Valuing a book of business on marriage breakdown – Don’t forget the taxes

The breakdown of a marriage is difficult to work through.  Apart from parental concerns, the most contentious issues tend to revolve around valuing and dividing property.  This can be challenging enough when it’s about bricks and mortar, but can be especially problematic when the nature of the property is unclear.  

Take for example an investment advisor’s book of business.  Is it property?  Is it property that is subject to matrimonial division?  And if so, what value should be placed on it?

These are the key questions raised in LMJ v. RGJ (2015 SKQB 136), a recently reported case from the Saskatchewan Queen’s Bench Family Law Division.  While these issues are not entirely novel, the element of this case that caught my attention was the role that tax played – or arguably did not play – in the valuation.

Nature of a book of business

The definition of “family property” in the Saskatchewan Family Property Act is quite broad. This is not unlike its provincial counterparts, which are also expansively drafted.  

The judge in LMJ v. RGJ did not have to look back more than a handful of years to find a number of family cases in other provinces dealing with valuation of an investor’s book of business.  Consistently it was found that there was goodwill of significant value associated with the client contact, knowledge of investment objectives, and familiarity with historic investments.  

As to whether an advisor may not have the contractual right to take the clients, such a limitation may reduce value but does not detract from the fact that the goodwill is a marketable asset.  In support, a passage is quoted from a 2008 Supreme Court of Canada decision that refers to the “cultural reality” of the investment industry where advisors “frequently change employers”. 

RGJ led evidence from representatives of his dealership to the effect that he had no financial ownership in the book of business, did not own the list of clients and could not sell it.  Though the judge acknowledged the dealer’s regulations, no written contract was produced that explicitly prevented RGJ from taking the clients.  As well it was noted that RGJ’s Will refers to the “proceeds raised from the sale of my client accounts” being held for the benefit of his children, and that the dealer’s business succession plan (to which he was not yet subscribed) paid compensation based on a retiring advisor’s three most recent years of commissions.

Bottom line: the book of business was subject to matrimonial division.

Gross valuation 

RGJ took the position that there should be no value attributed to the book of business.

By contrast, LMJ offered an expert for determination of the value of the book.  The expert’s report considered the most recent three years of RGJ’s gross commissions, recommending a valuation range from $1.8M to $2.1M.  

The judge accepted the three-year approach of the expert, but began one year earlier than suggested, arriving at a value of $1.6M.  This contributed $800,000 towards the ultimately ordered equalization payment of $641,775 from RGJ to LMJ.  

And taxes?

RGJ’s counsel argued that the valuations in the LMJ expert report should be discounted for taxes (and other inconsistencies).  Unfortunately for RGJ, there was no evidence for the court to consider in order to make such a ruling.  

The judge referred to a case from the Saskatchewan Court of Appeal stating that it is not sufficient to merely raise an issue of potential tax liability.  Evidence is required to support a tax discount; in the context of determining capital gains, that would at least require the adjusted cost base and marginal tax rates.  In fact, the SKCA suggests that this evidence combined with the proposed calculation may be sufficient, without the need to bring forward an expert.

At the extreme assuming a nominal ACB on the $1.6M valuation on RGJ‘s book, that could have been a tax discount nearing $400,000.  Alternatively, depending on the nature of the dealer’s business succession program, it is possible that those future payments could be treated as regular income, meaning that close to half could be lost to taxes.  

And finally, consider that the book is not actually being sold presently, presenting a further challenge for RGJ to find the liquidity to fund the equalization payment.

Saving for a home – Debate between HBP and TFSA heats up

It is an age-old debate in personal finance whether it is more cost-effective to rent or buy a home — then add in the emotional element.  Assuming the ultimate decision is to buy, attention then turns to assembling the downpayment.  

Looking past the bank of mom and dad, traditionally that meant building up a reserve in a non-registered account beginning years ahead of the intended purchase.  As such deposits are after-tax savings subject to annual taxation on earnings, that could make for a slow exercise.  

Since 1992, accumulation in a registered retirement savings plan has been available for this purpose through the Home Buyers’ Plan (the HBP).  And since 2009, the multi-purpose tax-free savings account has provided another avenue.

While RRSP and TFSA both offer tax-free accumulation, the pre-tax RRSP allows greater gross accumulation, which would seem to favour usage of the HBP.  On closer look however, the choice is neutral at best, and in my opinion instead leans toward employing the TFSA.  

The simplicity of TFSAs

The TFSA became available for deposits in 2009.  The initial $5,000 annual contribution limit increased through indexing to $5,500 in 2013, and earlier this year was moved up to $10,000 (though it will no longer be indexed).  Depending on the outcome of the current federal election, TFSA room may be further adjusted, but there is no suggestion that either the program itself or its tax functioning are at risk.

The TFSA is funded out of after-tax money, so less money is available to go into a TFSA compared to an RRSP deposit.  To illustrate, a person at a 35% marginal tax rate who had a dollar to put into an RRSP (assuming available room), would have only 65 cents to go into a TFSA.  This is a double-edged sword for the RRSP though, as all deposits and all growth will eventually be taxable.

On the other hand, TFSA withdrawals are not taxed.  Thus the amount available for a downpayment is simply the value of the TFSA at any given time.  Once a withdrawal is made, there is no service cost or repayment obligation, and the taxpayer is entitled to a dollar-for-dollar credit for re-contribution the year following withdrawal.

HBP accessing RRSPs

At its core (without getting into all the minutia), the HBP allows a first time home buyer to make a withdrawal from an RRSP without facing current taxation.  The original withdrawal limit of $20,000 per person (or as much as $40,000 for a couple) was increased to $25,000 in 2009, and there is now an election proposal to further increase it to $35,000.

The quid pro quo is that the withdrawn amount must be returned to the RRSP over the 15 years following the home purchase (or sooner if the person is able, and wishes to do so).  Those future replenishing payments are not deductible. 

For a renter anxious to enter into home ownership, the HBP opens the door to a larger pot of money to achieve a desired downpayment.  This could be particularly helpful in getting past the threshold below which an insurance premium would be payable for the mortgage to be covered by the Canadian Mortgage and Housing Corporation.  And obviously a larger downpayment means a smaller amount being financed.

This last point is critical, as larger annual interest charges eat into a household budget for years, and often decades.  But what is the trade-off cost of using the HBP for that downpayment?  

Just as mortgage payments are non-deductible, again so too HBP repayments.  Put another way using our 35% taxpayer once more, roughly $1.50 of the person’s pre-tax income would be required to fund each repayment dollar.  To derive a truer cost of financing, an aspiring  homeowner would be advised to budget based on the combined cost of mortgage and HBP.  

Still, whereas mortgage payments are mandatory (in a practical sense), couldn’t a person simply forego one or more HBP repayments if things get tight?  The answer is yes, but then the un-repaid amount is taken into taxable income – And remember, no cash comes available at that time, as it was spent years earlier to buy the home.  The tax payment itself is not deductible, costing our erstwhile 35% homeowner almost 75 cents of pre-tax income to pay the roughly 50 cents of tax.  And unlike TFSA room, spent RRSP room is non-recoverable.

It is also bears mentioning that likely our homeowner will have higher income in future.  While plainly positive on its own, as household costs ascend that could have an impact on the cost of HBP repayment or tax on un-paid instalments.  The net effect is ambiguous at best.

Transparency trumps 

Perhaps the picture offered here is a bit cynical.  Well-informed, well-disciplined purchasers may very well be able to navigate the HBP rules without harm, and possible to their advantage. Indeed, a couple planning a family could strategically manage the program so some future income is recognized by a low-bracket stay-at-home parent.  

Even so, the true cost of the HBP remains opaque and uncertain – an uncomfortable position to be in for the largest financial transaction of a person’s life.  For my money, the nod should go to the greater transparency and certainty of the TFSA, maybe with the HBP playing a minor supporting role.

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SIDEBAR/CALLOUT

According to Statistics Canada, 180,750 taxpayers did not pay their HBP instalment in 2012 (the last year for which data is available), collectively taking $812 million into income that year. 

Are Alberta trusts still worth it? – Mounting changes may make them uneconomical

There was a time when the creation of trusts in the province of Alberta was practically an industry unto itself.  I can attest from personal experience when I was in private law practice a decade or so back that Alberta firms advertised directly to their Ontario colleagues.

From then up to last year, among the provinces Alberta clearly had the lowest top bracket tax rate at 39%, being 29% federal and 10% provincial. At times that has ranged from 5% to over 15% better than elsewhere in the country.  

The expectation was that the trust’s residence for tax purposes would follow that of the trustee.  This came under scrutiny in 2012 in Fundy Settlement with the Supreme Court of Canada ruling that residency is determined based on the location of the trust’s central management and control.  In that case, that meant Canada rather than Barbados.  The Newfoundland Supreme Court considered that case in Discovery Trust earlier this year, upholding a trust’s contention that it was resident in Alberta.

Still, even if a trust is properly established, managed and documented, is it still worth the effort to have it taxed in Alberta? 

Changes to testamentary trusts

Inter vivos trusts have long been taxed at the highest combined federal-provincial tax rate, but testamentary trusts could take advantage of graduated brackets.  Potentially this benefit could be multiplied for someone who was a beneficiary out of more than one Will. 

After this year, with the exception of the first 36 months of an estate and trusts for qualified disabled beneficiaries, testamentary trusts will also be taxed at the highest bracket.

This obviously takes the shine off using testamentary trusts for tax purposes (let alone multiples), though where it is expected that a given beneficiary will be at top bracket in another province, a 39% tax rate may still seem useful — so long as the rate remains at that level. 

Alberta rate changes

Even before the election of a majority NDP government in Alberta earlier this year, the incumbent Progressive Conservatives had proposed adding another tax bracket.  This became moot once the election was called.

After winning a majority in May, the NDP moved swiftly to carry out a number of election promises before the summer.  This included the addition of 4 provincial brackets, 3 of them above the federal bracket ($138,586 in 2015): 12% at $125,000, 13% at $150,000, 14% at $200,000 and 15% at $300,000.  The rates are effective October 1, so there is a pro-rata calculation based on the addition applying for 1/4 of the year in 2015.  For the top bracket, that means 11.25% for 2015, and then 15% hereafter.  

Combined with the 29% federal bracket, that makes for a top combined rate of 44%, the same as Saskatchewan and slightly above the Newfoundland top rate of 43.3%.  Alberta is no longer the obvious choice.

Liberals election platform

At time of writing, the Liberals have just won a majority in the federal election.  A key plank in their tax platform was to reduce a middle federal bracket from 22% to 20.5%, and to add a top bracket for income over $200,000 at the rate of 33%.

With a majority mandate, it can be expected that these tax changes will be put in place, certainly for 2016.  That will raise all provincial combined top rates by that same 4% increment.  In Alberta’s case, that will take it to 48% in 2016.

This series of changes make for a significantly different tax proposition for testamentary trusts than would have been contemplated no more than three years ago, particularly for trusts resident in Alberta.  Those who have drafted their Wills intending to take advantage of the tax differential should take another look and decide if their plans still make sense.  For existing trusts, legal and tax advice is recommended if a variation of the trust is desirable or even possible.