All right, I'll be the first to admit it. My life is a little onetracked.
Here's proof: My career is taxation, and my hobby is investing. Being one-tracked makes me good at what I do, but-according to my wife-something far less than exciting at the dinner table. In fact, my wife Carolyn and I were at a friend's place for dinner once when the conversation turned to investment issues. I was in my element. Evidently, everyone else wished they were in bed.
After dinner, Carolyn said to me privately: "Tim, for the first time in my life, I envied my feet-they were asleep.Why can't you take up another hobby, like insect collecting or something?"
"Insect collecting," I replied. "Great idea! I could liquidate some of my South American holdings, and reassess my short position in that small resource play out west to free up some cash. Then I could undertake a fundamental analysis on any insect-related securities that I can locate in the market. Of course, I'd want to check the price-volume histories and look at other technical analyses. Heck, I could even take a long position in some bug-related futures contracts through my broker in Chicago. Carolyn, you're a genius.We could make millions!"
"Help, I married a financial geek!" my wife replied. "Tim, forget what I said about starting a new hobby."
At this point, I want to talk to those of you who, like me, are investors. And this will include just about everyone. In fact, you can consider yourself an investor for our discussion here if you have any money at all invested outside your Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), or other tax-deferred plan-or if you expect to have these types of investments down the road. These are called non-registered assets, also referred to as your open money.
Let's look at some strategies that are sure to keep the tax collector away from your open money. It's time for investors to step up to the plate, because these pages contain some guaranteed home runs.
Tim's Tip 50: Consider the impact that taxes can have on a non-registered portfolio.
If the truth be known, Canadian investors, financial advisors, and money managers have not focused enough on the impact that taxes can have on your accumulation of wealth over the long run. Now, don't blame your financial advisor for not paying much attention to after-tax investing if in fact your advisor hasn't been concerned about the issue.
You see, there hasn't been much research on the issue of after-tax returns, so most advisors have not been fed the proper information on the subject. As for money managers in Canada today, most grew up in the pension industry where, quite frankly, income taxes don't matter (money in a pension fund isn't subject to taxes annually).
The bottom line? Canadian investors have not been shown that after-tax investing is critical to building wealth. But times are changing. Canadians are starting to recognize the impact taxes can have on a portfolio. I'm here to tell you that focusing on after-tax returns is so important when investing outside an RRSP or RRIF that it could mean the difference between having plenty in retirement, and moving in with the kids or performing on a street corner to make ends meet (and unless you're Bono, performing on a street corner is not likely to get you far).
There are two things in particular that will determine how much tax you pay annually on your non-registered investments: portfolio make-up and portfolio turnover.
Did You Know?
A recent survey by Stats Canada showed that 70 per cent of all investable wealth in Canada today is outside of RRSPs and RRIFs, where taxes can easily impact the growth of those assets. And don't forget, the next decade will see billions of dollars moving from one generation to the next here in Canada.
When money changes generations, it generally ends up in non-registered accounts since RRSP and RRIF assets rarely stay in those tax-deferred plans when moving to the hands of children or grandchildren.
Portfolio Make-Up Matters
When I talk about portfolio make-up, I'm talking about the types of investments you're holding in your portfolio (remember, I'm referring to those investments outside your RRSP or RRIF; there are no taxes annually on income earned inside those registered plans). You see, the types of investments you hold will determine the type of income you earn from your investments, which will affect how much tax you pay each year.
The bottom line? A focus on after-tax investing is critical! Generally, your investments will fall into three broad categories:
• money market investments
• fixed income investments
• equity investments
Money market investments include cash and near-cash investments such as Guaranteed Investment Certificates (GICs), Canada Savings Bonds, or money market mutual funds. Fixed income investments, as the name suggests, provide a steady stream of income to the investor, and generally include corporate bonds, government bonds, mortgage-backed securities, preferred shares, income trusts, or mutual funds that invest in these and similar types of investments. Equity investments are different in that you're an owner, not a loaner. That is, equity investments provide you with ownership in something, whether it's a business, real estate, natural resources, or something similar. Equity investments include common shares in publicly traded companies, real estate, or mutual funds that invest in these or similar things.
What's the difference between money market, fixed income, and equity investments from a tax point of view? It's a critical question. Money market and fixed income investments will generally provide you with interest income (and perhaps with dividends in the case of preferred shares), with little opportunity to generate capital gains. Equity investments, on the other hand, provide an opportunity for capital gains (or losses!) and perhaps some dividend income in the case of common shares.
Make no mistake, these differences are crucial. You see, interest income is taxed at a much higher rate than dividends from a Canadian company, and capital gains.
Flip to page 296 at the back of the book and you'll see the difference in marginal tax rates that apply to these different types of income in each province. If you're in the highest tax bracket, you'll face marginal tax rates on these types of income approximately as follows (these are averages for Canada in 2009):
• Interest income 45.0 per cent
• Canadian ineligible dividends 31.3 per cent
• Canadian eligible dividends 25.0 per cent
• Capital gains 22.5 per cent
The bottom line? Money market and fixed income investments are not generally tax-smart because interest income is downright ugly from a tax perspective.
Equities, on the other hand, make more sense from a tax perspective since capital gains are taxed at much lower rates. In fact, only half of any capital gains you realize will have to be included in your income.
Portfolio Turnover Matters
In addition to portfolio make-up, the turnover of your portfolio is critical as well. Every time you liquidate an investment and then reinvest the money, you've "turned over" that investment. The more selling and buying that goes on in your portfolio, the higher your rate of turnover. The problem with turnover is that each sale is a taxable event when it takes place outside of a registered plan. If taxes are triggered, it leaves you with less money to reinvest. This means that your next investment has to perform better than you might have thought: It has to provide you with the rate of return you're expecting, but must go further, to replace the dollars you paid in taxes from liquidating the previous investment. Sure, taxes may eventually be paid on your gains, but it's better to defer the tax to the future than to prepay tax today-it's a timing issue.
You need to know that turnover can take place at two levels: the investor level, and the money manager level. That is, there are generally two culprits who can be accused of turning over your investments: you, and/or the money manager (typically the mutual fund manager where you're invested in funds). You create turnover every time you choose to sell a security that you hold in your portfolio, whether it's a stock, bond, mutual fund, or some other investment. The money manager creates turnover in the same way by selling securities inside the fund you're holding. In either case, guess who pays the tax on any taxable capital gains realized. You got it: You pay the tax.
By the way, you might think that a turnover rate of 100 per cent is not realistic for a mutual fund in a given year. Think again. In any given year, there will be many funds with rates of turnover in excess of 100 per cent. I've seen funds with turnover rates as high as 800 per cent in a year! If you're not sure what the rates of turnover are for the funds you're investing in, call the fund companies you're dealing with and ask.
Tax-Smart Rules Want to minimize the tax you're paying on your investments outside your RRSP or RRIF? You should.We've seen that taxes do matter-a lot! After the discussion we've had here, you'll now understand that there are two rules to start with to minimize taxes annually on your investments: 1. Focus on capital gains when investing outside of your registered plans.
2. Keep portfolio turnover to an absolute minimum.
Let me make a couple of last points. Earning capital gains outside of a registered plan is important for tax efficiency. Today, there are also a number of mutual funds and income trusts that provide distributions as a return of capital (ROC). A ROC is tax free when the distribution is received. The distribution will reduce your adjusted cost base in the specific investment so that, when you eventually sell it, you'll have a larger capital gain or smaller capital loss at that time. A ROC, then, manages to push the tax hit to the year you sell the investment and results in a capital gain at that time. It's a tax deferral. Not too shabby. See Tip 54 for more on income trusts.
Finally, speak to a trusted financial advisor about which specific money managers attempt to keep turnover to a minimum. Focus on these managers when investing outside your RRSP or RRIF.
TO MAKE A LONG STORY SHORT:
• After-tax investing has been ignored for too long by investors, financial advisors, and money managers alike. Today, Canadians are starting to think about after-tax returns, because taxes do matter.
• Taxes on a portfolio are affected by two things: portfolio make-up and portfolio turnover.
• Minimize taxes by focusing on earning capital gains or returns of capital outside your registered plans and by keeping turnover to a minimum.
Tim's Tip 51: Call your profits capital gains and your losses business losses.
Sometimes you're going to make money on your investments, and sometimes you're going to lose it. But are you going to call your profits capital gains or business income? Similarly, are you going to call your losses capital losses or business losses?
This issue can be as clear as mud. No doubt about it, this is one of the very gray areas in our tax law. And it can be tough making key decisions on the gray issues, where it often comes down to toss-ups and testosterone.
Saya loves to invest. In fact, she follows the stock market closely. In an average month, Saya makes about eight trades on her brokerage account.
Last year, she generated $35,000 in profits from her investing. But investing is not Saya's primary source of income. She works as a technician in an architect's office, and she earns $45,000 each year as an employee there. Should Saya's profits from investing be considered capital gains or business income?
She could argue either way.
Here's the general rule: Where you have the ability to argue either way, call your profits capital gains. Here's why: Just 50 per cent of capital gains are taxable in Canada, while business income is fully taxable. Have you incurred losses? You'll be better off calling these business losses than calling them capital losses. After all, capital losses can only be applied against capital gains to reduce tax, while business losses can be applied against any source of income at all.
Keep in mind that, in many cases, it will be clear whether your profits and losses are capital or income in nature. Consider the analogy of the tree and its fruit. If you bought a tree with the intention of growing and selling fruit, then the tree would be a capital asset to you. So, if you were to sell the tree itself at a profit, that profit would normally be considered a capital gain. The profits from selling the fruit would be considered business income. As far as the tax collector is concerned, your primary intention when you bought the asset will normally determine the proper treatment.
Want a more lifelike example? Suppose you bought a condominium for the purpose of renting it out, and someone offered a good price to buy the condo from you.
Because you bought the condo to generate rents (your "fruit" in this case), the condo is a capital asset, and any profit on the sale is likely a capital gain. If, however, you bought the condo largely to sell it at a profit, and not primarily to rent it, then you could argue that the transaction was income in nature. It's what we call an "adventure in the nature of trade." If you lost money flipping the property in this case, it's arguably a business loss.
In any event, it's important to document your reasoning for the position you take when reporting your gains and losses. And be consistent! That is, don't treat your stock profits as capital gains and your losses from similar investments as business losses. The tax collector doesn't really have a sense of humour in this regard.
In fact, I need to tell you about the recent court decision in Baird v. The Queen, where the taxpayer reported losses from the sale of marketable securities as business losses rather than capital losses. The Tax Court of Canada concluded that the taxpayer failed to establish on a balance of probabilities that he was a "trader" in securities or was involved in an "adventure in the nature of trade." The court noted that: (1) the taxpayer treated his transactions in an inconsistent manner (in the prior year, he had reported his profits as capital gains, but his losses were now being treated as business losses), (2) the accountant of the taxpayer could not explain why, in the prior year, the taxpayer was not considered a "trader" whereas in the year in question the expectation is that he'd be considered a trader and therefore should be afforded business loss treatment, (3) filing on a business loss basis was opportunistic tax planning, (4) the taxpayer did not report any business expenses in this "trading" business, and (5) the taxpayer's wife did not give any evidence as to his "business" and therefore a negative inference was drawn by the court. The key here is to be consistent from one year to the next- if you look like you're being opportunistic, your planning is not likely to work.
I should also share some good news. On November 30, 2006, the CRA issued a technical interpretation (document 2006-0185041E5; you'll need to visit a tax pro if you hope to obtain a copy-CRA won't be any help), which clarified that it's possible to segregate your portfolio into two parts: One part that may be treated on income account, and one that may be treated on capital account. (This assumes you have not made a special election under subsection 39(4) of the Income Tax Act to have all your Canadian securities treated on capital account) Now, CRA did say that, "normally, however, such situations would be rare and the initial presumption will be that gains or losses made or incurred by a particular taxpayer or transactions in securities, having regard to the taxpayer's circumstances, are either all of a capital nature or are all of an income nature, as the case may be." (See Interpretation Bulletin IT-479R, paragraph 33, available online at www.cra.gc.ca.) Nevertheless, CRA went on to say that if you can demonstrate clearly that you have two distinct pools of securities (two separate accounts makes sense) and you have acted differently with respect to each pool or account, you may be afforded capital treatment on one account, and income treatment on the other. This can be useful if you're hoping to take advantage of certain tax treatment that works in your favour.
Here's one last point: Any profits or losses that you generate from short-selling a stock will generally be considered business income or losses. It only makes sense. You see, a short sale doesn't provide the opportunity for any "fruit from the tree" such as interest, dividends, royalties, or rents. No fruit? Then these securities are more akin to an "adventure in the nature of trade" and will be treated as income.
TO MAKE A LONG STORY SHORT:
• It may not always be clear whether you should treat your investment profits and losses as capital or income.
• Where possible, you'll want to argue that your profits are capital gains and your losses are business losses. It may be possible to treat different investment accounts differently in this regard. Visit a tax pro to talk this over.
• Document your reasoning and be consistent from one transaction to the next, and one year to the next.
Tim's Tip 52: Claim a capital gains reserve to spread your tax bill over time.
Ah, yes, one of the mysteries of the universe-how to avoid tax on capital gains when an asset has appreciated in value. It's not an easy question to answer. I wish more magic were available here. Your best bet in this situation may be to push the expected tax bill as far off into the future as possible. You can do this simply by not selling the asset. But if you're determined to sell, you can at least minimize the tax hit by spreading it out over a maximum five-year period.
You see, the tax collector will allow you to claim what is called a capital gains reserve-a deduction-when you have sold something at a profit but have not yet collected the full amount of your proceeds from the sale.
Lisa decided last year to sell the family cottage. She had bought it for $75,000 and was offered $175,000 for it-a $100,000 profit she couldn't refuse. She wasn't able to shelter this $100,000 capital gain in any way, so she decided to take payment from the purchaser over a five-year period-$35,000 each year. This way, the capital gain was not taxed all at once last year. Rather, Lisa will pay tax on the gain over the five-year period-she'll report just $20,000 each year. She reported the full $100,000 capital gain last year, but claimed a capital gains reserve for 80 per cent (four-fifths) of the gain. The gain will be taken into income slowly over five years.
You'll have to take any capital gains into income at a rate not less than 20 per cent (one-fifth) each year. If you're not keen on the idea of taking payment over five years because you're giving up use of the proceeds today, there's a simple solution: Build an "interest" charge into the selling price so that you're compensated for the time delay in collecting payment. For example, Lisa could have collected, say, $37,500 each year rather than $35,000-for a total selling price of $187,500. The additional $2,500 each year is like interest income, but the good news is that it should be taxed as a capital gain (only one-half of capital gains are taxable) if you build it into the selling price!
TO MAKE A LONG STORY SHORT:
• It's very difficult to avoid paying tax on accrued capital gains on assets you own.
• Your best bet may be to push the tax bill as far into the future as possible.
• A taxable capital gain can be spread out for up to five years by taking payment of the proceeds over an extended period. This is called a capital gains reserve.
Tim's Tip 53: Consider investing to earn eligible dividends for big tax savings.
Some big changes were introduced in 2006 that will impact Canadian investors for years to come. By way of background, the federal government had been concerned about the amount of money being invested by Canadians in income trusts. Why?
Because income trusts can result in a significant deferral of tax for investors (see Tip 56 for more). To stem the flow of money invested in income trusts, the federal government proposed to equal the playing field between income trusts and publicly traded shares so that investors may be less inclined to invest in income trusts and more inclined to invest in shares.
What did the feds do? They reduced the tax rate on eligible dividends from certain Canadian companies. Let's take a look at the new rules.
Lower Tax Rates
Eligible dividends from Canadian companies will be subject to lower tax rates than ineligible dividends. You see, eligible dividends will benefit from a 45 per cent gross-up (as opposed to a 25 per cent gross-up for ineligible dividends) and a larger dividend tax credit equal to 18.97 per cent of the grossed-up dividend (13.33 per cent for ineligible dividends). The end result is a lower marginal tax rate on eligible dividends (see the marginal tax rate tables starting on page 297). In fact, it's interesting to note that, at certain income levels, eligible dividends may have a negative marginal tax rate (more about this in a minute).
By comparison, the average marginal tax rate on eligible dividends is 25 per cent, while ineligible dividends have an average marginal tax rate of 31.3 per cent.
An eligible dividend is generally a dividend paid by a large publicly traded Canadian corporation. Some dividends paid by a Canadian-controlled private corporation (CCPC) may also qualify.
Okay, let's get more specific here. If a corporation is a CCPC or a deposit insurance corporation, it can pay eligible dividends only to the extent of its "general rate income pool" (GRIP)-a balance generally reflecting taxable income that has not benefited from the low small business tax rate or any of certain other special tax rates.
A corporation resident in Canada that is neither a CCPC nor a deposit insurance corporation (a "non-CCPC") can pay eligible dividends in any amount, unless it has a "low rate income pool" (LRIP), in which case it must pay dividends out of this LRIP before it can pay eligible dividends.
The LRIP is generally made up of taxable income that benefited from small business tax rates, either in the hands of the dividend-paying non-CCPC itself (at a time when it was a CCPC) or in the hands of a CCPC that paid an ineligible dividend to the non-CCPC. Many non- CCPCs will never have an LRIP, with the result that the company will be able to designate all of its dividends as eligible dividends.
By the way, a given corporation will have, at most, one GRIP or one LRIP at any time, and that one pool is relevant to the dividends it pays on all classes of its shares.
This means that, subject to any constraints in the existing law and the need to avoid artificial manipulations of the pools, a corporation can choose which of its shareholders will receive eligible or ineligible dividends.
Strategies to Consider
The low tax rate available on eligible dividends brings to mind some tax strategies to consider. First, if you own a CCPC, you may want to give thought to creating a general rate income pool (GRIP) by foregoing the small business deduction (and thereby foregoing the small business tax rate). This will enable the CCPC to pay eligible dividends (subject to the LRIP limitation). You see, a new election allows a CCPC to do this without also giving up other benefits of CCPC status. This is simply a number-crunching exercise that your accountant can help you with, to determine if the idea is right for you.
Secondly, given the new, lower marginal tax rate on eligible dividends, it would be a mistake for some investors to hold all of their stocks in their registered plans, if those stocks pay eligible dividends. That is, to the extent you want to hold equities in your portfolio, you may be better off holding certain equities outside your RRSP or registered retirement income fund even if you have the contribution room to hold those assets inside the plan.
Consider this: The dividend tax credit has been increased under the new rules so much that the credit, in some cases, will not only offset the tax owing on the dividend received, but will go further and reduce the tax on other income you have as well. For example, a taxpayer in Ontario earning $30,000 annually will pay $4,230 on that income (2009 tax rates). Add $5,000 of eligible dividends to his income, and his total tax bill drops to $3,857. Did you catch that? The marginal tax rate on those dividends is actually a negative number. Now, once your income hits a certain level ($40,726 in Ontario at 2009 tax rates), your eligible dividends will increase your taxes-albeit at a lower rate than other income.
TO MAKE A LONG STORY SHORT:
• Changes introduced in 2006 will provide a lower marginal tax rate on eligible dividends paid, typically, by large publicly traded Canadian corporations.
• Some private corporations may also be entitled to pay eligible dividends to the extent they have a general rate income pool (GRIP).
• It may now make sense for some private company owners to forego the small business tax rate in exchange for the ability to pay eligible dividends, but this is strategy that your accountant should advise on, depending on your circumstances.
• It may also make sense to hold certain stock outside of registered plans to the extent eligible dividends will be paid on those stocks. This may be particularly true where your income is lower and you may have a negative marginal tax rate on eligible dividends.
Tim's Tip 54: Think about reporting your spouse's dividends on your own tax return where possible.
Sure, it may sound crazy, but taking income from the lower-income spouse and adding it to the income of the higher-income spouse could actually save you taxes.
You see, if your spouse earns dividends (eligible or ineligible) from a Canadian company, he or she will be entitled to claim a dividend tax credit. This is simply a credit that is deducted from the taxes your spouse would otherwise pay. But what if your spouse isn't going to pay any tax because of not having much income? In this case, the dividend tax credit could go to waste.
The good news? Our tax law will allow you to elect to include all (it's all or nothing) of your spouse's Canadian dividends on your tax return, where you'll be able to claim the dividend tax credit. How can this possibly save you tax? Simple.
By removing the dividend income from your spouse's tax return, your spouse's income will be reduced. This will increase the spousal credit you're entitled to claim for having a spouse who is dependent on you. In fact, the tax collector won't allow you to make this election to report your spouse's dividends unless the spousal credit you're entitled to claim is increased as a result of removing the dividends from your spouse's return. Follow me?
In the end, you'll need to calculate your and your spouse's combined tax bills both ways: (1) having your spouse report his or her own dividends, and (2) reporting your spouse's dividends on your tax return instead. This will tell you whether or not you stand to benefit from the transfer. This is where tax software is going to come in handy. It's easy to do these "what if" calculations with software.
The other option is to speak to a tax pro or a financial advisor who may be able to do the calculations for you.
TO MAKE A LONG STORY SHORT:
• It may be possible to save tax by reporting Canadian dividends received by your lowerincome spouse on your tax return instead.
• This transfer can be made only where doing so will increase the spousal credit that you're able to claim as a result of your spouse being a dependant.
• You'll need to crunch some numbers to see if this transfer will be beneficial for you.
Tip 55: Use a tax-free savings account for a number of benefits.
The 2008 federal budget introduced a new type of savings account, called a Tax- Free Savings Account (TFSA) that will allow you to earn income on a tax-free basis inside the account. Want the basics? You won't be entitled to a deduction for money contributed to the TFSA, but all the earnings inside the TFSA became tax-free, and all withdrawals from the TFSA are also tax-free. TFSAs became available at the start of 2009.
Any Canadian resident who is age 18 or older will be able to establish a TFSA.
You'll be able to open an account at most financial institutions, such as banks, trust companies, credit unions, and just about any other institution that also offers registered retirement savings plans (RRSPs). You'll have to provide the issuer with your social insurance number when you open the account. And you can open more than one TFSA, but your total contributions to TFSAs in a particular year can't be more than your contribution room.
You'll be able to contribute an amount up to your contribution limit for the year.
That contribution limit-or contribution "room"-is made up of three amounts:
• $5,000 for each year starting in 2009 (this $5,000 will be indexed to inflation and rounded to the nearest $500 on a yearly basis), plus
• Any withdrawals made in the previous year (that is, you'll be able to "re-contribute"
any amounts you withdraw from the TFSA, on top of new contribution room you accumulate each year), plus
• Any unused contribution room from prior years.
By the way, the Canada Revenue Agency (CRA) will determine the TFSA contribution room (based on information provided by issuers) for each eligible individual who files an annual T1 individual income tax return. Individuals who have not filed returns for prior years (because for example, there was no tax payable) will be able to establish their entitlement to contribution room by filing a return for those years or by other means acceptable to the CRA. I expect that the CRA will provide information on your notice of assessment annually as to the amount of your available TFSA contribution room.
Jacob is 25 years old, is a Canadian resident, and will therefore be given $5,000 of TFSA contribution room in 2010. Let's assume he has made the maximum TFSA contributions in prior years and has never made withdrawals. He contributes $2,000 to a TFSA in 2010, and so $3,000 of contribution room is carried forward and can be contributed in the future. Jacob's contribution room for 2011, then, is $5,000 (for 2011) plus $3,000 of contribution room carried forward from the prior year, for a total of $8,000. If Jacob does not make a contribution to a TFSA in 2011, but decides to withdraw $1,000, his contribution room for 2012 would be $5,000 (for 2012), plus $8,000 (carried forward from 2011), plus the $1,000 withdrawn, for a total of $14,000. (Note: The contribution limits for 2010 and later years had not been announced at the time of writing, so I have used $5,000 as the contribution amount here.) There is no limit on the length of time you can carry forward unused TFSA contribution room. But be sure not to contribute more than your contribution room. If you make an excess contribution, you'll face a tax of one per cent per month on any excess amount, and this tax will apply every month that the excess remains in the TFSA. In addition, you'll pay a penalty equal too 100-per cent of any gains or income earned on the excess amount (thanks to changes announced on October 16, 2009).
Withdrawals from a TFSA There are no restrictions on the amount of withdrawals you can make, nor are there mandatory withdrawals required, as with a registered retirement income fund (RRIF). And withdrawals are not taxable, and so they will not impact income-tested benefits such as Canada Child Tax Benefits, the Working Income Tax Benefit, Old Age Security benefits, the Guaranteed Income Supplement, Employment Insurance Benefits, age credits, or GST tax credits, for example.
Transfers to a TFSA
The government announced changes to the rules around TFSAs on October 16, 2009, to shut down certain abuses. And so the government shut down asset transfers from RRSPs and other registered or non-registered accounts to TFSAs. Some taxpayers were shifting value from, say, an RRSP to a TFSA by making frequent transfers and exploiting small gains in asset values. The rule change causes a penalty equal to 100 per cent of amounts in the TFSA reasonably attributed to these transfers.
This means that a cash contribution to a TFSA is the way to go.
What type of investments can you hold in a TFSA? The same investments that you can hold in an RRSP, such as mutual funds, publicly traded securities, GICs, bonds, and even certain shares of small business corporations. For a more complete list of eligible investments, see Tip 70. On October 16, 2009, the government announced that any gains on non-qualified and prohibited investments will be taxed at 100 per cent, and any income on that income will be taxed at regular income rates (same as interest income). So stay away from non-qualified and prohibited investments.
Borrowing to Invest
Unlike your RRSP, you can use the assets inside the TFSA as security for a loan if you want. The problem, however, is that you won't be able to deduct the interest on the loan where the loan proceeds have been contributed to a TFSA for investment inside the plan. The rationale is that you're not going to pay tax on any earnings inside the TFSA or upon withdrawing those funds later, so the taxman isn't keen on allowing a deduction for the interest in this case.
Here's some welcome news. If you provide funds to your spouse or common-law partner to invest in a TFSA, any income earned in your spouse's plan will not be attributed back to you to be taxed in your hands. That is, the TFSA allows you to side-step the attribution rules which I spoke about back in Tip 10.
Death of a Taxpayer
If you own a TFSA, what happens upon your death? Well, the earnings that accrue in the account after the account holder's death will be taxable, while those earnings that accrue before death would remain exempt. The good news, however, is that it's possible to maintain the tax-free status of the earnings if the account holder names his or her spouse or common-law partner as the successor account holder.
Alternatively, the assets of the deceased's TFSA could be transferred to the TFSA of the surviving spouse or common-law partner on a tax-deferred basis without any impact on the survivor's existing contribution room.
If you get up and leave Canada-that is, become a non-resident for tax purposes- you'll be allowed to maintain your TFSA, and you won't be taxed on any earnings in the account or on withdrawals. But, you won't be allowed to contribute any more to a TFSA, and no contribution room would accrue for any year throughout which you are a non-resident.
If your marriage breaks down, any amount can be transferred directly from one spouse or common-law partner's TFSA to the other's. The amount of the transfer would not affect either person's contribution room, and there would be no tax to pay on the transfer of assets from one plan to the next.
Inside a TFSA Just as your investment losses inside an RRSP cannot be claimed, the same is true for losses inside a TFSA. You cannot simply use those losses against income or capital gains realized outside of the TFSA. And inside the TFSA, those losses will not benefit you since the income inside the plan is not taxable anyway.
TFSA Strategies Okay, so are TFSAs really a good deal? Should every Canadian have a TFSA? To be honest, I am hard pressed to think of any reason why you would not open a TFSA. Sure, the contribution limits are fairly modest, but some tax free compounding inside a TFSA is better than none at all. So, yes, I think that every eligible person should open a TFSA.
Now, consider the following strategies to make the most of a TFSA:
1. Compare TFSAs to RRSPs. In all likelihood, it will make sense to set aside money in both a TFSA and RRSP. If you do the math, you'll see that both TFSAs and RRSPs work out to be equal in after-tax returns assuming your marginal tax rate remains the same in retirement as it is today (see the table below). And there's the rub. If your marginal tax rate is going to be different in retirement, then one plan may work better than the other. Here are the three scenarios and how they may affect your choice of account to use:
• If the two rates are identical, as in the table below, the TFSA and the RRSP are equally effective tax-savings alternatives.
• If the tax rate at the time of withdrawal is lower than at the time of contribution, the RRSP is the better choice.
• If the tax rate at the time of withdrawal is higher than at the time of contribution, the advantage goes to the TFSA.
• As a practical matter, the low contribution limits on a TFSA likely make it a poor choice for your sole retirement funding vehicle.
2. Side-step the attribution rules. It's possible to use a TFSA to avoid the attribution rules in our tax law. You might recall that, if you simply give money to your spouse to invest, any income earned by your spouse will generally be attributed back to you and will be taxed in your hands (refer back to Tip 10). Not so with a TFSA. For example, you could give your spouse $5,000 in 2010 for him to contribute to his TFSA. Any earnings on that $5,000 inside the TFSA will not be subject to the attribution rules. Now, the attribution rules will be avoided as long as those dollars you've given or loaned to your spouse remain in a TFSA. If you remove those dollars from the account, they will then be subject to the attribution rules if those dollars then earn income outside of the TFSA. Over a period of years, you'll be able to accumulate a fair bit in your spouse's TFSA, growing on a tax-free basis. And so, it makes much sense for both you and your spouse or common-law partner to open TFSAs, and if your spouse doesn't have the means to contribute to his or her plan, you should give the money for that purpose if you can.
3. Save for an education. Saving for a child's education is still best accomplished by using a registered education savings plan (RESP) provided you are receiving Canada Education Savings Grants (CESGs) on contributions to the RESP. But where the maximum in CESGs has been received already, and further RESP contributions won't attract those grants, I believe it can make sense to save inside a TFSA from that point onward since neither the RESP nor the TFSA provides a tax deduction for contributions, but the TFSA does offer tax-free withdrawals, which the RESP does not offer.While CESGs are being paid into the RESP, you'll still be better off with the RESP, but not beyond that point.
4. Shelter fixed income. To the extent you are going to hold interest-bearing investments in your portfolio, you should consider holding those assets in a registered plan (RRSP or RRIF), and in a TFSA. This way, the highly taxed interest income won't present a tax burden annually.
5. Shelter option or shorting strategies. If you get involved in certain options strategies, or in short-selling, the profits you make, if any, can be taxed as regular income. If this is the case, consider whether to undertake these strategies inside a TFSA. The advantage is that the income will be sheltered from tax. The disadvantage may be that you won't then be able to claim a deduction for any expenses related to earning that income, but I suspect you'll prefer to have the income fully sheltered inside the TFSA if possible.
6. Shelter foreign dividends. Foreign dividends are not subject to the dividend grossup and tax credit system available on Canadian dividends, and so foreign dividends are taxed as regular income. Earning that income inside a TFSA can shelter that income from tax.
7. Minimize benefit clawbacks. By holding income-producing securities inside the TFSA rather than in your personal hands, income that may otherwise increase your net income and thereby reduce certain benefits (Old Age Security benefits, for example) may no longer cause a clawback of those benefits.
8. Shelter private company shares. It's possible in some cases to hold private company shares inside an RRSP, and likewise inside a TFSA. The rules are complex, but as a general guideline, the annuitant under the plan cannot hold a significant interest in the private company. The company itself must also be a Small Business Corporation, which means that, generally, the company must be a Canadian Controlled Private Corporation in which 90 per cent of the assets of the corporation are used in an active business carried on primarily in Canada. The rules have been simplified here, so visit a tax pro for more information and advice on whether certain shares will qualify. Imagine, however, that you're a minority shareholder in a private company and are able to hold those shares in a TFSA; any gains on the shares would be tax-free if the company grows in value. This could be a huge win if the company's growth is significant.
TO MAKE A LONG STORY SHORT:
• The 2008 federal budget introduced a new Tax-Free Savings Account (TFSA) which offers tax-free compounding of investments, and tax free withdrawals at any time. There is no deduction for contributions to a TFSA.
• Every Canadian resident age 18 or older should open a TFSA.
• There are a number of potential benefits and strategies to consider with TFSAs, and these are generally designed to: Split income between spouses, reduce taxable income, and reduce the clawback of income-tested benefits.
Understanding Tax-Smart Strategies
Tim's Tip 56: Understand the advantages and drawbacks of income trusts.
The last few years saw an incredible proliferation of income trusts in Canada. It seems that every investor and his or her brother has been craving investment yield, and in the wake of weak equity markets, income trusts became the investment of choice. Now, income trusts are not exactly new. They appeared first in the 1980s in the form of real estate investment and oil and gas royalty trusts, which are still common today. In fact, the first three editions of this book spoke at length about real estate and royalty trusts.
More recently, businesses of all kinds converted into income trusts in order to attract the capital of investors. This is no longer the case given recent changes to the taxation of income trusts introduced on October 31, 2006. Let's look at how income trusts work, the recent changes, and more.
Income Trusts: How They Work
There are different forms that income trusts can take, but generally they work this way: Investors purchase units of a mutual fund trust-called an income trust. That income trust then uses about 25 per cent of the funds raised to invest in the shares of an operating company (the underlying business). The other 75 per cent of the cash raised by the fund is loaned to the operating company at a high rate of interest.
The key to making these income trusts work is the interest paid by the operating company to the income trust on the loan. You see, that interest expense to the company is designed to virtually eliminate any profits in the operating company. That is, the interest expense is high enough to offset most of the profits of the operating company. Further, some dividends may be paid by the operating company to the income trust on the shares owned by the trust.
The interest income or dividends received by the income trust is then distributed by the trust to investors. The distributions made to the investors of the fund may be classified as interest, dividends, or a return of capital, and will be taxed in the hands of the investor accordingly (more on taxation in a minute).
Income Trusts: Advantages
The most significant benefits of income trusts used to be the tax benefits, but changes announced on October 31, 2006, have reduced those benefits. You see, it used to be that income trusts provided a significant elimination or deferral of tax. How so? Go back to my explanation of the most common income trust structure. A corporation would earn business income, but this income would be fully or largely offset by interest deductions resulting from money borrowed by the corporation from the income trust. The result? Little or no tax to the corporation. Then, the income trust would distribute the income to the end investor and would claim a deduction for the amount distributed. The result? Little or no tax to the trust. Finally, the end investor may pay little or no tax to the extent the income trust units are held in a registered plan, or the distribution is a return of capital. The government decided that the tax benefits were a little too attractive, and made big changes, which I'll talk about in a minute.
Yet, there are still some benefits to income trusts. Consider these:
• A significant deferral or elimination of tax at the operating company level through the use of high-yield debt owing to the mutual fund trust.
• A deferral of tax on the income distributed by the trust to the unitholders of the trust to the extent that the units are held inside registered plans such as RRSPs, RRIFs, and RPPs.
• Where the units are not held in registered plans, a deferral of tax on the income distributed to unitholders of the trust is available to the extent that the distributions are characterized as a return of capital.
Aside from these tax advantages, the income trust structure appears to be a transparent mechanism for monitoring the company's performance (important at a time when confidence in management integrity is at an all-time low). How so? If cash distributions are made, the company has been successful. If cash distributions are not made, the company has not been successful. Financial statements can be restated if management lacked integrity, but this won't impact the cash distributions to investors. Once the cash has been distributed, it can't be taken back.
Income Trusts: Recent Changes
The changes announced on October 31, 2006, will impact Canadian resident trusts and partnerships whose units are listed on a stock exchange or other public market.
The trusts and partnerships that will be impacted are those that hold one or more "non-portfolio properties" (basically, property used in carrying on a business in Canada, including Canadian resource properties, timber resource properties, and more). The government has chosen to call these "Specified Investment Flow- Through" (SIFT) entities. Your typical income trust is now known as a SIFT trust.
As an aside, the changes will not impact trusts that hold passive real estate investments (your typical real estate investment trust).
The changes will impact these SIFT trusts by not permitting the trusts to deduct certain distributions that would normally be deductible. Basically, any part of a distribution that can be attributed to a business carried on in Canada or to income from (or capital gains on) non-portfolio properties will not be deductible. The bottom line? The income trust will now pay some tax. That tax will be at the same rate that a corporation would face if it had earned the income. This tax should reduce the level of distributions that an income trust can make to an investor, and therefore should have an impact on income trust values.
But the changes will have other tax impacts. You see, any amount that is not deductible to the SIFT trust and that becomes payable by a SIFT trust to you, the investor, will be taxed in your hands as though it is a taxable dividend from a Canadian corporation. The bottom line is that the tax treatment will be no different to you than if you had invested in a corporation instead of an income trust. By the way, this "deemed dividend" will be an eligible dividend available for the reduced tax rate on certain dividends (see Tip 53).
I will also mention that returns of capital have never been deductible to an income trust, and are not taxable to investors. Returns of capital will remain untouched by these changes. This is not to say that the amount of cash paid out as a return of capital will remain the same, but the tax treatment will remain the same.
Income Trusts: Other Considerations
One drawback to income trusts is that they are often sold by advisors as, and misunderstood by investors to be, fixed income investments. Don't ever forget that income trusts can only make distributions if the underlying operating company is profitable.
In this sense, these are equity investments, and should be thought of as equities.
Also, keep in mind that there is a difference between a return on investment and a cash yield. The cash yield you receive from an income trust can be quite high, even though the return on investment from the underlying business may be lower.
The reason for this is that the income trust may make a return of capital to you as an investor, and that return of capital is included in your cash yield calculation. If you do receive your original capital back, this is not the same as receiving a return on your investment.
Finally, keep in mind that income trusts are designed to pay out virtually all profits of the underlying business. Therefore, there should not theoretically be significant growth in the value of income trust units over time. Any business that fails to retain its profits should have difficulty growing. The bottom line? Be wary of any income trusts that seem to appreciate in value significantly without any justifiable reason.
TO MAKE A LONG STORY SHORT:
• Income trusts have been a popular investment in Canada over the last few years. They are equity investments that have fixed-income qualities and may be appropriate for investors who require income.
• Income trusts can offer investors interest or dividend income, or a tax-efficient return of capital.
• Recent changes to the taxation of income trusts were introduced on October 31, 2006.
The changes reduce the tax benefits, but there are still benefits worth considering, not the least of which is the transperancy into whether management is doing a good job.
Tim's Tip 57: Look at flow-through shares for a tax deduction and diversification.
My friend Paul has a good sense of humour, and an even better nine iron. On the way home from a round of golf last summer, he kept me in stitches in the car as he relayed one joke after another. I don't know how he remembers them all. At one point he proclaimed, "Tim, I need some gas."
Thinking he was trying to be funny, I responded, "Great, let's stop for some spicy Mexican food."
He looked at me, straight-faced, and said, "No, I'm talking about my investment portfolio. I have absolutely no exposure to hard assets, and I've heard there are some tax breaks available in the resource sector. Is it true?" He was serious.
"Well, yeah, flow-through shares can offer some tax breaks," I said.
I spent the next half-hour explaining to Paul the benefits and risks of flow-through shares. Let me give you the highlights.
Flow-through Share Basics
Flow-through shares can provide attractive investment returns in addition to the direct tax savings that so many Canadians like Paul are looking for. A flow-through share is a creative, but higher-risk, investment issued by Canadian resource companies looking to raise capital for exploration and development. These shares are designed to provide the investor with tax deductions that generally equal the value of the amount invested-or come close to it.
You see, these resource companies are able to renounce certain deductions and flow them through to the individual investor so that the investor can claim the deduction instead. I'm talking primarily about Canadian exploration expenses (CEE), which are 100-per cent deductible by the investor, and Canadian development expenses (CDE), which are 30-per cent deductible on a declining balance basis. The fact is, a resource company can renounce these expenditures up to one year before incurring the actual costs. That's right, a company issuing flow-through shares in 2009 is able to renounce its eligible expenditures in calendar 2009 without actually incurring those expenses until the year 2010.
Flow-through Tax Facts
As I said, flow-through shares provide a tax deduction to the investor that is typically equal to the amount invested in the shares. The deduction doesn't usually come all in one year, but you can expect about 90 per cent of it in the first year, with the balance in the second and perhaps the third year. Under Canadian tax law, the adjusted cost base of your flow-through shares will be reduced by any deductions you're able to claim. This means that any sale of a flow-through share will give rise to a guaranteed taxable capital gain. But don't let this scare you off. In fact, there may be some tax planning opportunities here. If, for example, you have capital losses to use up, investing in flow-through shares that provide a capital gain down the road will guarantee a way to use some or all of those losses.
Take a look at some of these other tax uses for flow-through shares:
• Minimize the tax hit on RRSP and RRIF withdrawals.
The tax deductions available from the flow-through shares can offset the taxable income created by the withdrawal.
• Reduce the clawback of Old Age Security (OAS) or other benefits. The deductions from flow-through shares can help to reduce your net income and minimize the clawback of these social benefits.
• Mitigate the tax impact of receiving a bonus. A taxable bonus from your employer can push your tax bill up significantly, and can even push you into a higher marginal tax bracket. The deduction from the flow-through shares can help to reduce this burden.
• Provide additional deductions once RRSPs have been maximized.Where you haven't got additional RRSP contribution room, flow-through shares can provide the same effect.
• Reduce the tax impact of realized capital gains. Have you sold any of your assets at a profit this year? If so, the tax deduction from flow-through shares can provide some relief from the taxable capital gain.
Risks and Returns
But the question remains: What kind of return can you expect from a flow-through share? The table shows that you can achieve a 22.5-per cent after-tax return on your investment if you sell your shares, one year after claiming the full deductions, for the same price you paid. If you sell the shares for a different price, this return will increase or decrease. You might be interested in knowing that flow-through shares also provide some downside protection. You see, even if your shares drop in value by 29 per cent, you'll still break even, thanks to the tax savings you enjoy, assuming a marginal tax rate of 45 per cent.
There's no doubt that these shares are higher-risk investments and will fluctuate in value with changes in resource prices or interest rates. As resource prices fall, so will the value of your flow-through shares. And a rise in interest rates may cause the same effect as interest-bearing investments become more attractive relative to these shares. The bottom line? You wouldn't want to hold more than 5 to 10 per cent of your portfolio in flow-throughs. Nevertheless, oil and gas securities can play an important role in a well-diversified portfolio, and flow-through shares offer tax breaks that little else can today. Your best bet may be to take advantage of the diversification and experienced management offered through a limited partnership or mutual fund that invests in flow-through shares.
Speak to a financial advisor to find out more, or to buy flow-through shares.
TO MAKE A LONG STORY SHORT:
• Flow-through shares are shares in resource companies that are undertaking exploration and development. These shares provide a tax deduction that is typically equal to the amount invested.
• Because of the tax deduction, there are many practical uses for flow-through shares in tax planning, including the ability to help charities at a low cost to you.
• These are higher-risk investments that should not form more than 5 to 10 per cent of your portfolio.
Tim's Tip 58: Utilize an equity monetization strategy to diversify without triggering tax.
Recently, The Wall Street Journal profiled Gillette Co.'s research lab and reported that the company is working on a new deodorant that blocks odour receptors in the noses of people around you. Evidently, you can't stink if no one can smell you.
According to lab director Dr. Ahmet Baydar, Gillette carries out its testing using a synthetic version of underarm odour called the "malodor compound," which can leave an entire office reeking for days. "Just three or four molecules is all it takes,"
Baydar says. Testing also involves placing five judges in a "hot room" to sniff the armpits of test subjects. Armpits are rated on a scale of 1 to 10, with 10 meaning "your head snaps back," according to one employee.
Dealing with body odour can be a real dilemma. But it's nothing technology can't fix. And if you're an investor, certain tax problems can be fixed with technology too.
Investment technology, that is. In fact, there's plenty you can accomplish with an equity monetization strategy.
Picture this. You're the proud owner of a stock that has appreciated in value and you've got too much tied up in this one security. That's right, you've got too many eggs in one basket. The problem? If you sell all or a portion of your holdings in the stock in order to diversify, you're going to trigger a tax liability large enough to wipe out the national debt, give or take. Not to worry. An equity monetization strategy can help.
Under this strategy, you can make use of a customized over-the-counter derivative contract-a forward sale contract-that will allow you to: (1) lock in any gains on paper that you have enjoyed, (2) defer tax on a sale of the stock by avoiding an actual disposition, (3) diversify your holdings through use of a loan, (4) create an interest deduction, and (5) avoid any margin calls that might otherwise apply when borrowing.
The forward contract will allow you to lock-in a selling price at a future pre-determined date. Basically, a financial institution (say, a bank) agrees to buy your stock from you at a set price on a future date. Typically, you'll be restricted to publicly traded securities. Once you've locked in a price, the bank will now lend you money based on the price you'll be collecting for your stock when the forward contract matures. Consider Frank's story.
Frank owns 25,000 shares of XYZ company, which trades at $40 today, for a total value of $1-million.
His bank is willing to enter a forward contract with Frank that will give him the right to sell his XYZ shares to that bank for $45 per share five years from now. That is, Frank is guaranteed to receive $1.125-million in five years for his XYZ shares.
In Frank's case, the bank has agreed to a cash settlement in five years when the forward contract matures. Suppose that XYZ stock trades at $40 in five years. In that case, the bank will pay Frank $5 per share, since it guaranteed him a price of $45 ($5 profit per share) for the stock, and Frank will keep the stock. If XYZ is trading at $48 in five years, Frank will have to pay the bank $3 per share because he was only guaranteed to receive a profit of $5 per share, and he'll keep his XYZ shares. Any profit over the forward price of $45 belongs to the bank. Finally, if XYZ trades at $45 per share in five years, no cash will change hands, and Frank will keep his stock.
Under the strategy, the bank will lend Frank $1-million. After all, Frank is guaranteed to receive $1.125-million in five years-so the bank, and Frank, know he'll be able to make good on the loan. Yes, the stock and forward contract will be pledged as collateral.
The result? Frank has now eliminated any future risk of price fluctuations on his XYZ stock, has avoided a taxable disposition of the stock, will manage to diversify his portfolio with the newly borrowed $1-million, and can deduct the annual interest on the borrowed money invested. Finally, there's no potential for margin calls here. The drawback? Frank gives up any upside potential on his shares over the price in the forward contract.
To ensure this strategy works from a tax perspective, it's best to have a cash, not a physical, settlement at maturity of the forward contract. Also, negotiate to retain all rights to dividends and votes attached to the shares during the term of the forward contract. Finally, visit a tax pro to discuss the idea in your situation.
TO MAKE A LONG STORY SHORT:
• An equity monetization strategy will allow you to diversify a portfolio on a tax efficient basis when you have too much invested in one security.
• The strategy allows you to: (1) lock in any gains on paper that you have enjoyed, (2) defer tax on a sale of the stock by avoiding an actual disposition, (3) diversify your holdings through use of a loan, (4) create an interest deduction, and (5) avoid any margin calls that might otherwise apply when borrowing.
• Visit a tax pro to talk over this idea before jumping in.
Tim's Tip 59: Consider an investment in a private company in certain situations.
There are two general types of private companies you might consider investing in: (1) a holding company designed primarily to earn investment income, and (2) an active business corporation. Let's take a look at these separately.
Holding Companies As a general rule, there has been no use setting up a corporation to hold investments over the last few years because there has been no real opportunity to defer tax by earning income in the corporation as there was in the past.While this is still the case generally, there are other things that can be accomplished by investing inside a corporation. It's time to think outside the typical tax box.
There are four potential benefits to setting up an investment holding corporation.
• to minimize clawback of Old Age Security benefits
• to minimize taxes on death
• to minimize probate fees
• to provide a source for earned income Is this idea for everyone? Absolutely not. But if you have significant open money (investments outside your RRSP or RRIF)-generally $300,000 or more-then the idea could be for you. Consider Ruth.
Ruth is 67 years young and makes withdrawals from her RRSP every year, but her main source of income is the interest she earns on $500,000 worth of investments. Because of this interest income, she suffers a clawback of her Old Age Security benefits.
Here's what she did: Ruth transferred the $500,000 of investments to a new holding company. This was set up as a loan by Ruth to the company. Now, the interest income earned on the investments is no longer reported by Ruth on her personal tax return-it's taxed in the corporation instead. As a result, her clawback problem is minimized. Next, the company is going to declare-but not pay-a dividend to Ruth each year that is equal to the after-tax earnings of Bulls, Bears, and Baseball: Strategies for Investors 169 Ch05.qxd:05_101TaxSecrets2007_p136-181 12/17/09 5:58 PM Page 169 the company. Since Ruth needs the investment earnings to meet her costs of living, she withdraws the after-tax income earned by the company each year as a tax-free repayment of the loan the company owes her. Alternatively, she could take a director's fee or salary from the corporation each year, which would count as earned income-providing her with RRSP contribution room.
Upon her death, two things may happen. First, the dividends still owing to her (that were declared but not paid) will be taxed, but may be reported on a separate tax return called a rights or things return-which will save her tax.
Finally, Ruth may be able to pass the shares in her private company to her heirs without probate, by way of a separate will, since the family won't require probate on these shares.
Whoa. Did you catch all that? Let's look at the benefits of an investment holding company once again-in slow motion.
First, you may be able to minimize or eliminate a clawback on OAS benefits by removing income from your personal tax return. You see, when you put your assets into the corporation, the company will report the income and pay the tax from that point forward.
Second, you can minimize taxes upon death. By having the company declare but not pay dividends each year equal to the after-tax earnings of the company, you create an asset for yourself-a dividend receivable. Upon your death, this asset can be reported on a separate tax return called a rights or things return. This separate return entitles you to the basic personal credit all over again ($10,320 for 2009) and a lower marginal tax rate on the first $40,726 of income.
By the way, if you need cash flow during your lifetime, you can withdraw cash from the company as a repayment of the loan you made when you transferred your investments to the company. Once this loan has been repaid, the company could make good on the dividends it owes to you.
Third, probate fees may be minimized. Here's how: Since family members are shareholders and directors of the company, and heirs of any shares, it may be possible to pass these shares to your heirs through a separate and non-probatable will. After all, who in your family will require probate in this case? Probably no one. But these shares must pass to your heirs outside of your original will, which may have to go through probate. Speak to your lawyer about this idea. It's based on an Ontario court decision in Granovsky v. The Queen (1998).
Finally, the corporation can be a source of earned income for you. Earned income is most commonly paid in the form of director's fees or salary and will provide you with RRSP contribution room that will benefit you while you're under age 71-and sometimes beyond (see Chapter 6, Tip 74).
It's time to take a look at the tax benefits of investing in the shares of a small private company that carries on an active business. Sometimes this type of company is referred to as a Canadian-controlled private corporation (CCPC). A CCPC is simply a corporation that is not controlled by a public corporation or by non-residents of Canada, and is not listed on a prescribed Canadian stock exchange or certain foreign stock exchanges. Typically, these are small to mediumsized companies and normally include most Canadian businesses- maybe even the one next door, or your own business.
There can be a number of tax benefits to owning shares in this type of company. Read on.
Enhanced Capital Gains Exemption
If you own shares in a small business, and those shares increase in value over time, there's a strong possibility that you'll be able to shelter up to $750,000 (based on 2007 federal budget changes; formerly $500,00) of that increase from tax-through the $750,000 enhanced capital gains exemption. To be eligible, your small company shares will have to be qualified small business corporation (QSBC) shares.
Using the full $750,000 exemption could save you $168,750 in taxes if your marginal tax rate is 45 per cent.
What in the world are QSBC shares? In general, these are shares that you (or a related person) must have owned for a two-year period. In addition, the company must be a CCPC. Finally, at the time the shares are sold, the company must be using 90 per cent or more of its assets to carry on an active business primarily in Canada, and the same must hold true for 50 per cent or more of its assets throughout the two-year period you've owned the stock. Sound complex? The truth is, the definition has been simplified here. Be sure to have a tax pro review the company's financial statements to determine whether it qualifies for the $750,000 exemption.
Capital Gain Rollover
Thanks to the 2000 federal budget, it may be possible to dispose of your shares in your small private company and to defer the tax on any gain by reinvesting the proceeds in the shares of another small business corporation. In this case, your adjusted cost base of the new shares is simply reduced by the gain that you defer so that, eventually, you'll be taxed on that gain. Certain conditions must be met to qualify for this capital gain rollover, including these: you must acquire newly issued common shares from the treasury of the new small business; you must be an individual (not a trust); and only dispositions after February 27, 2000, qualify. There used to be a cap of $2-million (by reference to your adjusted cost base) on the number of shares on which you could defer your gain, but this cap was eliminated in the 2003 federal budget for dispositions after February 18, 2003. To qualify, the new company you're investing in must have a carrying value for its assets of $50-million or less before and after your investment in the company. Other requirements must also be met. Talk to a tax pro for more details if you think you qualify.
Allowable Business Investment Losses
Okay, so you're still not convinced that shares in a small business are worth owning-despite the enhanced capital gains exemption and the capital gain rollover.
Too risky, right? But consider this: Your investment in that small business could also offer greater downside protection than other investments if the investment goes sour.
Again, the company has to be a CCPC, and 90 per cent or more of its assets must be used in an active business that operates primarily in Canada.
If it becomes evident that you'll never recover your investment in the small business, you may be entitled to claim an allowable business investment loss (ABIL).
This ABIL equals one-half of the invested money you've lost and can be deducted on your tax return against any source of income. Normally, when you lose money on shares you own, you've incurred a capital loss that can only be used to offset capital gains. You should also be aware that, where you've lent money to a small business instead of buying shares, you may still be eligible for ABIL treatment.
TSX Venture Exchange Stocks If you happen to own stocks that trade on the TSX Venture Exchange, you might be interested in knowing that presently Tier 3 stocks trading on that exchange are not considered to be traded on a "prescribed" stock exchange. The result? Those stocks are currently considered to be private company shares for tax purposes. This means that you may be able to shelter gains on those shares with the enhanced capital gains exemption or consider any losses to be ABILs. The company will have to meet certain tests to qualify as a Small Business Corporation for these tax benefits, but a call to the company to determine whether it meets the test could save you some tax.
Qualified Farm or Fishing Property I talked about the enhanced capital gains exemption to shelter any gains on qualified small business corporation shares. This exemption is extended to shelter any capital gains on qualified farm or fishing property-which normally includes most family farms, farm quotas, and fishing quotas. There are some conditions that the farm or fishing property must meet to be eligible, so visit a tax pro to determine for sure whether you'll be eligible. By the way, the eligibility of qualified fishing property was new in 2006, and it applies to dispositions of such property after May 1, 2006.
TO MAKE A LONG STORY SHORT:
• A private company that you invest in can take two forms: (1) a holding company, or (2) an active business corporation.
• A holding company may be used to reduce clawbacks of OAS, minimize taxes on death, reduce probate fees, and provide a source for earned income.
• An investment in an active business that is a Canadian-controlled private corporation can offer tax benefits in the form of an enhanced capital gains exemption if the shares increase in value, a capital gain rollover if the shares are sold, and an allowable business investment loss if the investment turns sour.
• Companies trading on the TSX Venture Exchange (Tier 3) may qualify for this capital gains exemption or ABIL treatment.
• Gains on qualified farm or fishing property can also be sheltered using the enhanced capital gains exemption. Qualified fishing property became eligible in 2006 for dispositions after May 1, 2006.
Sheltering Income with Life Insurance
Tim's Tip 60: Consider an exempt life insurance policy for tax-sheltered growth.
There's no doubt about it: Life insurance can be confusing-and sometimes downright intimidating. But don't let this stop you from considering life insurance as an investment tool. Is this for everyone? Nope. But it may be worth discussing the strategy with a trusted financial advisor who can crunch the numbers for your specific situation to see if the idea makes sense.
As an investment tool, an exempt life insurance policy can provide a tax shelter offered by little else. You see, under an exempt policy, a portion of each premium that you pay will cover the cost of your insurance, and the balance will be deposited in a growing pool of investments. The policy is called exempt because the investment component of the policy grows exempt from tax. That's right, tax-sheltered growth can be yours-much like what you experience with your RRSP. The best part of this is that, upon your death, the face value of the policy, plus the accumulated investments, are paid out on a tax-free basis to your beneficiaries.
I know what you're probably thinking: "Tim, the problem is that I can't enjoy those investments during my lifetime. I have to die for anyone to benefit here."
Not true. You'll be able to access those investments in a number of ways.
For example, you can simply make withdrawals of the accumulated investments during your lifetime, although there could be a tax bill to pay when you do this.
Alternatively, you could borrow, using the investments in the policy as collateral.
Upon your death, the life insurance proceeds would be used to pay off the debt.
This last idea is called leveraged life insurance, and I like it in some cases, but the idea does come with some risks. Provided it's set up properly and conservatively, it can make sense for some.
Where will you find an exempt life insurance policy? Most whole life and universal policies are set up to be exempt, but not all policies are created equal. It's important to find out your investment options. Make sure you're able to invest in equities to maximize your investment growth over the long term. Speak to a financial advisor who is licensed to sell life insurance.
TO MAKE A LONG STORY SHORT:
• An exempt life insurance policy will allow the tax-sheltered growth of investments inside the policy.
• The face value of the policy plus the accumulated investments will be paid out tax-free to your beneficiaries upon your death.
• There are ways of accessing the investments in the policy during your lifetime, although there may be tax or interest costs involved in doing this.
Tim's Tip 61: Learn how to use cascading life insurance to shelter investment growth from tax for years.
Do yourself a favour. Speak to your insurance broker this week. Insurance brokers always have a good story or two about insurance claims. My broker recently shared with me the true story of Arlene Evans. You see, in December 1990, the Kansas Court of Appeals affirmed Arlene Evans' challenge to Provident Life and Accident Insurance Co.'s determination that her husband had committed suicide. Though he was found in his bathtub, clothed and charred, she said it was an accident, that he was a heavy smoker and had often burned himself. Her strongest argument was that he often struck matches after passing gas, to clear the air, and that the fire that killed him was started this way. Hey, accidents happen.
When you speak to your broker, ask about another insurance story: cascading life insurance. It may not be as interesting as the story about Arlene Evans, but it'll save you more tax.
The cascading insurance strategy takes advantage of Subsection 148(8) of our tax law, which will allow you to transfer ownership of a life insurance policy to any of your children, free of tax, where a child of yours is the life that is insured under the policy. (A "child" includes any natural or adopted child, a grandchild, stepchild, or a son- or daughter-in-law.) On the surface, the idea may seem crazy. I mean, who's going to buy insurance on the life of a child? Glad you asked. Canadians who would like to pass assets to the next generation completely free of tax and probate, and then to subsequent generations in the same manner- hence the cascading effect-should consider the strategy.
The cascading insurance strategy takes advantage of the fact that it's possible to invest money inside a universal life insurance policy on a tax-sheltered basis (see Tip 60), and that the death benefit, along with the accumulated investments in the policy, are all paid out tax-free to the beneficiaries when the insured dies. The best way to understand cascading life insurance is to walk through an example.
Barbara is 70 years of age. She has $200,000 of non-registered money that she doesn't need to meet her costs of living. She wants to minimize her tax hit on the income from this money annually. In addition, she wants to shelter the money from tax and probate fees when she passes it to her daughter Allison, who is aged 35, and ultimately to her grandson Mark, Allison's son, who is a minor. Barbara purchased a universal life insurance policy and put the $200,000 into the policy over a five-year period. She named Allison as the contingent owner. The insurance is placed on Allison's life and Barbara's grandson Mark is the beneficiary. When Barbara dies, Allison will become the owner (since she was named the contingent owner) with the result that Allison will then own the accumulated investments inside the policy. The policy will pass to Allison free of tax and probate fees. What are Allison's options? She could make withdrawals from the accumulating investments in the policy (a taxable event), borrow money using the investments in the policy as collateral (providing her with tax-free cash flow), or she could reserve the whole policy for her son Mark (he'll receive the insurance proceeds free of tax and probate fees upon her death).
A cascading life insurance strategy allows you to accomplish a few things, including: transferring money to the next generation without giving up control during your lifetime; eliminating current taxes in your hands on the money invested in the policy; eliminating probate fees on the assets in the policy; and providing you with access to the funds in the policy if needed. Not a bad deal.
TO MAKE A LONG STORY SHORT:
• The cascading insurance strategy takes advantage of our tax law, which allows you to transfer ownership of a life insurance policy free of tax to any of your children when a child's life is insured under the policy.
• The strategy will allow you to transfer money to the next generation free of tax and probate fees, minimize annual tax on the investments placed inside the policy, and maintain control of and access to the funds in the policy during your lifetime.
• Your insurance broker may have some great stories to tell about insurance claims.
Tim's Tip 62: Establish a back-to-back prescribed annuity for tax-efficient cash flow.
Here's a clever idea for those of you who rely on interest-bearing investments for an income stream. It's called a back-to-back prescribed annuity, and it could really boost your income. Here's the deal: A back-to-back simply involves buying a prescribed annuity plus term-to-100 insurance. The best way to understand this tactic is through a couple of examples. Let's look at Howard's situation, then Lily's.
Howard is 70 years old and has $100,000 invested in GICs paying 5.5 per cent interest, which provide him with $5,500 of income annually. Howard's marginal tax rate is 45 per cent, since he has other income sources, too. The bottom line is that Howard will pay taxes of $2,475 annually on his GIC income, and will be left with $3,025 each year as disposable income. Howard would like to leave the $100,000 to his children, so he likes the GICs because he can use the interest generated without ever touching the $100,000 capital.
It's true that Howard's investment in GICs will successfully preserve his $100,000 capital, but the interest income is highly taxed, and so he's left with very little (just $3,025) each year. Lily's financial advisor had a better idea. Here's her story.
Lily is also 70 years of age and has $100,000 that used to be invested in GICs, providing the same $3,025 after taxes that Howard receives. Lily's advisor had another plan: to use a back-to-back prescribed annuity. Here's what Lily did: She bought a prescribed life annuity with the $100,000 she had sitting in GICs. The annuity will pay her $12,491 a year. Since only a portion of each annuity payment is taxable, the tax on the annuity will be just $2,077 each year. You see, each annuity payment is made up of interest income plus a return of capital, and the capital is returned tax-free. The interest portion attracts some tax-but much less than she was paying with the GICs. After taxes, Lily is left with $10,414 ($12,491 minus $2,077) which is much higher than the $3,025 she received annually with the GICs.
The moral of the story is that a prescribed annuity can provide much more cash than GICs and similar investments, and a smaller tax bill to boot. The drawback? Each time Lily receives an annuity payment, she's getting back some of her original $100,000 capital, so that she won't be able to leave her children the $100,000 that she could have with the GICs. In fact, aside from buying an annuity with a guaranteed payment period, there's no way to leave any of that $100,000 to her kids since the insurance company will keep whatever's left of her capital on her death.
But there is a solution. With the extra cash she's receiving, Lily can buy a term-to-100 life insurance policy that will pay her children $100,000 when she dies. The cost of the policy? About $3,281 each year. So follow the numbers here. Lily takes the $10,414 she has been receiving after taxes, pays her insurance premiums of $3,281, and is still left with $7,133 in her pocket each year. This $7,133 is a full $4,108 more than the $3,025 of after-tax income she used to receive on her GICs.
Now you'll understand why this strategy is called a back-to-back prescribed annuity. The idea involves buying both a life annuity and an insurance policy back-to-back.
There's one more twist on this strategy that you might want to consider. It may be a very good idea to take some of the additional cash generated from the back-toback annuity and invest in good quality equities to protect yourself against inflation and provide an emergency fund. You see, when you buy a life annuity, the interest rate is locked in at the start, and it's a very expensive option to arrange for indexed annuity payments that increase each year with inflation. By investing just a portion of your capital in a back-to-back prescribed annuity (enough to beat the cash flow from the GIC), buying term-to-100 insurance, and investing the rest in equities, you will have significantly improved your financial health by reducing taxes, providing a hedge against inflation, and setting aside an emergency fund.
To set this idea in motion, just visit a financial advisor who is licensed to sell life insurance.
TO MAKE A LONG STORY SHORT:
• A back-to-back prescribed annuity involves buying a life annuity to provide increased cash flow and then buying a term-to-100 life insurance policy to replace the capital used to buy the annuity.
• Take this a step further by using some of the additional cash to invest in good quality equity investments as a hedge against inflation and to provide an emergency fund.
Borrowing to Invest: Leveraging
Tim's Tip 63: Consider leverage to accelerate wealth creation and provide tax deductions.
What is this strategy called leveraging? Simply put, it's borrowing money to invest.
And make no mistake, leveraging can offer some significant financial benefits. The catch? You've got to do this prudently. If you're not careful to follow the rules of prudent leveraging, you could be in for more harm than good. In this tip I want to look at the rewards, risks, and rules of prudently borrowing money to invest.
The Rewards of Leveraging
There are definite potential rewards to leveraging. Consider these five rewards:
• Reward 1: Leveraging is a forced investment plan. The money you borrow is invested up front, and you pay for this investment through required monthly loan payments.
• Reward 2: You can build wealth using another's resources.Where you've got cash flow, but little in the way of investments, you can use someone else's resources to jump-start the wealth accumulation process.
• Reward 3: Leveraging can boost your effective returns.While leveraging won't improve your actual returns, it can increase your effective returns (see Jack's story below).
• Reward 4: You can reach your financial goals faster. Leveraging gets more money working for you sooner than you might otherwise be able to achieve. The result?
You may be able to reach your financial goals sooner.
• Reward 5: Leveraging can create a tax deduction for interest costs. Let's not forget about tax deductions. Interest costs are generally deductible for tax purposes when you've invested the borrowed money. I'll talk more about this in Tip 64.
Jack borrowed $50,000 to add to his own $50,000 available to invest, for a total portfolio of $100,000. He earned a 10-per cent pre-tax return on the total portfolio last year, or $10,000-all in capital growth. Jack is paying interest of 8 per cent on the loan, which cost him $4,000 ($50,000 multiplied by 8 per cent) last year. After all taxes and interest have been paid, Jack managed to put $5,500 in his pocket last year. This represents an 11-per cent after-tax rate of return for Jack ($5,500 as a percentage of his own $50,000 is 11 per cent).
That's right, his portfolio grew by 10 per cent before tax (which is 7.5 per cent Bulls, Bears, and Baseball: Strategies for Investors 181 Ch05.qxd:05_101TaxSecrets2007_p136-181 12/17/09 5:58 PM Page 181 after tax given our assumptions), but Jack's effective rate of return was 11 per cent after tax! That is, if Jack had not borrowed any money, his after-tax return would have been 7.5 per cent. His leveraging strategy, however, created an effective return of 11 per cent after tax.
Jack's story is spelled out more clearly in the table below. You'll notice from the table that leveraging can magnify your returns so that your effective return is higher than you could achieve without borrowing money. In Jack's example, a 7.5 per cent after-tax return was magnified to 11 per cent after taxes.
The Risks of Leveraging
Now, before you hop on the leveraging bandwagon, you need to understand the downside potential too. Check out the table one more time.What would have happened if Jack's portfolio had lost 10 per cent of its value last year, rather than gaining 10 per cent? Jack's effective loss from a 10-per cent decline in value would have been 19 per cent! And this calculation assumes that Jack would be able to use the capital loss to offset capital gains on other investments. If he were unable to use the capital losses in this manner, his effective loss would have been 24 per cent for the year! Yikes.
As you can see, leveraging is great when your portfolio is growing in value. But when your investments drop in value, the effective loss can sting. In fact, the risks of leveraging include the following: • Risk 1: Your investments could drop in value. We just discussed this one.
• Risk 2: Interest rates could rise. As interest rates rise, the break-even rate of return you'll need in order to make leveraging profitable will also rise.
• Risk 3: Your cash flow could suffer. Cash flow is critical. If you run short on cash, you may be forced to sell investments at a bad time to meet loan payments.
• Risk 4: Margin calls could be made. Depending on the type of loan you assume, you may be required to come up with more cash, or liquidate investments, in the case of a margin call. A margin call can arise if your investments start dropping in value.
• Risk 5: Tax deductions could be disallowed. A deduction for interest costs is generally available when borrowing to invest-but it's not guaranteed. If interest costs are not deductible, the break-even rate of return in order for leveraging to work will increase. I'll talk more about interest deductibility in Tip 64.
• Risk 6: You might just get greedy. Getting greedy could cause you to borrow more than you should. You then run the risk of not being able to meet loan payments if interest rates rise or your cash flow suffers.
• Risk 7: You could lose sleep at night. Leveraging could keep you up at night if you're not conservative in how much you borrow.
The Rules of Prudent Leveraging
Don't let the risks I've just mentioned scare you too much. As long as you follow the rules of prudent leveraging, you'll largely be able to manage those risks. Here are the eight rules you should follow:
• Rule 1: Understand the risks and rewards of leveraging.
I've talked briefly about these risks and rewards above.
• Rule 2: Borrow only a reasonable amount of money.
As a general rule, don't borrow more than 30 per cent of your net worth.
• Rule 3: Make sure you've got sufficient and stable cash flow. Stay conservative. If you can afford loan payments of, say, $300 monthly, then take out a loan that will cost you $100 monthly-about 30 per cent of what you can afford. This leaves room for increases to interest rates or other changes in your circumstances.
Leveraging is only for those with a stable source of cash flow.
• Rule 4: Leverage for the long term only. Over the long term-10 years or more-there is a greater probability that your investments will have increased in value- which is critical when leveraging. Over the short term, your investments could be up or down-who knows?
• Rule 5: Make sure you're diversified. It's critical that your portfolio grow in value over time when leveraging.
Minimizing volatility is done best by prudent diversification.
• Rule 6: Keep your interest costs deductible. Deductible interest costs will reduce your break-even rate of return required to benefit from leveraging.
• Rule 7: Choose the most appropriate type of loan. I like loans that have no potential for margin calls (a home equity loan, for example). An interest-only loan requires payments of interest only each month, which will enable you to borrow more money for a given monthly payment. If your cash flow is stable and sufficient, I prefer this type of loan. Granted, a blended payment of principal and interest is more conservative since the loan balance drops over time.
• Rule 8: Work with a trusted financial advisor. This is key. You see, a good advisor will ensure that your emotions don't drive bad investment decisions. Leveraging can be an emotional experience if your investments drop in value. Your advisor is there to help you stick to a proper game plan.
TO MAKE A LONG STORY SHORT:
• Leveraging is the idea of borrowing money to invest, and should be done prudently.
• Leveraging can significantly increase your effective rate of return. It can also magnify your losses.
• Be sure to understand the rewards, risks, and rules of prudent leveraging before trying the strategy.
• Find more information on leveraging in the booklet Don't Just Invest, Upvest, written by me and published by AIC Limited. Your financial advisor can get you a copy.
Tim's Tip 64: Deduct as much of your interest cost as possible.
Generally, the tax collector will allow you a deduction for your interest costs when you've borrowed for business purposes or to make investments. But a deduction is not guaranteed.
Our tax law says that you're entitled to claim a deduction for your interest costs if you've used the borrowed money to earn income from a business, or income from property. Income from property includes interest, dividends, rents, and royalties-but not capital gains. This is not to say that you'll have to avoid earning capital gains when investing borrowed money. It simply means that you must have a reasonable expectation of earning interest, dividends, rents, or royalties, perhaps in addition to capital gains.
The Proposed Changes
On October 31, 2003, both the Department of Finance and the CRA made announcements on the issue of interest deductibility. Like most tax professionals, I was quite upset about the proposed changes. You see, these two departments of the federal government released differing views on interest deductibility. Talk about confusing. Let me briefly tell you what each department said: Canada Revenue Agency: The CRA released Interpretation Bulletin IT-533 on October 31, 2003. That bulletin announced that the CRA will permit full interest deductions provided you have a reasonable expectation of earning some income from property. It's not necessary that the income you expect to earn be higher than the interest costs you're paying to the bank on the loan. The test is really a "reasonable expectation of income" test. This position is consistent with the Supreme Court of Canada decision in the case Ludco Enterprises Inc. v. The Queen (2001).
Department of Finance: On October 31, 2003, Finance announced proposed changes to our tax law which differ from CRA's assessment policy as outlined in IT-533. Finance announced that, in order to deduct full interest costs, you must have a reasonable expectation of profit.What this means is that you must reasonably expect to earn more interest, dividends, rents, or royalties from your investment than the interest you are paying to the bank on the loan, over the time you expect to own the investment (called the "profitability time period").
It's simply not realistic to expect the income from an investment in, say, common shares, to exceed the interest costs on the loan (investors will often invest for capital growth, not income). For example, the average dividend yield on common shares is about 2 per cent, while a loan at your bank is going to cost you more than 2 per cent without a doubt. The difference, then, would not be deductible under Finance's proposals.What an impact this tax policy would have on capital markets in Canada! In short, our government was saying on October 31, 2003 that "we are going to change the tax law to at least partially deny interest deductions in most situations (Department of Finance announcement), but don't worry, we won't enforce the new tax law (CRA announcement)."
Gee, thanks for the certainty.
Now, don't panic. I fully expect that, when the dust settles, investors will be entitled to deduct interest costs when they have a reasonable expectation of earning some interest, dividends, rents, or royalties. The question remains:Will this be the result because the CRA has said it will administer the law this way in IT-533, or because our tax law is worded to allow this treatment? I'll feel much better if our tax law explicitly allows this treatment.
Where are we today with these proposed changes?
Although the 2009 budget did not announce any changes to these proposals, the Department of Finance has said in the past that they have "sought to respond by developing a more modest legislation initiative that will respond to these concerns while still achieving the Government's objectives." Finance also said that they will release alternative proposals "at an early opportunity." Check with a local tax professional on the status of interest deductibility before jumping into any leveraged investing program.
By the way, the rules around interest deductibility changed significantly in Quebec in 2004. Quebec will only allow an interest deduction to the extent interest, dividends, or taxable capital gains are reported in a year.
Keep It Deductible
Even if it turns out that you can fully deduct your interest costs, you could lose your interest deduction in future years. You see, the tax collector is going to trace your borrowed money to its current use to determine whether the interest remains deductible year after year. Let's say, for argument's sake, that you borrow $100,000 to invest in units of a mutual fund, and your units grow to a total of $150,000. At that time, you sell $50,000 of those units. If your loan remains outstanding after this sale, what portion of your interest will remain deductible? The tax collector will look to where your sale proceeds are today. If you were to reinvest those proceeds of $50,000, you'd be entitled to continue deducting the full amount of the interest on your loan. If, however, you took that $50,000 and used it for personal purposes- to take a vacation, renovate your home, pay down debt, or even pay down interest on your debt-you'd lose the ability to deduct one-third ($50,000 is one-third of $150,000) of your remaining interest costs.
Consider these ideas to keep your interest deductible: Skim the interest, dividends, or other income from property (but not capital gains) from your leveraged investments before these amounts are reinvested, and spend this income in any way you'd like. This won't jeopardize your interest deduction because you're not dipping into your principal, or invested capital. However, once this income is reinvested in additional units or shares, it forms part of your capital, and you may run into an interest deductibility problem when you make withdrawals later.
Pay down your investment loans with income from your investments, or by using proceeds from the sale of investments in the leveraged investment account.
Normally, when you withdraw capital from your leveraged investment account and use the proceeds for any purpose other than investing, you'll lose a portion of your interest deductibility, as I just discussed in the example above. There's an exception, however, if you take capital from the account and use the proceeds to pay down the very same loan used to make that investment. In this case, the CRA has said (in technical interpretation 2001-0081025, dated February 12, 2002) that they will not reduce the percentage of interest costs that remain deductible. Any remaining interest costs on the debt should remain fully deductible. Intuitively this makes some sense, since the investment loan in this case will itself be reduced, thereby reducing the interest that will be deducted by the investor going forward.
TO MAKE A LONG STORY SHORT:
• Interest is normally deductible when the borrowed money is used for business or investment purposes.
• Proposed changes to the tax law will require that you have a reasonable expectation of profit in order to deduct full interest costs. These proposed changes may not be enacted as currently written. Check with a tax pro for an update.
• The tax collector will look to your current use of borrowed money to determine whether your interest costs will remain deductible. Keep your borrowed money invested to preserve interest deductions.
Getting into the Game
From mutual funds to flow-through shares, investing properly can make you a clear winner in the tax game.
Turn now to the Tax Planning Tip Sheet at the front of the book and review the strategies you've read about in Chapter 5. Ask yourself, "Can this tip apply to me?"When you've finished this book, take your Tip Sheet to a tax professional if you'd like more information on each strategy or help in implementing the ideas.
Excerpted from 101 Tax Secrets For Canadians. Copyright (c) 2010 by Tim Cestnick.
Excerpted with permission of the publisher John Wiley & Sons Canada, Ltd.