Tag: Capital gains

Last chance for trust planning in 2015

What to do with capital gains in testamentary trusts

With the passage of Bill C-43 in December 2014, most testamentary trusts will be subject to top marginal tax rates. The two exceptions are the first 36 months of a graduated rate estate and a qualified disability trust for a beneficiary who meets the criteria for the disability tax credit.

For most testamentary trusts, the new tax rates kick in on December 31, 2015. While trustees cannot change the law, they may be able to take planning steps to mitigate the damage, at least in the case of investments carrying unrealized capital gains.

Advisors managing such investments should reach out to trustees to inform them about appreciated holdings, so they can take action before it’s too late.

Changes: Timeline and cost

Until now, the main tax distinction among personal trusts has been the way they came into existence. Inter vivos trusts, those created while a person is living, are subject to top marginal brackets and use a calendar year-end. Testamentary trusts are created under a person’s will, and had been entitled to graduated tax bracket treatment. They could also choose a non-calendar year-end.

Both these tax advantages (and others) for testamentary trusts have now been eliminated. As a quick phase-in, existing testamentary trusts will have a deemed year-end this December 31 to bring them in line with calendar year-ends thereafter.

These changes will affect income earned annually in future, understanding that a trust is subject to the combined federal-provincial personal tax rates in the province where it is resident. On the federal component alone, the tax will almost double on the first dollar of income for testamentary trusts for 2016 and beyond, given that the lowest federal bracket is 15% and the highest 29%.

For capital gains, the federal increase will be 7% (since only half of capital gains are taxable). Here are the net differences based on combined rates in each province.

Table: Combined federal-provincial tax rates on capital gains

Province    Top bracket     Low bracket   Difference
BC                      22.9%              10.0%              12.9%
AB                     19.5%               12.5%              7.0%
SK                      22.0%              13.0%              9.0%
MB                     23.2%              12.9%              10.3%
ON                     24.8%              10.0%              14.8%
QC                     25.0%              14.3%              10.7%
NB                     23.4%              12.3%              11.1%
NS                      25.0%              11.9%              13.1%
PE                      23.7%              12.4%              11.3%
NL                      21.2%              11.4%              9.8%

Taking action on capital gains

It may be possible for capital gains to be managed in the face of this development. If a trust holds investments with as yet unrealized capital gains, the trustee may trigger some or all those gains through dispositions.

To be clear on the application of the new rules, there will be a deemed year-end on December 31, but not a deemed disposition of capital assets. This means a trustee must take steps to cause actual dispositions while graduated brackets remain applicable.

For securities, extra care should be exercised to allow for the three business days from trade date to settlement date to ensure gains are realized before the trust’s year-end. As well, trades by the trust and related parties in the month before and after must be carefully scrutinized, lest the superficial capital loss rules be inadvertently triggered, potentially undoing the plan.

For trusts with a non-calendar year-end, there will be two year-ends in 2015. So, it is doubly critical to act with haste for such trusts, as with each passing day, planning opportunities are expiring. There is no grandfathering or carryforward that will make those low rates available in 2016 or later. Simply put, the last opportunity for these trusts to access graduated brackets is in 2015.

Revisiting planning options

Preferential tax treatment has been a useful feature of testamentary trusts for almost half a century. In some situations, it may have been a by-product of other planning priorities such as managing disability needs, controlling asset distribution or providing for minors. Elsewhere, the tax aspects may have been central to the plan. Either way, trustees will begin looking at whether current trusts can or should continue, which may mean more asset movements to come.

Five tax principles for building better portfolios

Successful portfolio building is most often achieved – and repeated – when chosen strategies rest upon time-tested foundations.  

Such investment strategies in turn should incorporate or at least consider tax implications, given that almost half of investment returns can be lost to taxes. As the old adage goes, “It’s not how you make out; it’s what you take out.”

Here then are five tax principles that should underlie every client portfolio. Individually and in combination, these principles can help investors to achieve some absolute tax savings and otherwise defer the incidence of tax to a later date.

1. Cash preservation due to tax deferral

According to the concept of time value of money, a dollar received today is preferred to one to be received in future, all else being equal. Similarly, delaying an expense – such as a tax payment – keeps more cash available to an investor for the present and allows the potential for continuing gain in investment value until that payment comes due. 

2. Less recognition through lower distributions

Income is generally a desirable thing, but for a mutual fund investor not seeking current income, it can be frustrating to receive unwanted distributions. Apart from having to redeploy those distributions – often right back into the same investment vehicle – there is current tax to be paid on that realized income and thus less money continuing to be invested.

3. Tax-preferred income with capital gains and dividends 

It is not uncommon for novice investors to assume that investment income, like employment income, is fully taxable. Isn’t it as simple as totalling up your income and applying the appropriate tax rate to find out how much you owe? In truth, there is an important distinction as to the type of income before you apply that tax rate – such as one-half taxable capital gains and possibly lower effective rates on dividends.

4. Rebalance holdings without triggering taxation 

It is important for an investment portfolio to be responsive to changing needs, whether prompted by market forces or investor circumstances. Within registered accounts like RRSPs and RRIFs, rebalancing may be undertaken without fear of triggering taxes. For non-registered accounts, however, dispositions generally trigger unrealized capital gains – except where a structure like a mutual fund corporation is used to defer that taxation.

5. Easing recognition via controlled drawdown 

Retirees’ views on investment income taxation may be anchored in the registered investment world, specifically RRIFs. As registered accounts are held in pre-tax form, withdrawals are fully taxable. On the other hand, non-registered investments originate from after-tax funds and each withdrawal is normally a combination of non-taxable capital and one-half taxable capital gains – and it is even possible to have the early distribution of the non-taxable capital from some investment structures like mutual funds. 

Time to pull the trigger? Making use of capital losses

In the midst of the current market turmoil you’ve continued to counsel your clients to stay invested for the long term because even these conditions will eventually pass.

Still you know, market downturns can provide planning opportunities to take advantage of losses and offset other capital gains. 

As a result of fund distributions due to internal rebalancing or your client’s own decision to dispose of some investments, capital gains may have been realized in the current year.  Those gains could be neutralized by making dispositions designed to crystallize sufficient offsetting capital losses, with any excess carried back to recover capital gains related taxes paid in the last three years, or perhaps set the stage to carry forward in anticipation of future gains.

But what happened to staying invested for the long term?  So long as the business fundamentals underlying your portfolio construction remain valid, these broader market movements should not completely invalidate well considered past choices.  

If you re-acquire those same funds within 30 days though, those capital losses cannot offset the gains due to the superficial loss rules.  Particularly with the wild market swings we’ve experienced, stepping out of the market for 24 hours – let alone 30 days – may mean missing a large part of the recovery. 

Part of the answer may be to employ fund switches not exposed to the superficial loss rules.  Specifically, if you are disposing of mutual fund trust units, you could immediately acquire shares of a mutual fund corporation with the same or similar holdings.  And it works the other way too if you want to dispose of fund shares to acquire fund units.

By the way, be ready to counsel your clients on what to do with the newfound cash recovered from those past paid taxes.