looked great,” says Harvey. “Managers were able to throw the investments into some mild equity and bonds and watch it grow, while their clients got thousands of dollars back from the government.”

But then things changed. A mandate came down that the investments had to be transferred into a government-specified group of funds. “The fund managers were essentially handcuffed,” says Harvey. “They had to find companies that hadn’t been around that long, within a very small region in Canada, or in a particular province.” By then, investors were already locked into the program. As a result, many have come to see LSIFs as high-risk venture capital.

“You have to be prepared to lose the capital,” says Harvey, who hasn’t sold any LSIFs since he became licensed to do so six years ago. “You have to have a reasonable expectation of losing it. [Otherwise], LSIFs may not be for you.”

Corporate-class funds

Unlike LSIFs, corporate-class funds (CCFs) have a much broader appeal. Some say they are the mutual fund world’s answer to the tax-efficient competitiveness of ETFs. Corporate-class structures are set up as mutual fund corporations with multiple share classes. These instruments are good for people who want to buy and sell often to switch into a different fund or class share, without realizing regular income as a result.

Under a single corporate umbrella, traders can sell units of an equity fund to buy a bond fund when it’s deemed favourable, for example, and normally not realize capital gains in the transaction. “It’s a rollover at the same tax base,” says Nicholas Miazek, a consultant at T.E. Wealth in Calgary, Alta. “For a client that’s rebalancing to a more conservative asset mix later in life, it’s not going to trigger a taxable event.”

CCFs have appeal for a wide range of investors. A growing number of Canadian seniors, for example, are selling their homes and realizing the equity. They’re ideally situated to use CCFs for both income protection and a decent tax shelter. “All of a sudden, these seniors find themselves with half a million dollars in cash, but if it earns interest, it may disqualify them for government benefits they’re receiving,” explains Harvey.

While income from the sale of a principal residence is not taxable, the interest they’d earn if they put the money into a savings account is. Likewise, mutual funds typically distribute income evenly among shareholders—in the form of dividends, income or capital gains—as the funds are bought and sold.

But within the CCF, shares are generally traded within the same group of corporate funds, so investors don’t realize any income—and are not taxed—until they choose to redeem their individual shares.

“With CCFs, they can retain the earnings and let them build inside the fund,” says Harvey. “The fund manager can draw on the principal to supplement their income without being penalized on the tax side, and their government benefits can be restored.”

Investors can set up a formal plan, where they can draw 5% to 10% annually from the principal tax-free. As with segregated funds, CCFs allow a return-on-premium (or return-on-principal) that is tax-free. Unlike segregated funds, however, CCF investors are able to defer the tax on the growth in their shares.

Word of caution

Say an investor puts $300,000 into a CCF and leaves it for 10 years, at which point it’s worth $400,000. If the investor then wants to withdraw $10,000, she would be allowed $7,500 (¾ of the total investment) tax-free, but would have to pay tax on the other $2,500.

If, however, she decides 10 years later that she wants to switch to a CCF income plan, she can still draw on the principal with no tax penalty. So appealing are the potential earnings and tax-sheltering opportunities of CCFs—and others—that some planners have been advising more affluent clients to take out loans, with tax-deductible interest, in order to invest. But this high-risk strategy is not suited to everyone.

“You never know how the value of the underlying units will change if you invest in CCFs,” says Miazek. “If they plunge in value, you’ll have a large loan liability, [but won’t] have the capital to repay it. And there are so many new products coming out, that it’s impossible to say how these funds will react in different markets.”

Miazek also warns that CCFs are known for marginally higher fund management fees and broker transaction costs, in what is still a new market. “The fees can have a drag on your net return,” he says. “Sometimes you’re willing to pay a higher expense ratio if you know you’re going to get the return. “The biggest pitfall is always the history of the fund manager; I’m not sure we have that history with CCFs yet.”

The other thing to keep in mind is that although CCFs greatly reduce distribution of funds, there is no guarantee distribution will be eliminated altogether.

Bottom line

Most planners caution clients against investing just for the benefit of immediate tax savings or deferral. “It’s not all about immediate tax sheltering,” says Miazek. “Tax exemption now is often not as important as how the underlying assets are managed year-over-year.”

Insurance as an investment

Most advisors wouldn’t recommend insurance purely as an investment vehicle. But for those who need coverage, topping up a term life plan with a permanent life package can offer an alternative to GICs, as a tax-sheltered, fixed-income investment.

Earnings within a universal or whole-life plan are tax-deferrable—providing they meet CRA guidelines—until the policyholder cashes in. “Permanent life insurance is primarily designed to accommodate a long-term need, upon death, but along the way can be a very powerful, low-risk investment,” says Matthew Harvey, owner of Harvey Financial Solutions Inc., in Kincardine, Ont. “For young adults, who foresee having lifelong insurance needs anyway, it can offer them the opportunity to build up funds in a fixed-income investment that generates average returns of 5% per year.”

Harvey says 75% of permanent life insurance he sells, however, is to people over 55, many of whom wish they’d considered a plan earlier. “People in this age group have often shifted a good portion of their assets into fixed-income investments,” explains Harvey. “Now they have the added benefit of building those guaranteed investments within their life insurance plan, rather than in a GIC, which would be subject to tax.”

ETFs offer tax benefits

With ETFs, your clients hold a basket of shares that mirror fluctuations in the stock market. There’s not a whole lot of buying and selling, which means investors aren’t receiving monthly or annual income from the funds.

“With ETFs you only get taxed on capital gains or losses when you sell your own shares,” says Cheng-Chung Yu, president of Cheng-Chung Yu Professional Corporation in Markham, Ont. “And when you cash out, most of your earnings will be subject to tax on capital gains, not income or dividends.”

Part 2: Update on Flow-Through Shares

A look at changes to this strategy since the 2011 Budget

By Mike George, Director, Tax and Estate Planning at Richardson GMP Limited

On October 3, 2011, the government introduced legislation to implement measures outlined in the 2011 Federal Budget that limit some of the benefits previously realized on these types of donations.

About flow-through shares

To encourage exploration and resource development by Canadian oil and gas, mining or renewable energy companies, the government allows them to issue flow-through common shares. These companies use the proceeds for exploration and development and renounce or flow through its tax deductions (many of which can’t be used by these yet-to-be-profitable companies) to shareholders for use on their own personal and corporate tax returns. Investors generally are able to deduct the entire cost of the flow-through shares from their net income.

By doing so, the investment’s adjusted cost base becomes zero, meaning the entire value of the investment will be taxed as a capital gain when it is sold—a good deal, when you consider only 50% of all capital gains are taxable. Most people like to think of flow-through shares as an investment and a tax tool in one. However, as with most tax analysis, you must consider the investment in conjunction with the tax attributes.

Many investors invest in flow-through limited partnerships to diversify their holdings. These partnerships invest in exploration and development companies. These partnerships are then typically rolled over into a mutual fund. This can spread the risk among a number of different companies.

Profitable donations

For tax purposes, a gift of securities is normally treated as a disposition at its fair market value. However, when you donate publicly listed securities directly to a registered charity, you are not required to pay tax on capital gains realized on the disposition. Shares, bonds and other rights listed on a Canadian or foreign-prescribed stock exchange, as well as Canadian mutual fund units and segregated fund units, qualify for this incentive.

Advantage of the Capital Dividend Account

The Capital Dividend Account (CDA) is a notional account that tracks the amount of a company’s tax-free income that can be distributed tax-free to shareholders. The CDA typically consists of the tax-free portion of capital gains (currently 50% of the gain) as well as life insurance proceeds. Where eligible shares are donated to charities, the full amount of the gain goes into the CDA. For flow-through shares, 50% of the gain goes into the CDA for purchases made after March 22, 2011.

The amount tracked in the CDA can then be distributed to shareholders tax-free as a capital dividend. In certain provinces, the tax rate to pay out a dividend can be in excess of 40%, so you can see the value of converting this otherwise-taxable dividend into a tax-free capital dividend.

It’s worth noting the importance of working with a company’s accountants when selling corporate assets or investments at a loss. If you’ve sold assets at a loss, this reduces the tax-free amount available for distributions. Inadvertently paying out a capital dividend in excess of the CDA balance can result in heavy tax penalties.

In addition to creating an opportunity to extract funds, the small business that chooses to invest in flow-through shares can utilize the tax deductions to reduce company income to the small business limit—generally between $400,000 and $500,000, depending on the province—thereby reducing taxes payable.

Personal or corporate?

Should a philanthropically inclined shareholder donate as an individual or donate assets from their corporation? As with most questions of this nature, it depends. For example, if the individual investor is expecting to receive a large lump sum of taxable income (stock option benefits or gain on the sale of a business), investing in a flow-through limited partnership can offset the gain and defer taxes to another year when the shares are sold.

In addition, seniors receiving OAS payments might also find it more efficient to invest as an individual in order to lower their net income in certain years, making them eligible for full or partial OAS payments. When determining whether it makes more sense to invest and take deductions personally or in a private company, it is necessary to weigh these scenarios along with the different personal and corporate tax rates and donation tax credits, as well as the long-term plans for winding up the company.

Part 3: Pre-Emptive Slice

Foreign countries are eager to get their tax cut before the CRA takes its piece

By Raf Brusilow

Scared of foreign taxes whittling down your clients’ investment income abroad? Don’t panic—just make sure you’re making use of the foreign tax credit rules. Luckily for Canadian investors, tax treaties exist between Canada and a majority of foreign economies. These agreements are intended to make investing abroad easier by preventing double-taxation on individual income; and tax treaty rules always trump domestic taxation laws.

Most countries limit withholding taxes on investment income by foreign individuals at 15% for income distributions like dividends and 10% for interest income. Plus, those withholding taxes are usually eligible for a foreign tax credit. This means any income taxes Canadian investors pay abroad usually get credited fully towards their own tax responsibilities here at home.

So if a foreign mutual fund distributes its income, the Canadian investor will be charged the maximum 15% withholding tax, but that amount will be claimable back on his or her Canadian tax return as a foreign tax credit.

Treaty countries like the U.S. also generally exempt taxation on income within registered plans like the RRSP and RRIF. Government interest on instruments like T-Bills is also exempt from withholding taxes (but will be taxed accordingly in Canada).

Brian Segal, a tax partner at Baker & McKenzie in Toronto, acknowledges paying foreign tax can be administratively burdensome in some cases. However, the goal, he says, shouldn’t necessarily be to avoid paying foreign taxes—if the foreign tax rate is lower than the Canadian tax rate—but rather to make sure any foreign taxes that are paid are eligible for a foreign tax credit in Canada.

“What you want to avoid is a situation where you’re taxed abroad but that tax is not creditable, or only partially creditable, in Canada,” Segal says. Problems can crop up when clients borrow money to invest abroad, something Segal advises against if the interest is subject to foreign withholding tax.

Example: Foreign leveraged investment

Alex borrows $1,000 from a Canadian bank at a rate of 10% (borrowing cost: $100) in order to invest in the Netherlands, earning a 10% return on that $1,000 investment ($100 as well).

The Netherlands will charge a 10% withholding tax on Alex’s interest income ($10), but his expenses ($100) and income ($100) cancel out on Alex’s Canadian tax return. He’ll pay no tax in Canada but cannot claim the foreign tax credit and simply loses the $10 he paid in Dutch withholding taxes, even though the investment was a wash.

Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management, says a similar scenario exists with the TFSA. Clients who hold foreign securities in a TFSA may pay withholding taxes on income and dividends within that foreign country.

However, since income within the TFSA isn’t taxable, your clients cannot claim a foreign tax credit for those withholding taxes.

“You can hold anything in a non-registered account because you will receive a tax credit for any withholding tax you pay. I would avoid a TFSA for any ownership of U.S. stocks, for example,” Golombek says.

It’s more complicated when clients hold dual citizenship. Each country deals with citizens living abroad differently. In the U.S., for example, the Internal Revenue Service only applies the tax treaty and charges dual-status aliens solely on U.S. income for the parts of a year that they reside in the U.S. Once they achieve resident alien status, they’re charged on all income earned. Special rules for exemptions exist for certain groups, residents of Canada among them.

Terry Ritchie, a partner with Transition Financial Advisors Group, says some countries, including the U.S., will impose an estate tax on investments held separately within their borders. Stocks bought via instruments like mutual funds would not qualify for the estate tax, so it’s important for clients to buy any foreign stocks through such vehicles or use a Canadian investment advisor.

Real property in countries like the U.S. is also subject to estate taxes. The only way to avoid this is to invest in real estate indirectly through mutual funds, corporations or Real Estate Investment Trusts (REITs).

As well, the U.S. imposes a 10% withholding tax (called FIRPTA) on the sale price on foreign persons for any real property valued greater than $300,000 and not used as a personal residence (defined as half a given year). This can add up to a huge hit for Canadian snowbirds selling their winter getaways.

Foreign property sellers can apply for a reduction or elimination of that 10% FIRPTA tax, something Ritchie says the U.S. is usually quite reasonable about granting, particularly in situations where the withholding tax would exceed a person’s overall tax liability. These situations are more common given recent devaluation of U.S. real estate. “The process of exemption can take a while as you need to get a U.S. tax number. You’ve got to be proactive,” says Ritchie.“But the IRS grants [the exemption] all the time.”

Avoiding foreign tax filing and audits

To avoid being audited by or having to file formal income tax returns within a foreign country, clients will want to stay away from investments that qualify them as engaging in a trade or business within that country. Owning rental real estate, commercial buildings or active businesses will qualify a client.

The easiest way to avoid having to file with a foreign revenue service is to stay with passive investments acquired locally. “I’ve never heard of people being audited when they hold U.S.-based investments in a Canadian account, so if you live in Canada you should be doing your investing through a Canadian advisor,” says Jamie Golombek, managing director of tax and estate planning with CIBC Wealth Management.

Part 4: Managing Client Income

Systematic Withdrawal Plans and Return of Capital Distributions offer tax advantages

By Lisa MacColl

Systematic Withdrawal Plans (SWPs) can be a tax-efficient means of providing regular income to your clients while preserving capital.

The what and how of SWPs

A SWP is a periodic withdrawal from an investment account that provides income for your client by redeeming units at set intervals. Most investment firms offer SWPs, and they can be set up at any interval—monthly, quarterly or annually—to provide your client with a regular source of income.

If an advisor and client determine the need for regular income for the client, the advisor can set up a SWP to withdraw funds from the client’s investment account at periodic intervals. Jamie Golombek, Managing Director of Tax and Estate Planning at CIBC, says a SWP allows the redemption of units for a tax-efficient cash flow.

“A large portion of what is withdrawn, at least at the outset, is cost base, and therefore the amount of tax you pay on each withdrawal is minimal.”

Dennis Tew, Chief Financial Officer for Franklin Templeton Investments, states SWPs are a good way for clients to “average out of the market; they are not getting out at one particularly high or low price, and it allows clients to take out small bits of their investment over time.” Tew says non-registered investment products are best suited to SWPs, although many people use them for the minimum annual RRIF withdrawal.

Golombek adds there is no tax advantage to using a SWP on a registered plan—other than pure convenience—because the full value of any withdrawal from a registered plan is taxable.

Some cautions

Tew advises the withdrawal amount should be monitored to ensure the client doesn’t run out of money prematurely. “People set these things up and assume that their investment’s rate of return will be sufficient to allow the client to withdraw only the investment gain. In a downturn, a client could be eroding their capital. They may run out of money before they expect to.”

When withdrawals are automated, it’s important to set up annual reviews and adjust the SWP to the previous year’s rate of return. The client won’t thank you if their capital is suddenly depleted. “Clients should not assume that they will consistently receive a 7% or 8% rate of return.”

Golombek adds some clients may not be aware they still have to pay tax on distributions in the fund, even if they are withdrawing units. Each withdrawal may trigger a capital gain, and clients need to keep track of the withdrawals to report the correct capital gain to the CRA.

He further cautions against SWPs from a fund with a significant accrued capital gain, unless there is an unrealized capital loss somewhere else to offset it. In addition, if there are no distributions from the fund, the fund company may not send any tax slips to the client. However, capital gains will be reported on the client’s investment statement, and are reported to the CRA.

Return of capital

There are also tax implications associated with Return of Capital (ROC) distributions (ROC) that your clients need to be aware of. An ROC is a distribution from the fund to investors in excess of the income or gains realized by the fund. According to Golombek, they can be “a distribution of non-taxable amounts, such as depreciation, in this case of an income trust that can be flowed through to the investor, or unrealized gains effectively distributed by the fund to investors at the end of the year.”

ROC distributions are reported in Box 42 on a T3 by the fund company. And while ROC distributions are not considered income by the CRA, they reduce the adjusted cost base (ACB) of the investment. This will have tax implications when the units are sold because capital gains or losses are calculated on the ACB of shares at the time of sale. An ROC distribution reduces the ACB, which will create a higher capital gain when the unit is sold.

For example, if client A purchases units worth $1,000, and then receives an ROC distribution of $100, the ACB becomes $900. If the client redeems the units for $1,500, she will have a capital gain of $600. Without the ROC distribution, the capital gain would have been $500. An ROC distribution is not considered income, and no capital gain is triggered until the units are sold. Each ROC distribution will be reported annually in Box 42 on a T3. However, since no capital gain is triggered until the units are sold, there could be several years’ worth of ROC that will need to be considered in order to report the correct capital gain amount.

Because ROC is reported on tax forms, tracking the ROC to calculate the correct tax base requires careful planning, especially if a client holds the units over a long period of time. Client A might be expecting a capital gain of only $500 if he is unaware that ROC distributions change the ACB. The advisor will need to track any ROC reported in Box 42 on the T3 to ensure that the correct ACB is used to calculate capital gains or losses.

Advisors need to educate clients about the potential tax implications of unrealized capital gains. If a client holds funds which distribute ROCs, and the client is also receiving SWPs, the client could deplete the fund and trigger a large, unanticipated capital gain with no funds to cover it. Worse, Golombek notes a significant enough capital gain could trigger clawbacks of social program payments such as the Guaranteed Income Supplement or OAS.

When a client dies, the CRA values all assets as of the day before the date of death, and deems them sold. Because ROC distributions change the ACB, careful estate planning is necessary to anticipate the capital gain from the deemed disposition of the funds. The advisor needs to be aware of any ROC distributions that have been reported over the years, so that she can calculate the ACB. If a large capital gain will be triggered because of the current value of investments, then a client might need to purchase additional life insurance—to cover the anticipated tax on the capital gain on the deemed disposition.

If the spouse intends to hold the investments, then client and spouse could consider a joint last-to-die life insurance policy that only pays out when both of the insured have died. If Client A dies before he redeems the units, and the spouse opts to do a spousal rollover under the Income Tax Act, then the change in ACB due to the accrued ROC from client A’s account will ultimately be the responsibility of the spouse or the spouse’s estate when the units are redeemed.

She may be unaware of any changes to the ACB due to ROC distributions, and when the units are redeemed, the capital gain due to the ACB will produce a higher tax bill than expected. Estate planning techniques such as the use of life insurance products can help mitigate the tax impact.

Tew advises that when using tax-efficient SWPs (Series T) instead of a SWP, clients need to ensure “there are sufficient funds left in the estate to cover the tax liability.” SWPs and ROC distributions can be efficient means to get income into your clients’ hands while deferring the tax liability. With a bit of education and careful estate planning, clients can have income when they need it most.

Example

Client A purchases units worth $1,000 in year 2011. Fund distributes a ROC worth $100 in 2011, 2012, and 2013. Client sells units in 2014 for $1,500.

Here is how the accounting would look. (Assume no other unit purchases, redemptions or fund distributions):

• Initial investment: $1,000
• ROC 2011: $100
• ROC 2012: $100
• ROC 2013: $100
• Redemption 2014: $1,500
• Capital Gain: $800

(initial investment $1000-(3 x $100 ROC) = ACB of $700

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