Chapter 17 - Impediments to Wealth Accumulation Flashcards
What are the 3 greatest impediments to wealth accumulation?
Taxes, transaction costs, and inflation.
What types of taxation do options and futures face?
Capital gains/losses and interest
How are dividends from Canadian corps more favourable than foreign dividends?
The actual amount of dividend is included plus a “gross up”, a federal tax credit can than be claimed on the grossed up amount. The gross-up factor is 38% and the tax credit is around 15% of the grossed up amount.
How are foreign source dividends taxed?
Just like interest income.
What are situations where a capital gain would be taxed as ordinary income?
Profits/losses from the short sale of stocks are considered income as there is no intention of benefit from outright ownership. Gains/losses on stock trading may be included as business income if the basis of the business was trading stocks.
How are capital gains that result from the sale of foreign securities priced in another currency treated for tax reporting purposes?
Both the purchase and sale transactions have to be converted from the foreign currency to Canadian dollars using the foreign exchange rates applicable at the time of each transaction.
What is return of capital?
Some mutual funds and REITs occasionally make distributions in excess of the taxable income that investors receive from the fund/trust, the excess is known as “return of capital”. The RoC is not taxed, it adjusts the ACB instead, reducing it
What does return of capital do to ACB?
It reduces the fund/trust’s ACB
What is tax-loss harvesting?
Voluntarily selling poorly-performing securities that are not expected to recover to create a tax deduction to offset realized gains.
What are the superficial loss rules for tax-loss harvesting?
Investors cannot buy the same security within 30 days before/after the loss trade. The new security should be different enough to satisfy the tax authorities.
What is crystallization?
Managing unrealized gains by doing tax-loss harvesting to offset capital gains, then re-purchasing more of the security in the gain position. This effectively creates a new, higher ACB without paying any (or little) tax.
How can one reduce the yield of securities in their portfolio (for tax purposes) without significantly impacting their portfolio’s risk?
Buy higher-yielding, more value-oriented stocks for a separate non-taxable account. For bonds, replace higher-coupon bonds with bonds trading at a discount to par.
How can purchasing a put option be a tax strategy?
If an investor is looking to liquidate a position but doesn’t want to do so until a more favourable tax year, they can purchase a put to protect their position until they’re ready to sell. However, the cost of the put needs to be contrasted with the tax savings.
How are ETFs legally organized in Canada?
As mutual fund trusts with the trust’s units listed and traded on an exchange.
What are the 2 ways a standard (passive) ETF can be constructed?
Either through full replication or approximately constructed through “sampling”
When would sampling be used over full replication?
Fixed income or if the number of holdings within the index is high.
What is sampling?
The process by which a portfolio manager selects securities and their weighting to best match an index’s performance. This is often done for fixed income ETFs and equity ETFs where liquidity is an issue.
Sampling can lead to tracking error, but can be more efficient on a cost basis.
Which index funds would have greater or lower tax efficiency?
Ones that hold a greater number of small- or mid-cap stocks where turnover is higher.
What are ‘flow-through shares’?
A type of common equity issued by junior resource companies. These allow exploration companies, which typically show accounting losses, to raise capital from investors. The resource companies renounce certain deductible expenses and flow them through to investors.
What are Canadian Exploration Expenses (CEEs)?
Specific deductible expenses incurred by exploration companies in Canada in non-development processes such as prospecting, sampling, surveying, drilling that are available in flow-through shares to flow through to investors and are 100% deductible in the year they are incurred.
What are Canadian Development Expenses (CDEs)?
Similar to CEEs, these are funds spent on drilling and completing oil wells, or sinking or excavating mine shafts that are available to investors through flow-through shares. CDEs are accumulated in a pool and tax-paying investors can use up to 30% in unclaimed balances in any 1 year.
What are ‘super flow-through shares’?
Flow-through shares that carry the additional 15% federal tax credit for qualified companies that undertake exploration for new mining developments in Canada. (Though this federal tax credit has been extended, it may not be around for long)
What are the risks of flow-through shares?
While the tax breaks are generous, the stocks are equity positions in junior resource companies, which are among the riskiest asset classes available.
What is a way to minimize risk while investing in flow-through shares?
Can minimize risk by investing in flow-through limited partnerships, which hold a portfolio of flow-through issuers and will often have geologists on staff to evaluate a company’s chances of striking a deposit. LPs also have the advantage of economies of scale as they can purchase shares in private placements.
How do limited partnership investments work?
Provide investors with a flow-through of expenses from a business for tax deductions with limited exposure to legal liability. Investors can deduct the majority of expenses in the 1st year, though this only provides tax deferral (not savings).
What is Alternative Minimum Tax (AMT)?
AMT is meant to ensure that taxpayers pay a minimum amount of tax even if a significant portion of their income is sheltered or reduced by deductions. The taxpayer pays the higher of regular income tax or the AMT amount. This is a concern when significant income is sheltered in any type of tax shelter, such as a limited partnership. However, if AMT is paid, the excess of the AMT over regular income tax can be carried forward up to 7 years to offset regular income tax.
Why can real return bonds be safer than nominal bonds?
Market price of RRB is affected only by changes in the real interest rate. The YTM is certain since interest and principal are indexed. However, the market price of RRBs can often be more volatile as interest rate changes affect RRBs far more than nominal bonds. Coupon payments are smaller than nominal bonds with similar maturities, so RRBs display greater price sensitivity to changes in real interest rates.
Why is it important to invest in real estate directly for inflation protection (vs REITs)?
At their core, REITs are financial assets with values based on real estate, so they will lose capital value during periods of inflation.
What is often the best way to invest in commodities as an inflation hedge?
Equity investments in commodity-based companies as they require no storage costs and are often more liquid and less risky than derivatives. This can also be done through mutual funds and ETFs.
