Tag: Investing

Practical applications of corporate class mutual funds

Corporate class mutual funds have unique features that make them stand out from other investment options. Chief among the tax benefits of these features are the:

  • Ability to rebalance holdings within the corporation without triggering dispositions, due to the exchangeability of share classes at adjusted cost base; and
  • Expectation of lower current distributions, due to the netting of gains and losses across share classes under consolidated corporate accounting.

While these are key details for an advisor’s knowledge, seldom does a client explicitly request benefits or features, let alone ask for an asset class or particular product. Rather, clients view financial advisors as problem solvers: the client has a current concern or future expectation and looks to the advisor to resolve the issue or at the very least suggest options that assist in moving toward a satisfactory resolution.

With that in mind here are a few situations where an advisor may have the opportunity to discuss the merits of corporate class funds as an addition, alternative or complement to a client’s current condition or investment approach.

Personal annuities

An annuity can provide guaranteed lifetime income, the price being the commitment of a lump sum of capital. You can also purchase a guarantee in case you die early. So what’s the cost of betting against yourself on both ends?

It may provide a reality check to compare the annuity income against the drawdown of a continuing managed portfolio. In the RRSP world, a person can hedge expectations by allocating between the security of a registered annuity and the flexibility of a RRIF. Either way, all eventual flows are fully taxable.

For non-registered funds, the taxes are a little more complicated. Generally for personal annuities, each payment is a fixed proportion of non-taxable capital and fully taxable interest. By comparison, a systematic withdrawal out of a corporate class mutual fund yields both non-taxable capital and one-half taxable capital gains, with the taxable portion increasing over the years.

Using reasonable return assumptions, a comparison of those annuity flows against the projected draw from the mutual fund corporation can provide some context for the cost of those guarantees. Whether or not this review changes a client’s course, this type of analysis will assure a more fully informed decision.

Managing foreign dividends

In an article earlier this year (Fundamentals, March 2011: “Is home bias simply rational self-interest?”), I adverted to the interaction between foreign dividends and corporate class funds. I have had a few advisor conversations on the topic since then and thought this would be an appropriate place to flesh out those earlier comments.

Foreign dividends are treated as regular income, which from an investment perspective is the same rate applied to interest. Accordingly, a top-tax-bracket investor receiving foreign dividends faces a tax rate of nearly double the rate applicable to Canadian eligible dividends. The rate disparity is even more pronounced at lower brackets once the two-stage mechanics of the gross-up and tax credit procedure are applied.

Another possibility is for an investor to hold foreign interests through shares of a Canadian mutual fund corporation. Foreign dividends are income to the corporation itself, and the corporation can apply its expenses against that income to reduce its potential to pay taxes. The investor thus expects capital appreciation, with only one-half of eventual capital gains then being taxable.

Passive investments within private corporations

Private corporations may be entitled to a low tax rate on active business income, but passive investment income is subject to the full corporate rate plus a penalty tax. With their tax-deferral benefits and low distribution expectations, mutual fund corporation shares would be an ideal consideration for private corporations.

In terms of accessing the funds, a T-series overlay could be used to receive a greater amount of non-taxable return of capital in early years, deferring capital gains until later.

As corporations face flat taxation – as opposed to the graduated bracket treatment of individuals – the tax-deferral opportunity can therefore be particularly effective in the private corporation context.

For some numerical support on these examples and discussion of other practical uses of corporate class shares, you can view the replay of our recent webcast on the topic – and obtain continuing education credit in the process.

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.