Tag: Investing

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. 

Coming to terms with HST

This past holiday season, the kids received a DVD of heritage-era cartoons, not the ones with either of the famous big-eared rodents, but instead a collection of fractured fairy tales.  One in particular caught my attention — a tongue-in-cheek version of the story of the ant and the grasshopper.  

You’ll recall the original pitted the industrious ant against the perpetually procrastinating grasshopper.  The ant stored food for the lean times while the grasshopper consumed and played.  Come winter, the grasshopper either died out or came grovelling to the ant’s storehouse.

Of course this isn’t all that amusing for the wee ‘uns, so the cartoonists exercised their poetic licence and acerbic wit to turn the tale on its head. The grasshopper could do no wrong, and the ant (despite the best of intentions and efforts) ended up worse off for those saving ways.

At one point, my eldest (all of 5 years old) commented between giggles that it didn’t make much sense, but it sure was funny.  And it was, for a cartoon.

Not so funny if savers in reality were to be worse off for their efforts. This would be particularly ill fortuned if it were attributable, even if only in part, to taxes imposed by their own government.

Taxes are innately good

It’s true and it’s an important premise that needs to be stated before continuing.

Taxes are the primary means by which we finance our society. They are the necessary balance to service the expense of providing the infrastructure and public goods that otherwise would be left undelivered or unsupported if we all operated strictly in our respective self-interests. 

Thus, while taxes themselves may be good, the implementation of an effective taxation system struggles with NIMBY.  No, that’s not another classic cartoon character. It’s a classic response to the spectre of new taxes: “Not in my backyard.”  

The problem with NIMBY is it’s totally lacking in principles, while laden with self-interest.  

So the issue is not “if” tax revenue must be raised, but “how” to do so. This then is where political, social and economic values may very well come into conflict, often lining up along political party lines. Although the tension may be unavoidable, its resolution need not be insurmountable.

The impending HST

A broad-based consumption tax like the GST, and in turn the HST, can be an effective way to spread tax need across a population. Though it is inherently regressive in that it imposes a higher burden on low-income payers, the concurrent implementation of a targeted tax credit mechanism can be used to address this equity concern.

Being broad-based is critical. If otherwise taxable units are zero-rated or exempted from tax liability, the tax base may be eroded and remaining taxable units must be charged a higher rate. Whether the distinction arises out of social policy or industry lobbying, it influences consumer actions and has economic consequences. With respect to industry lobbying particularly, the undercurrent of self-interest again surfaces.  

That said, in my opinion there is an even more fundamental concept to be probed, which is whether consumption taxes should apply to savings, directly or indirectly.

Savings as consumption

Savings is not as simple a concept as one might expect. There is a large body of tax and economic literature on the issue, and it is an ongoing debate. Much of this is under the umbrella of income tax — specifically if and how unrealized income should be taxed.  In the Canadian system, we generally defer taxation on unrealized capital gains, and on all types of income and accretions in most registered plans until withdrawn.

So, having taken a position on the taxation of savings in the income tax realm, is that being coordinated on the consumption tax side?

To the person on the street, a reasonable definition of savings might be “that which is not consumed.” Accepting that for the moment, it would seem illogical that a consumption tax might be applied to something that is not consumed, at least in the practical sense.

The counterpoint would hold that GST/HST is not imposed on savings, but rather on services employed in the management of those savings, such as mutual fund management fees. Nevertheless, it is the savings that carry the burden of the tax — though one degree removed — and therefore the distinction may be technically correct but practically indistinguishable.

Presumably, if savings are kept clear of GST/HST (directly or indirectly), there will be more to be consumed later. Arguably then, this may be no more than a deferral of the consumption tax, and potentially an increase in the base upon which to impose that tax when truly brought into consumption in future.   

Is that all, folks?

The precarious state of the pension and retirement income system has been in the forefront as we have worked through the current economic downturn.  In fact, the ministers of finance met to discuss the system this past December and will come together again in May.

While the Ontario HST can be expected to be implemented pretty much intact come July, here’s to hoping that future amendments to the GST and HST take into full consideration the practical impact they have on savings, retirement and the broader economy.

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.