Tag: Dividend

Dividend taxation – Is home bias simply rational self-interest?

The field of behavioural finance observes how we act as investors and often attempts to explain why we act the way we do.   

One of the more familiar observations is “home bias,” which is the tendency to prefer investing in domestic firms over foreign firms. This tendency came to mind recently in a conversation I had with an investment colleague who shared with me some historical global data on the contribution of dividends to total return. 

While his purpose was to explain his general preference for dividend-paying stocks over non-dividend stocks, it struck me that this could also partially explain home bias. In fact, it could underlie a strategy for tax-managing home bias. 

Non-registered taxation 

All income and gains in the registered world (i.e., RRSPs, RRIFs) are deferred within the respective plan, then fully taxable when drawn out. By comparison, the after-tax return of a non-registered investment is directly dependent upon income type:

  • Interest & foreign income        Fully taxable
  • Realized capital gains              Half is taxable
  • Canadian eligible dividends    Gross-up/tax credit

On a national basis, the 2011 average combined top tax rates for the three categories above are about 44%, 22% and 24%, respectively (as at February 1, 2011). To be clear, the third category is reserved for Canadian dividends, while foreign dividends fall within foreign income in the first category. In contrast, there is no domestic/foreign distinction for capital gains. 

Total return

The return on an investment is a combination of the income it generates and distributes (and when it distributes), and its value when the investor sells it. With respect to stocks, one may expect periodic dividend payments and usually also hope to realize capital appreciation upon disposition.

A key skill of a portfolio manager is to assess the quality of interim flows and expected value of fund holdings at realization. In addition to the manager’s assessment, a Canadian investing in that particular fund also needs to consider a critical tax criterion: the aforementioned tax distinction between domestic and foreign dividends.

So how much might one expect dividends to contribute to total return?

The historical global data

As my colleague pointed out, we are likely at the end of a roughly 20-year bull market that has seen significant capital appreciation for stocks. In the wake of the recent downturn, a shift appears to be emerging toward an emphasis on “yield,” which, in my non-technical view, appears to be the desire for income-producing investments.  

Based on the data* we reviewed together, that’s probably a good long-term approach. Over the 30-year period to October 31, 2009, the contribution of dividends to total returns in seven major economies ranged from 35% to 67%, with the worldwide average being 49%. Canada came in at 50% even.

Asset allocation by tax environment

In the non-registered environment, the greater the proportional contribution of dividends to total return, the more important is the domestic/foreign distinction. As a simplified example using the 2011 top bracket national average, a dollar of non-registered return comprising 50% capital gain and 50% dividend will net to 77¢ after-tax on a Canadian stock, versus 66¢ on a foreign stock.  

Thus, to maintain geographic/risk diversification across both tax environments, an investor might be inclined to skew registered accounts toward foreign holdings and non-registered toward Canadian.

A further alternative/complement on the non-registered side may be to hold shares in a Canadian mutual fund corporation that in turn has foreign exposure. Such an investor can generally expect to receive eligible dividends, capital gains dividends and capital appreciation, despite that the corporation itself may receive foreign income.

Paying attention to and managing dividend taxation this way enables an advisor to offer useful insight and guidance in recommending appropriate holdings across a client’s entire portfolio.

* Source: FactSet Research Systems Inc. Returns are in local currency. Data as at October 31, 2009.  Percentages stated represent the percentage of the total return comprised of dividends. 

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. 

Taxing Canadian dividends

With the turn of the calendar this New Year’s Day, we flipped the page to the next chapter in the ongoing evolution of Canadian dividend taxation.

We witnessed the low-water mark in 2009 for eligible dividend taxation across the country.  Come April, top tax bracket residents in five provinces will pay less tax on dividends than on capital gains.  

Now, as we move forward to 2012, all provinces and territories will adopt increased effective rates applying to eligible dividends.    

Integration model 

The two-stage treatment of dividends is an application of tax integration theory, whereby a taxpayer should be indifferent whether income is earned directly or as a shareholder via a corporation.  

The Canadian income tax system uses a model that assumes the shareholder is a top- bracket taxpayer. This, however, has implications for lower-bracket taxpayers.

The integration model is designed to correct for potential double taxation where income is earned in a corporation and then distributed to a shareholder. The corporation pays tax on that income; therefore, a mechanism is needed to reconcile that earlier corporate tax payment when the income is realized in the shareholder’s hands.

On the shareholder’s top line, the dividend gross-up emulates the pre-tax value of the income to the corporation, upon which the shareholder calculates tax owing. The dividend tax credit reduces this preliminary tax liability by the estimated tax already paid by the corporation to arrive at the bottom-line tax due. Only Canadian corporations (presumed to have paid Canadian taxes) are entitled to this treatment; dividends from foreign corporations are fully taxable.

Since 2006, our income tax system has distinguished Canadian dividends as ineligible and eligible. Ineligible dividends arise out of small business corporations entitled to the small business rate and have separate gross-up and tax credit rates.  

Eligible dividends are the subject of the most recent legislative changes. Though eligible dividends can also be generated from small business corporations, most taxpayers receive them via portfolio investments.

Adjustments for 2010

In 2010, the federal gross-up and dividend tax credit rates applying to dividends will both be adjusted downward. This is designed to keep the system in balance as corporate tax rates come down from 19% to 18% this year, to 16.5% in 2011 and 15% in 2012.

The gross-up figure will come down from 45% to 44% this year, to 41% next year, and will eventually reach 38% in 2012.  This federal gross-up also applies when calculating provincial/territorial gross tax due, though somewhat indirectly in Quebec.  

Concurrently, the federal dividend tax credit applying to the grossed-up dividend will fall from roughly 19% to about 18% this year, just under 16.5% next year, and will come to rest at just over 15% in 2012.  

Each province and territory independently sets its own dividend tax credit to use in determining net provincial/territorial tax liability.

The net effect of the federal adjustments and provincial/territorial coordination is that the effective rate on dividends will increase in 2010, except in New Brunswick where the government is collapsing the number of brackets and reducing rates as part of an overhaul of the system leading up to 2012.

Legislative developments apart [DASH] which may very well be coming, given recent and prevailing economic events [DASH] the upward trend is expected to continue in all provinces and territories from 2010 through 2012.

Lower bracket taxpayers

The integration model is based on the shareholder being at the top marginal tax rate. Obviously, this is not always the case. 

For taxpayers in lower tax brackets, the combination of the gross-up and tax credit generally results in an even lower effective rate on dividends. While it varies in different provinces and territories, the marginal tax rate for annual income of $60,000 is at or near 30%, whereas the effective rate on eligible dividends is at or below the single-digit threshold.  As with all investments, a number of factors must be considered when assessing their suitability for individual clients. For example, potential clawbacks need to be considered for older investors. However, even with these recent changes, dividend-producing investments continue to warrant consideration and inclusion in a tax-informed investment portfolio.