Tax-efficient investing, part 1

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“Tax-efficient Investing: Part 1” is eligible for CE credits, see Accreditation details for more information

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: Placement Matters

Advisors should consider keeping long-term capital gains outside RRSPs

By Sheldon Gordon

Tax-efficient investing doesn’t mean tax-free investing. It means generating more of your investment returns from asset classes that attract lower rates of tax. To do that, you should try to put clients in investments that carry the lowest tax exposure relative to income generated (for example, Canadian dividends or capital gains).

“It’s not just what you make, it’s what you keep,” Joseph Link (not his real name), a vice president and investment advisor at a large brokerage, tells clients. Given a choice of investing in taxable and registered accounts, you have to consider the best place for each investment for tax purposes, Link adds.

You’re not out to thwart the CRA, though. Tax efficiency should be the cherry on the sundae.

Tax-deferred plans

The benefit of a tax-deferred plan such as an RRSP or RESP is an investor doesn’t have to pay immediate tax on income and gains earned in the plan.

This allows the investor to focus on the rate of return from the investment without considering income tax. However, funds removed from the plan are taxable. The amounts contributed to an RESP can be withdrawn tax-free. Withdrawals of earnings and government grants, together known as the Education Assistance Payment, are taxable.

When investing in a non-registered account, the investor must consider the taxes on interest, dividends or capital gains, as those will be taxed when received or realized. In 2011, an eligible Canadian dividend received by taxpayers at the top marginal rate in Ontario will be taxed at 28.19% and a capital gain earned by those taxpayers will be taxed at 23.20%, so when comparing equity investments, the preferred strategy is to own stocks, which may be traded more frequently and result in periodic capital gains, or paying high dividend rates, inside registered plans. This preserves pre-tax capital inside the plans.

“If a client earns long-term capital gains inside an RRSP, when he withdraws them, [he will] pay tax at a rate of 46.41% if [he’s] a top-bracket Ontario taxpayer,” says Link. “If he earned them outside a tax-deferral plan, he would pay tax on the gain at only half that rate.”

If you sell any investments for a loss outside of a tax-deferred plan, you can use those losses to offset current capital gains or carry them forward to offset future capital gains. (Capital losses within a tax-deferral plan have no tax benefit.)

While dividend-paying stocks take priority over growth stocks for inclusion in a tax-deferral plan, this is especially true of foreign dividend-paying stocks relative to their Canadian counterparts. The tax rate on Canadian dividends is just over 28.19%, while foreign dividends are taxed at 46.41% at the top marginal tax rate (both Ontario). This difference results from a dividend tax credit that applies only to dividends from Canadian companies.

Deferred, not eliminated

Some advisors oppose an RRSP-based tax-efficiency strategy. When the investor converts the RRSP to a RRIF at age 71, he’ll be required to make annual withdrawals that will be taxed at his top marginal rate, which could be as high as 46.41% on distributions from the plan. If the same Ontario investor had paid tax on Canadian dividends and capital gains when earned, he’d have paid only 28.19% and 23.21%, respectively.

“When you’re in your 30s and 40s, the money you put away has such a long time horizon that any increase in the tax rate upon removal of the funds will be more than made up for by reinvestment of the capital over time,” says John Campbell, Tax Group Leader and CA with Hilborn Ellis Grant LLP.

“But when you’re over 50 and you have greater clarity on what your retirement years are going to look like,” he tells clients, “you may want a more dynamic approach to your investment strategy that will result in lower taxes.”

OAS is also a complicating factor. Canadians are eligible for the pension at age 65, but it can be clawed back depending on their tax brackets. A senior reaches that threshold much faster when she has dividends (which are grossed up to $1.44 of taxable income for every $1 of dividends) than when she has capital gains (which are treated as 50 cents of taxable income for every $1 of capital gains).

If the client’s taxable income is close to the $67,668 (2011) threshold, suggest reordering her investment priorities for tax purposes— emphasizing capital gains over dividends—in order to avoid the OAS clawback.

Covered calls

Covered calls can also maximize tax efficiency. A call is a contract that gives the holder the right to buy a specified stock at a specified price (the strike price) within a set period. The investor who buys the call (Investor A) exercises that option only if the stock rises above the strike price. Investor B, who writes and sells the calls, already owns the underlying stock, so it’s “covered.”

Investor A only pays B a premium—a fraction of the strike price—when he buys the option. If, however, the stock price is “out of the money” (when the strike price is higher than the market price), Investor A won’t exercise the option and it will expire. Investor B keeps the stock and uses the premium to reduce his cost base.

Premiums paid to Investor B for call options are taxed at the same rate as capital gains—one-half the top marginal tax rate when the underlying stock is ultimately sold. So Investor B is able both to keep the stock and earn cash flow that receives favourable tax treatment.

For Investor A, the premiums are treated as capital losses, which can then be carried forward to offset future capital gains.

Long-term capital gains inside an RRSP

Consider an investor in Ontario, who is subject to the top marginal tax rates. When deciding which investments to hold within and outside their RRSP, there is a distinct tax cost when the security generating long-term capital gains is held inside the RRSP.

Investment in RRSP	Initial Amount	Value In 10 Years	Tax on gain within RRSP	Tax on profit when withdrawn from RRSP	Tax on profit if investment held outside of RRSP
Interest-bearing security	$100	$200	$0	$46.41	$46.41
Capital gains security	$100	$300	$0	$92.82	$46.41

*Assume top tax rates in Ontario

TFSAs work for savers Denise Wright-Ianni, a CGA in Toronto, notes a saver might be better off contributing to a TFSA rather than an RRSP.

“If you need the money in the short term—five years or fewer—you might want to use a TFSA,” she says. “If you’re not at a high rate of tax, you might want to save the RRSP contribution room until you’re in a higher tax bracket when it’s most beneficial. Since you’re planning to pull the money out [in the short term], why use up RRSP room [now]?”

Part 2: Calculating After-Tax Returns for Mutual Funds

How to evaluate a fund’s tax efficiency

By Andre Fok Kam

For a quantitative evaluation of a fund’s tax efficiency, we need to have information on both its pre-tax and its after-tax returns.

In Canada, there is currently no requirement for investment funds to disclose after-tax returns. This is unfortunate because it is after-tax returns that matter to the taxable investor. However, even in the absence of such information, it is possible to do a qualitative evaluation of a fund’s tax efficiency.

In the United States, the SEC has required mutual funds to publish standardized after-tax returns in their prospectus since 2001. This requirement has made U.S. investors better aware of the impact of taxes on their investment returns. The taxation of mutual funds and their investors in the U.S. is very broadly the same as in Canada. Mutual funds are subject to tax on their income but may deduct for tax purposes the amount of distributions to their investors. Most funds usually distribute all of their income and therefore pay no income tax. For their part, mutual fund investors pay tax on:

• Distributions received from the fund
• Capital gains realized on the redemption of their fund units

In order to illustrate how after-tax returns may be calculated and presented, we provide a brief overview of the SEC’s requirements on the subject.

Three types of return

U.S. mutual funds are required to publish three sets of returns:

• The return before taxes
• The return after taxes paid by investors on distributions
• The return after taxes paid by investors on distributions and the redemption of their fund units

There are two sets of after-tax returns. The first takes account only of the taxes paid by investors on the distributions they receive. The second also takes into account the taxes paid by investors on the capital gains realized when redeeming their fund units. All returns are required to be shown for one-year, five-year and ten-year periods or for the life of the fund, if shorter. The returns of a comparative index must also be shown. This enables investors to place the fund’s return in context.

An example of the disclosure of after-tax returns by U.S. mutual funds is given in the table below (“ABC Fund”).

ABC Fund

(You can plug in numbers for funds in client portfolios)

Average Annual Total Returns for Periods Ended December 31, 20xx
	1 Year	5 Years	10 Years
Return before Taxes
Return after Taxes on Distributions
Return after Taxes on Distributions and Redemption of Fund Units
Index

Return before taxes

All returns must be computed using standard methods prescribed by the SEC. The return before taxes is calculated in the same way as in Canada but with one important exception—it is calculated after sales charges. In the U.S., the following must be deducted when calculating the return before taxes:

• sales charges, i.e. upfront commissions paid by investors, in the case of fund series sold with a sales charge
• deferred sales charges, i.e. redemption fees, in the case of fund series sold with a deferred sales charge

The amount that is deducted in calculating the return is the maximum sales charge or deferred sales charge. The return before taxes is calculated by taking a hypothetical initial investment of $1,000 and comparing it with its value at the end of the relevant period. The return calculation is net of trading expenses, management fees, fund expenses and sales charges and assumes that the full amount of distributions (before any deduction for taxes paid by investors) is reinvested.

Return after taxes on distributions

Investors pay taxes on the distributions they receive from the fund. The SEC noted the tax consequences of distributions are surprising to many investors when they discover they can owe substantial taxes on their mutual fund investments that appear to be unrelated to fund performance.

The SEC noted that the return after taxes on distributions provides an indication of the tax efficiency of a fund. Tax efficiency is important to investors in a taxable account, in particular long-term investors, whose tax position may be significantly enhanced if the fund minimizes distributions.

The return after taxes on distributions differs from the before-tax return in that the taxes paid by the investors on the distributions are deducted and only the after-tax amount is assumed to be reinvested. The taxes are calculated using the highest federal income tax rates applicable to individuals on the reinvestment date. Consideration is given to the tax character of the components of the distributions —ordinary income, capital gains, return of capital, etc. No account is taken of state and local taxes.

Return after taxes on distributions and redemption of fund units

In addition, U.S. mutual funds must disclose their return after taxes on distributions and the redemption of fund units. When investors redeem their fund units, they realize a capital gain (or loss), which is the difference between the redemption proceeds and the tax cost of the units. Investors must pay tax on the capital gain and are allowed to deduct the capital loss, as the case may be. This return calculation takes account of both the taxes paid by investors on distributions and the taxes on the capital gain or loss that investors would have realized if they had redeemed the fund units at the end of the relevant period.

This is an excerpt from the Tax-efficient Fund Investing Course offered by the IFSE Institute, www.ifse.ca. Reprinted with permission.

Part 3: High-Debt, High-Risk, High-Tax?

Don’t let tax incentives trump the quality of the investment

By Christopher Mason

Investing in a heavily indebted company can be anxiety-inducing. Alongside capital gains, capital losses and dividends, can come tax benefits and traps. Although high-debt investing requires extra due diligence, a growing number of investors are accepting the risk and looking for gains.

“The high-yield asset class has grown considerably over the last five years and I think that speaks to the fact that people are acknowledging it as an attractive relative value alternative to higher-risk classes such as equities,” says Adrian Prenc, a portfolio manager at Marret Asset Management in Toronto.

Returns can outweigh risk

There are a few ways to incorporate an investment in a heavily indebted, stable company into a diversified portfolio while minimizing tax risk.

Managing capital gains and losses:

Given that capital gains and losses can be significant in high-debt investments, look for opportunities across your client’s entire portfolio to cancel the two out. “Any capital gains realized on disposition will only be 50% taxable at the client’s marginal tax rate, but while you’re holding on to it there will be no taxes payable, dividends aside, so from a tax perspective it can be very tax-effective,” says Cynthia Kett, CA, CFP and principal of Stewart & Kett Financial Advisors Inc in Toronto. However, capital losses are only deductible against taxable capital gains, either within three years previous or going forward indefinitely.

Capital gains versus interest:

If investing in heavily indebted companies, keep in mind you may receive higher interest payments if investing in bonds, but you’ll also have a higher chance of suffering a loss if the corporation runs into problems. “If you have a portfolio of these investments, don’t forget that capital losses can’t be applied to reduce your interest income on other bonds for income tax purposes,” says Bruce Ball, a chartered accountant and national tax partner at BDO.

Convertible bonds:

By earning interest until converting the debt you hold into shares, you can protect client assets while mitigating risk and reducing portfolio volatility. However, the interest earned on the bonds will be taxed.

High debt, healthy company:

Given the current macro concerns regarding an impending sovereign debt crisis and a slowing economy, if people choose high yield as an alternative, they should focus on higher-quality BB rated companies—and avoid companies with Triple-C ratings. “The default risk generally lies in the Triple-C range,” says Prenc.

Turnarounds:

If your client is looking at a company that is on the ropes and, based on an objective analysis, likely to recover, you might want to consider buying some of the company’s debt. Hold the debenture or bond and wait, rather than buy its stock. “If things go sideways, you are likely to become the equity owner,” says Benoît Poliquin, lead portfolio manager of Exponent Investment Management in Ottawa. “And if you judge the company’s prospects well, [your client] could do really well—the debt will increase in price as the prospects of the company improve, and [he] will have received a coupon income in the meantime,” he adds.

Perspective

It’s important to be aware of the tax implications of any investment decision. But don’t let it blind you from the quality of the investment itself. “In this type of investing, too often people look at the money they can potentially make, not at how they can get their money out,” Poliquin says.

Three questions help keep things in perspective:

• Force yourself to address risk: what are the odds of the client getting the initial investment back?
• Does this investment fit the client’s overall investment strategy?
• Is this investment efficient from an after-tax basis? “For the average investor, taxes should not be the primary consideration,” says Sean Cleary, a CFA and professor of finance at Queen’s University’s School of Business in Kingston.
• If you create a loss for the client, you may be able to parlay it into a beneficial tax situation, but doing so ignores the first question: is this a quality investment?

“Many investment mistakes come in putting the tax cart in front of the investment horse,” Poliquin says. “Tax issues are front-of-mind for a lot of retail investors because they are in a high tax bracket, but it can overshadow some fundamental investment questions.”

Experts also caution against housing high-yield debt in RRSPs to shield them from taxes. If the investment goes bust inside an RRSP, clients lose the tax writeoff, as well as the contribution room.

Tax expertise

If there isn’t expertise for these plays inside your firm, Ball says checking in with a tax expert at the end of each year can help your clients’ tax bill.

“If you have some winners at the end of the year, you also have some losers, [so] it might be a good time to sell them” and use the losses to offset the gains. However, be aware of the superficial loss rules.

Buyer beware

When it comes to investments offering tax incentives, such as labour-sponsored investment funds and flow-through shares, experts emphasize the need to focus on the quality of the investment, without the tax incentives.

Flow-through shares are offered by companies in the mining, oil and gas, and energy sectors to generate funds for capital-intensive projects. In return, they transfer tax deductions to investors. The tax cost of a $10,000 investment would be reduced to zero (so a $10,000 investment becomes a $10,000 deduction), and any proceeds derived from the investment’s sale would trigger a capital gain, which is only 50% taxable.

The risk associated with flow-through investments has increased amid market volatility, and already the federal government is weakening the tax benefits, through cancellation in the 2011 budget of a loophole that allowed investors to donate flow-through shares to charities in return for an exemption from tax on the capital gains.

Such tax incentives can cloud the quality of the investment. “If you don’t think it’s going to make money in the long run, you’re not going to do it, even if the tax incentives are attractive,” Kett says.

Dividend tax credits are also important. If you have a choice between receiving interest income on a bond versus a dividend for which you can claim a dividend tax credit, from a tax perspective the dividend becomes preferable.

“If you’re going to buy a high-yield bond, you have to make sure you’re being compensated for the haircut you get by not qualifying for the dividend tax credit,” Poliquin says. “If a broker calls up and says, ‘I’ve got a deal for you,’ and you qualify for the dividend tax credit, then it’s an easier sell. “This is why preferred shares are so popular with retail investors—the after-tax yield is higher. However, a preferred shareholder does not have the same claim on the company as a bondholder. This can be considered the cost to the preferential tax treatment,” Poliquin adds.

Relying too heavily on tax-favourable investments can also cause headaches. The government uses an Alternative Minimum Tax (AMT) to prevent investors with a disproportionate amount of tax-favoured investment income from paying little or no income tax. “Every investment decision needs to be based on fundamentals,” Kett says. “The tax tail doesn’t wag the dog.”

Part 4: Climbing the Annuity Ladder

Triple back-to-back annuities can work for business owners

By Staff, with files from Andre L’Esperance and Ashley Crozier

This strategy used by business owners combines an annuity, a life insurance policy and a loan within a private corporation. The loan is used to purchase the insurance, instead of company capital, and the interest is written off as a business expense (thus reducing its taxes). When the owner retires, he or she can use the annuity proceeds to pay capital gains tax associated with a business sale, or simply have an enhanced post-retirement income stream.

Mechanics

An operating or holding company purchases a life insurance policy on the shareholder’s life, and an annuity on a separate contract. The shareholder is the life insured and the corporation is named as the beneficiary.

Generally, the annuity payments are used to pay the life insurance premium and the tax on the annuity. The amount remaining can be paid out to the shareholder as a bonus or a dividend.

On the death of the shareholder, the life insurance proceeds are paid to the company and generate a credit to its Capital Dividend Account (CDA).

Under certain conditions, the insurance proceeds may be paid tax-free to the shareholder’s estate (via a tax-free capital dividend) and distributed to the heirs or charity, as directed in the will.

Some issues to be aware of:

• Typically, there is no capital created on death, as the death benefit either partly pays off the loan or repays the initial outlay.
• There have been challenges from CRA on limiting the amount of the interest deduction to the amount of the annuity taxable income.
• There is financial risk because the annuity is locked in for life, but the loan interest rate is only locked in for a fixed period. What if the insured lives beyond the loan’s renewal date and interest rates are then higher?
• There is no walk-away provision or exit clause.
• At best, a triple-back annuity provides a CDA credit and some annual deductions for Net Cost of Pure Insurance (NCPI).

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