Party’s over for tax-advantaged investing

If you’re investing primarily for the tax benefits, stop.

That’s the message of Budget 2013.

While many described the document as predictable and dull, the tax measures section gives advisors with high-income clients lots to think about.

Read: Budget 2013 will target tax loopholes: KPMG

The government has proposed killing many aggressive tax strategies to increase revenue.

Targets include leveraged insured annuities and leveraged life insurance arrangements, commonly known as 10/8 arrangements; the dividend tax credit; graduated tax rates for testamentary trusts; and character conversion transactions.

Read: CRA to give 10/8 decision

“The overall message of this budget is if the main reason for your investment is the tax advantage, CRA is going to look at changing the rules,” says John Campbell, tax partner at Hilborn LLP in Toronto.

Kim Moody of Moodys Tax Advisors in Calgary agrees.

“If it’s a strategy marketed to the masses, you can be sure the Department of Finance and CRA are aware of it. Someone’s going to check if that strategy is consistent with good tax policy. Buyer beware.”

For advisors, tax should never be the first consideration when choosing investments.

“You’re going to have to not only consider today’s tax rules, but also the tax rules that may be in place in future,” says Campbell. “So make sure clients know the risks of the investments.”

He suggests CRA will likely target situations where “you’re getting an undue tax advantage,” including re-characterizing income to a lower tax rate.

As a result, says Moody, “Make sure the plan is sound even without tax benefits.”

Here’s a rundown of the most important proposed changes.

10/8s

Back in December 2008, the CRA said it would examine 10/8 arrangements, where people would borrow money from their insurance companies at 10% to purchase policies guaranteed to pay 8%. Since the loan was considered investment-related, the after-tax cost of borrowing would fall to 5.5%, netting the policyholder 2.5% return.

Nearly five years later, the government’s proposed denying the interest tax deduction.

“We have not used this approach for many years,” says John Nicola, CEO of Nicola Wealth Management in Vancouver. “It’s better for clients to buy insurance policies and then go to a bank to borrow against the insurance.”

Fortunately, the budget offers a relief period: 10/8 holders can withdraw them before January 2014 without consequence. But Nicola cautions clients who are no longer insurable may have to keep their policies and pay the 2% difference.

Leveraged insured annuities

The budget also proposes to kybosh triple back-to-back annuities, a strategy used by business owners. It 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, reducing taxes.

Our experts say this will affect few clients, since high permanent insurance premiums and recent low interest rates made the strategy prohibitively expensive.

Nicola points out the government’s projected it will save $60 million by killing the two strategies – “so they were never big to begin with.”

Dividend tax credit

This affects shareholders in private companies. Budget 2013 proposes lowering the gross-up factor applicable to non-eligible dividends to 18% (it’s now 25%), and changing the effective rate of the corresponding dividend tax credit to 11%. Such dividends will now be taxed at higher rates.

Nicola says a preliminary calculation shows that in B.C., it’s still more tax-efficient for business owners to pay themselves with dividends than salaries (this will vary by province).

“We also prefer dividends because they don’t require CPP remittance,” he says, and offer better income-splitting opportunities.

Read: Business owners should use dividends

Another piece of good news: lowering the gross-up factor will help clients on the margin who face OAS or disability payment clawbacks based on gross income.

Tax rates for testamentary trusts

The government is concerned testamentary trusts are taxed at graduated rates, rather than the highest marginal tax rate, 29%, like inter vivos trusts. The budget proposes to issue a comment paper about unifying the two rates “to prevent the tax-motivated use of these trusts.”

Bad news for estate planners, say experts, because testamentary trusts are quite popular.

Moody has provisions for five in his will: one for his wife, and then one for each of his four children after she dies. “From the point of my death until the last kid dies, I get graduated tax rates on all my assets. That could be 100 years from now. Looks like they want to fix that,” he says.

Read: 5 tax benefits of testamentary trusts

Another problem: testamentary trusts aren’t always used primarily for tax purposes.

Nicola says many people use them to leave money to minor children. Without the graduated rates, children would be forced to withdraw the money at the age of majority to avoid being taxed at the highest marginal rate, instead of the lowest (assuming they have no other income). And, if the trust’s large, this could mean kids inherit far more than their parents intended.

Character conversion transactions

Flaherty mentioned these and synthetic dispositions (see below) in his budget speech. They refer to instruments that use derivatives to convert interest or dividend income into capital gains income to lower taxation.

“Whenever part of an investment’s selling feature is that taxation will be different based on structure, there’s risk CRA would take offence,” says Campbell.

Our experts suggest the budget could be referring to corporate-class funds, which are touted as tax-efficient vehicles for non-registered money, and capital yield funds.

Read: Corporate-class funds, ETFs still tax-efficient after budget

If your clients own them, Nicola suggests asking your fund issuer whether or not it thinks they’ll remain tax-advantaged.

If not, switch clients to others since the higher MER would no longer be justified.

Read: Why use corporate-class funds?

Nicola’s not concerned for his clients, the majority of whom are incorporated and hold their non-registered assets in their businesses. He says reasonable compensation planning can provide similar benefits to these funds.

So before you use a strategy that has extra costs or liquidity limitations, make sure you’re doing tax planning, says Nicola. “Apply that first before you look at exotic products,” he says.

Synthetic dispositions

Experts suggest this strategy likely applies only to the ultra-rich, and is often used by the Big 4 accounting firms.

One CA says the budget’s not* targeting situations where rich clients use options contracts to incur a loss at the end of the year and then obtain the corresponding gain as of January 1. The tax deferral grows each year. The accountant knows of one client who uses this strategy to push $500 million forward.

Read: Tax-loss harvest using ETFs

Wish list

Nicola would have liked to see an extension of charitable tax credits to donations of real estate and shares of private companies, but neither was put forward.

“Canadians have a lot of wealth tied up outside the stock market,” he says. Sure, they leave real estate and shares to charity in their wills, “but this would have been an opportunity to get that money into those charitable hands long before then.”

*The original version of this article stated that Budget 2013 was targeting this strategy, also known as commodity straddles. Upon further analysis, the CA determined that was incorrect.

Back to BUDGET 2013: Closing Loopholes

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.