Chapter 16 - Impediments to Wealth Accumulation Flashcards
How are the different impediments taxed?
a) Interest: Of all types of income, interest income is taxed most unfavourably. At the highest combined federal and provincial marginal tax rate, interest can be taxed at a rate as high as 50%.
b) Dividends: The availability of a tax credit makes the taxation of dividend income from Canadian corporations more favourable than the taxation of simple interest. Investors include in their taxable income the actual amount of dividends earned plus a ‘gross up’. A federal tax credit can then be claimed against federal taxes on the grossed up amount. Each province employs a similar mechanism to offset provincial taxes. For 20147, the gross up factor will be 38% and the federal tax credit will be 15.02% of the grossed up amount. Foreign dividends are taxed as regular income.
c) Capital gains: They arise from the sale or disposition of capital property. Capital gains are taxed the most favourably of all earnings types. Only half of any capital gains realized in a given year are included in income for tax purposes.
d) Return of Capital: Occasionally some mutual funds and REITs make distributions in excess of the taxable income investors receive from the fund or trust. The excess is known as a return of capital. A return of capital is not taxable in the year the investor receives it. Instead, the original cost of the units is reduced by the amount of the distribution and a new average cost per unit, known as the adjusted cost base (ACB) is calculated. This is used to calculate the capital gain or loss when the units are eventually sold.
What are some of the tax minimizing portfolio management strategies?
The aim of tax-aware investors is to minimize the amount, and control the timing, of taxes realized. Investors can achieve this goal using a combination of the following techniques:
- incorporating tax implications into each trade
- harvesting tax losses
- crystallization (managing unrealized gains)
- selling most expensive securities first
- reducing the yield of securities
- reducing securities turnover
- purchasing a put option.
What is Tax-Loss Harvesting?
Tax-loss harvesting is the act of voluntarily taking losses for the purpose of creating a current tax deduction to offset realized gains. The purpose is to minimize tax liabilities and keep the asset in the portfolio, where it can benefit the most from compounding.
Four issues are very important when making tax-harvesting trades:
- Limitations imposed by the CRA
- Portfolio risk and return profile could change
- Transaction cost may be prohibitive
- Portfolio losses may be too great.
CRA imposes limitations on tax-loss harvesting trades through its superficial loss rules: investors cannot buy the same security within 30 days before or after the loss trade. In addition, the capital loss may be applied only to the cost base of the original security. The new security should be different enough to satisfy the tax authorities yet similar enough to be a good substitute in the portfolio.
What is Crystallization?
Crystallization, or managing unrealized gains, is similar to tax-loss harvesting but takes the process one step further. After the offset trades are executed, more of the security in the gain position is purchased. This gaining security should be the portfolio holding with the largest unrealized gain and/or have the shortest expected holding period. The effect of the purchase is to increase the cost basis of the remaining lots. The unrealized gain is reduced and the future tax liability is lowered. Superficial loss rules do not apply here because the security repurchased was originally sold for a gain.
What is the benefit of purchasing a put option?
Purchasing a put option on an individual stock or index places a floor on the value of the security. This is valuable to an investor who needs to liquidate a position but may not want to do so until a year in which her tax position is more favourable. The put gives the investor time and protection for the cost of the contract.
What are the tax-efficient investments?
Tax efficiency measures how much of a pre-tax return an investor keeps after paying tax liabilities
on realized or unrealized gains. There are three commonly used measures or efficiency ratios:
Capture Ratio
RAT/ RBT
Relative Wealth Measure
( [RAT – RBT ] / [ 1 + RBT ] ) X 1,000
Morningstar Tax-Cost Ratio
(1 – [ (1 + RAT) / (1 +RBT) ] ) X 100
where:
RAT = return after tax return
RBT = return before tax
What is capture ratio?
The capture ratio is simply the relative proportions of after-tax and pre-tax returns. If portfolio 1 returned 10% before taxes and 9% after taxes, its capture ratio is said to be 90%. Higher positive numbers supposedly equal better tax efficiency. Unfortunately, the ratio makes less sense when returns are negative or tiny, or if after-tax returns are higher than pre-tax returns. With a 110% capture ratio, portfolio 4 cannot be more tax efficient than portfolio 1, even though both lost 100 basis points of return to tax.
What is the Relative Wealth Measure?
The Relative Wealth Measure (RWM) was developed in 2004 by members of the Association for Investment Management Research (AIMR, now the CFA Institute) Subcommittee for After- Tax Reporting in response to the weakness of the capture ratio. The RWM measures the amount per $1,000 of assets that needs to be invested at the pre-tax return to pay the tax liability. The RWM is not affected by the direction or magnitude of portfolio returns. Tax efficiency under the RWM implies the portfolio is generating net tax savings and is denoted with a positive number; the greater the positive number, the more tax efficient the portfolio. Tax inefficiency indicates the portfolio is paying proportionally more taxes and is denoted with a negative number; the larger the negative number, the more inefficient the portfolio.
What is the Morningstar tax-cost ratio?
The Morningstar tax-cost ratio is a variation of the RWM. It was developed to determine the percentage of assets lost to tax after distributions. A positive figure indicates that the portfolio paid tax and a negative number means the portfolio saved tax. The ratio can vary from zero for funds that have not made any distributions to more than 5% for funds that have issued significant distributions.
What are flow-through shares?
Flow-through shares are a type of common equity issued by junior resource companies. The sale of flow-through shares allows exploration companies, which typically show accounting
losses because they do not have the profitability to offset exploration costs, to raise capital from investors. In return, the resource companies renounce certain deductible expenses incurred in the running of their businesses. These deductions are flowed through to investors, though the costs must meet particular qualifications for investors to claim them.
The exploration company must have made the expenditures, known as Canadian exploration expenses (CEEs), within Canada and in non-development processes such as prospecting, sampling, surveying and drilling. Qualified CEEs are accumulated in a pool and are 100% available for deduction in the year they are incurred. Certain costs known as Canadian development expenses (CDEs) are also available for deduction. CDEs are funds spent on drilling and completing oil wells or sinking or excavating mine shafts. A company’s CDEs are accumulated in a pool and tax- paying investors can use up to 30% in unclaimed balances in any one year.
Someone who invests in flow-through shares will be able to claim as a deduction all of the upfront cost of the shares in the year of the purchase. The taxpayer also has the option of carrying back the deductions three years or carrying them forward seven years. On disposition, the flow- through shares carry an adjusted cost base of zero. Therefore, any positive value of the share position will be considered capital gains.
There is another 15% federal government tax credit available for qualified companies that undertake exploration for new developments within Canada. This applies only to mining activities and not to the extraction of oil or gas. Flow-through shares that carry the extra 15% federal tax credit are called super flow-through shares. The federal tax credit can be carried back three years or forward 20 years and is non-refundable (the investor must pay taxes to use the claim).
What is Alternative Minimum Tax?
Investors must be aware of the alternative minimum tax (AMT) when using tax shelters extensively. The AMT is meant to ensure that taxpayers pay a minimum amount of tax even if significant portions of their incomes are sheltered or reduced by certain deductions. The AMT is an alternative to a person’s regular income tax. The taxpayer pays the higher of the two taxes.
The AMT is a concern when significant income is sheltered in any type of tax shelter. For example, if much income is sheltered by losses incurred in a limited partnership investment or other tax shelter, the taxpayer may be subject to AMT even though regular income was largely or wholly reduced by the tax shelter. When considering making a tax-sheltered investment, the investor must be aware that the AMT may apply.
To compute the AMT, begin with the investor’s regular taxable income for the year. Certain deductions and exemptions are added back. This results in adjusted taxable income for AMT purposes.
If the AMT exceeds the regular tax, the AMT is payable. If the AMT is less than the regular income tax, the regular tax is paid. If the AMT is paid, the excess of the AMT over the regular tax amount can be carried forward as part of the minimum tax carryover. This can be carried forward seven years to offset regular income tax in any one year to the extent that regular tax exceeds the AMT for that year. This carry forward softens the blow of the AMT, in that taxpayers get back some of the AMT if they claim fewer deductions or credits in future years.
What are Inflation Sensitive Assets?
Real Return Bonds
Real return bonds (RRBs) are in some ways safer investments than are nominal bonds. The market price of an RRB is affected only by changes in the real interest rate, while the market price of a nominal bond varies with changes in the real interest rate and changes in inflation expectations. Furthermore, a nominal bond is exposed to forecast error risk, the chance that actual inflation over the life of the bond will be higher than expectations embedded in the yield.
For RRB investors, their real yield to maturity is certain because interest and principal are indexed to increases at the actual inflation rate.
Given the RRB’s inflation protection, an investor simply saving for retirement should consider buying RRBs if he expects actual inflation to be higher than the expectations embedded in nominal bonds.
Real Estate as an Inflation Hedge
Residential and commercial real estate has long been considered the asset to purchase to hedge against inflation. Academic research has confirmed the positive relationship between inflation and real estate returns.
The drawback to real estate investing is that it can be much more time and capital intensive
than investing in financial assets. In addition, there can be significant carrying costs and annual maintenance costs that must be borne to keep the property in good order. Investors can tailor the form of their exposure depending on the amount of time and capital they can commit. Participation can be 100% equity ownership, joint venture or limited partnership. Some real estate investment management companies organize pools with minimum commitments starting at about $500,000. For a management fee, these firms research, maintain and manage a portfolio of commercial properties.
Commodities as an Inflation Hedge
Commodities have long been considered an inflation hedge. Gorton and Rouwenhorst2 studied commodity futures returns from 1959 to 2004. They found that commodities were negatively correlated with bond and stock returns over most of that period. The negative correlation
was strongest over longer holding periods and stemmed primarily from commodities’ positive correlation with inflation in general and with unexpected inflation and changes in expected inflation.
Collectibles as an Inflation Hedge
Collectible items (for example, fine art, wine and antiques) have only recently made a name for themselves as an alternative asset. Shortly after the stock market crash of 1987, a painting by Vincent van Gogh, Irises, sold for a then-record US$53.9 million. The event heralded in a new bull market for art as investors, fearful of the stock market, poured money into Picassos, van Goghs and Warhols.
Anyone who wants to purchase collectibles should ask himself if he is purchasing the item as
an investor or as a collector. As an investor, the individual should be prepared to deal with the risks. The market for collectibles is very specialized because of the non-commoditized nature
of the assets. Liquidity can be very thin. It may be very difficult to quickly sell the item. Prices may plunge seemingly without reason. Collectibles pay no monetary dividends and may require considerable sums for insurance, storage and maintenance. Assessing the price appreciation potential of a collectible requires expert knowledge and experience, skills an investor may not have.
What is the explanation for a mutual fund distribution that has no up front tax liability?
A. The only kinds of investments that generate tax-free returns in Canada are RRSPs, RRIFs, and RESPs. When funds are removed from these registered plans they are all fully taxed. It seems you may have missed one of your T-slips for tax reporting.
B. Sometimes mutual funds or income trusts sell assets that generate gains which are not capital gains. Mutual funds and income trusts are subject to special tax treatment through the Income Tax Act allowing them to account for non-cash deductions, depreciation, and previous losses by distributing the funds they represent free of tax; it is called Return of Capital. Although the distribution is received tax-free, there is a tax consequence. The distribution reduces the ACB resulting in a larger capital gain to be taxed in the future.
C. Return of capital is one of the four types of investment return. It is a return of a portion of the dollars you originally invested and therefore does not trigger immediate tax. It reduces the adjusted cost base of your mutual fund units.
D. The only asset that really generates a tax-free return in Canada is one’s principal residence. Even registered plans are ultimately taxed and in some cases people wind up paying more tax on the withdrawals from the registered plans than if they had held the assets in a non-registered form.
The answer is C.
Sometimes mutual funds and real estate investment trusts pay out distributions in excess of the taxable income investors receive from the fund or trust due to previous losses, depreciation, or exploration & development allowances. Sometimes the payout represents the return of an investor’s capital.
Which is a tax minimizing portfolio management strategy?
A. Selling the most expensive securities last.
B. Increasing securities turnover.
C. Writing a put option.
D. Reducing the yield on securities.
The answer is D.
Tax-aware investors aim to minimize the amount and control the timing of taxes realized. Investors can achieve this goal by using a combination of the following techniques: incorporating tax implications into each trade; harvesting tax losses; crystallization; selling most expensive securities first; reducing the yield of securities; reducing securities turnover; purchasing a put option.
Select the efficiency ratio that measures the amount per $1,000 of assets that needs to be invested at the pre-tax return to pay the tax liability. A. Morningstar tax-cost ratio. B. Capture ratio. C. Effective return ratio. D. Relative wealth measure.
The Relative Wealth Measure (RWM) measures the amount per $1,000 of assets that needs to be invested at the pre-tax return to pay the tax liability.
