Tax-advantaged investing

Investors have been enjoying a broad equity market rally for the past year, but many market commentators are sounding cautious about future gains. It’s a stock picker’s market now, the refrain goes, suggesting that the easy money has been made.

On the fixed income side of the portfolio, yields remain stubbornly low, and investors are shying away in anticipation of rising interest rates in the second or third quarter.

With returns increasingly hard to come by, it may be time for advisors to focus on the expense side of the ledger. Finding lower-cost investments is only a small part of that battle, though. The real value-add is in tax-advantaged investing.

Investors may not even be aware of some of these tax-advantaged investing strategies – at best they may be aware of the simplest approaches.

“I don’t think people have really realized the impact of taxes yet,” says John Gallagher, associate portfolio manager at Foster & Associates in Toronto. “People do realize dividend yields are more tax-efficient, so there is a bit of tax awareness, but generally, it’s quite an educational process.”

Among investment products, there are two standout offerings: venture capital funds and flow-through funds. Each may conjure up notions of high-risk investments, but the tax benefits they provide can greatly reduce risk.

Venture capital explained

Venture capital funds benefit from federal and provincial tax credits, which naturally vary from one jurisdiction to another, but are generally between 15% and 25%. If a Saskatchewan investor places $5,000 in an eligible venture capital fund, he or she receives the 15% federal credit, as well as a 20% provincial credit, for a total tax credit of $1,750.

If the investment is made within an RRSP, they will also receive additional tax savings – in the case of a person earning $50,000, this would amount to an additional $1,750. The total out-of-pocket expense for the $5,000 investment is just $1,500. Even if the value of the fund lost 70%, the investor has broken even.

The massive tax credits the product provides make it an easy sell, once the client understands the process.

“It’s a bit addictive. If you went from getting a $1,000 tax refund to an additional $1,500, you’re going to like that,” Gallagher says. “It is probably one of the few things your clients ask you about: “So, where did I get that tax refund from last year?”

Flow-throughs explained

While flow-through share investing is popular in the resource-focused economies of Western Canada, it remains something of a mystery in the East. Flow-through shares allow investors to convert regular income into capital gains, using provisions in the Income Tax Act that encourage mineral and energy exploration.

The CRA offers a 100% deduction for capital spent on prospecting, called the Canadian Exploration Expenses (CEE) credit. To qualify for the credit, exploration companies must spend capital investments within two years of receipt.

Exploration is typically the domain of very small companies, and income is usually only generated when the prospecting team finds mineral or energy deposits. These companies can go years without posting a profit, and require a constant inflow of capital investment to keep geologists in the field.

With no revenues, these CEE credits remain unclaimed, and are the most valuable assets owned by these junior firms. To attract investors, the CRA allows issuance of special “flow-through” shares which allow the investors to claim the CEE credit.

In exchange for an investment of $10,000, for example, the exploration firm provides the investor with the 100% tax credit, in effect sheltering the initial investment. The conversion to a capital gain will follow upon disposition.

The most common strategy for participating in the flow-through market is the limited partnership (LP) route. Available by offering memorandum to qualified investors, LPs offer some of the same key advantages provided by mutual funds.

In the past, competition for flow-throughs was fierce, and it was difficult to place all of the capital raised by the LP in flow-throughs. The remaining capital would be invested in common equity in the same sector. The 100% CEE credit applies only to the amount placed in flow-throughs, so if only 70% of the initial capital pool is placed in flow-through shares, the investor tax credit portion is 70%.

But the market collapse of 2008 scared off many in the flow-through space, slashing valuations of the exploration companies and reducing competition for new flow-through issuance.

“In the old days, when you were doing flow-throughs, you were negotiating deals with people in a very fierce market,” says David Levi, president and chief executive officer of Matrix Asset Management, a firm created by the amalgamation of retail venture capital fund provider GrowthWorks, and flow-through specialist firm Mavrix Fund Management.

“The issue now is not can you get flow-through; it is getting the right flow-through,” he says. “Years ago people were paying huge premiums, today the premiums are almost non-existent.”

The holding period for an LP is usually about two years, matching the time limit for the exploration company to spend the cash. During this period, there is no formal market for LP units. Once this vesting period has elapsed, the partnership is usually converted into a mutual fund, with LP units exchanged for mutual fund units that can be bought or sold. With the initial tax benefits now passed on to the investor, the flow-through shares held by the LP serve as common equity in the exploration company.

The investor’s adjusted cost base (ACB) for their new fund holding is based on the percentage of the initial investment it was able to write off using the exploration tax credit. For example, if the LP was successful in deploying all capital into flow-through shares, the write-off would be 100% and the ACB on the fund is zero. If the investor was only able to write off 80% of the initial $10,000 investment, the ACB will be $2,000.

The balance of the value is considered a capital gain and the investor faces only the 50% inclusion rate, cutting his or her tax liability in half. The higher the initial deduction, the larger the capital gain and the greater the tax saving. The product is especially attractive for investors with a large capital loss carry-over, as they can apply the gain against the loss and face no tax.

Between the initial CEE deduction and the break on capital gains, investors have almost 30% downside protection on their investment. In Ontario, for example, assuming the investor is in the highest marginal tax bracket of 46% and they invest $10,000 into the flow-through LP, the 100% deduction will garner them an initial tax benefit of $4,600 – lowering their investment risk to $5,400.

When the assets are eventually disposed of, the 50% inclusion rate on capital gains will mean a tax hit of 23%, assuming the investor remains in the same tax bracket and the value of the fund does not change. If the value of the assets falls even by as much as 30%, to $7,000, the investor will only face capital gains tax of $1,771, leaving him with a post-tax balance of $5,229.

Client assessment

In assessing whether the client is right for flow-throughs or venture capital, Gallagher says the first step is to look at the prior year’s tax return, followed by an analysis of what they are currently invested in.

In terms of the client’s asset base, venture capital may be of value to middle-class investors, but flow-through shares are generally best reserved for those in the highest marginal tax bracket.

The advisor also needs to take into account the client’s liquidity needs. To get the full benefit of flow-through shares, the client needs to hold the investment for up to two years. In the case of the venture funds, investors will need to accept the longer holding period to make the most of the tax rebate.

“I think flow-throughs are fairly unique because there is generally no liquidity for 18 months, and I wouldn’t say it’s for everyone,” says Gallagher. “I would say, from my standpoint, maybe 10% of clients would be interested.”

Prior to the downturn of 2008, many investors may have thought they could tolerate a longer holding period. When the market tanked and liquidity dried up, they learned the downside of being locked into a product.

Despite the risky-sounding nature of both mineral exploration and venture capital funds, government policy toward these investments and the structure of the product go a long way toward mitigating the risks.

“You got a lot more comfort saying, with the flow-through you are getting about 50% of your money back, no matter what,” said Gallagher. “With the venture capital side you are going to get 60% to 70% in dividends, so that certainly adds a cushion there.”

But these products can provide some comfort in volatile markets. Venture funds do not swing as violently as the overall market because the companies are privately held and quite illiquid. Portfolio companies are valued on a weekly basis, rather than by ticks on the market. The true value of a company is rarely cut in half overnight.

Add in the tax credits and fund distributions, and the investor can better weather public market storms.

“It tends to be a much calmer place to be,” says Levi. “Companies are not as affected as the wild swings that you see in the market.”

The market collapse was not nearly so kind to the flow-through sector. The sudden downturn in commodity prices had a massive impact on flow-throughs, as investor appetite vanished. But Levi says the natural ebb and flow of the resource sector will bring prices – and investor interest – back.

“Because you’ve got the two-year lag in terms of being able to sell it, what you’ll find is that the rates of return were pretty poor for really one year [2008],” says Levi. “And, so that has had an impact on the market, because some people don’t make money.

“There is some slack in the market now, we can see with the recovery happening, that there will be tightness in oil and gas and in the commodities area.”

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Steven Lamb is the news editor of the Rogers Business and Professional Publishing, Financial Services Group.

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Steven Lamb