End of Canadian tax season

The last chance to dispose of stocks on the TSX will be at 12:59pm EST on December 24, 2015. These trades will settle in the 2015 calendar year. The exchange is closed on December 25, 2015 and also December 28, 2015 (in lieu of the December 26 Boxing Day holiday). Trades conducted on December 29, 2015 will settle in 2016.

Our American cousins journal their trades for taxation purposes on the transaction date and not settlement date, so they have up until December 31 to make their last-nanosecond trading decisions for tax purposes.

I have been insanely busy lately dredging the recent trainwrecks (mainly relating to oil and gas) and have been finding material of value, hence I haven’t been writing much here.

Canadian taxable deadline for capital gains/losses

Canadian investors have until mid-day on December 24th to book capital gains and losses for the year. As there is a three-day settlement period for stock trades and since December 25 and 26 are statutory holidays in Ontario, the trades will settle in the 2015 calendar year.

If you are selling US equities, the deadline is December 26th.

This is one of those tax rules where the CRA and IRS differ – the IRS will consider a disposition on the 31st of December to be valid for the 2014 calendar year.

There is some element of psychology that goes on in December – fund managers will not want to be seen (embarrassed) with certain holdings on their year-end statements, and investors have some tax incentive to ensuring that they book losses before year end to offset income taxes. This creates supply pressure on a reasonable number of stocks that experience declines throughout the year. Clearly the theme in 2014 will be the declines experienced in oil and gas producers.

Taxation year for Canada coming to a close

For Canadians, today is the last day to buy and sell stocks and debentures on the TSX and still have it count for the 2013 tax year.

The date for US securities is on the 26th because Boxing Day is not a trading holiday in the USA.

If it is your US tax return you are concerned with, you can sell securities up until December 31 to have the IRS consider it a 2013 tax year transaction.

Regardless of all of this, market movements at this time of year are on computer trading autopilot as most decision-makers with any market influence are away from their main desks.

Merry Christmas everybody.

Addendum to previous post regarding trade date vs. settlement date

I received a comment regarding the previous post on trade date vs. settlement date through email. It is comprehensive enough that I will just quote it here and thanked the individual in question for providing it.

Thank you for your posts. Regarding your post at http://divestor.com/2009/12/22/canadian-tax-rules-about-year-end-selling-trade-date-vs-settlement-date/, the link to IT-133 is broken. This is because the CRA cancelled the IT some time ago. I had considerable trouble finding out what happened to the IT, and whether or not it was due to a policy change at the CRA. So I wrote the CRA seeking a ruling on the issue of Trade vs. Settlement date. This was my reply:

Although IT-133 was cancelled, the comments contained therein continue to apply. The comments contained in paragraph 2 therein states as follows:

For the usual transactions on a Stock Exchange there is a disposition and acquisition of shares traded on a Stock Exchange, by the vendor and purchaser, respectively, on the settlement date which is the time designated by the Stock Exchange, usually two or three days subsequent to the trade date, on or before which the vendor is required to deliver the share certificates and the purchaser is required to make payment therefore.

We trust our comments will be of some assistance.

INCOME TAX RULINGS DIRECTORATE
FINANCIAL INDUSTRIES DIVISION

Please feel free to share the response publicly, but please keep my name private.

Trade date vs. Settlement date, calendar year, capital gains, Canada vs. USA

This is my first post about taxation in quite some time, but it is mostly a re-hash of my December 2009 post on the matter.

Taxation should always be a consideration in financial decision-making – e.g. all things being equal it should be preferential to include interest income in your tax-deferred accounts versus Canadian dividend income. At the end of the year, there are always decisions to be made with respect to determining when to crystallize income and/or losses through dispositions of securities.

In Canada, the calendar year where you dispose of securities is determined by the settlement date. In other words, you had until today (December 24) to sell your publicly traded securities since the settlement is 3 business days ahead – a trade today is settled on December 31st because of the Christmas holiday schedule. The TSX takes December 25 and 26th off.

If you decide to unload your shares on the TSX on December 27th, the settlement will be on January 2, 2013.

However, the Nasdaq and NYSE are open on December 26th, so if you dispose of your US shares on that date, the settlement will still be in 2012.

The taxation rules in the USA are slightly different – trade date is when your securities are disposed of, not settlement date. As far as the IRS is concerned, if you unload your shares on December 31st, that is a current year disposition and not the next calendar year.

This is one of the subtle quirks between the Canadian and US tax systems.

Links and after-tax calculations

I will preface this post by thanking Mark Goodfield at the Blunt Bean Counter for mentioning this site. I am quite happy to link to high-quality writers of Canadian finance that use their real names, and Mark has been on my very small list of site authors on the right-hand side underneath the “Canadian Finance” header.

In particular, I found his off-topic post about golfing at Pebble Beach to be highly entertaining. Since I am one of the world’s worst golfers, I can only live through the experience through other people and I note in sympathy of him having to be stuck in a foursome with an incapable golfer at Spanish Bay.

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My topic on taxation deals with the statement of before-tax and after-tax amounts. Taxation must be factored into all financial calculations (despite how much we dislike paying them), but most people intuitively think in terms of before-tax rather than after-tax amounts.

Here is an example: If you were given a choice of having $100,000 cash in a non-registered account or $120,000 in an RRSP account, which would you take?

Most people would take the $120,000 RRSP account.

However, the answer is not so clear. For example, if you decided to take the RRSP account and pulled it all out in one year, assuming no other income and a BC residence in 2011, you would be left with $86,425 in after-tax money to deal with.

If you split your withdrawals into two $60,000 batches, assuming the 2011 rates apply for 2012, you would still be left with $96,366 after-tax. Structured over three years would leave you with $102,043.

That said, if your goal is to invest the capital and generate income over a long period of time, it is far superior to do it through an RRSP than a non-registered account, where in the latter your returns will be whittled away by having to pay the CRA each year. With the RRSP, you would have a larger capital base to deal with and also the advantage of tax deferral.

However, if your primary method is to increase your wealth through capital gains, there are multiple scenarios where doing it through a non-registered account is superior to an RRSP – especially if your holding periods on your assets are of very long duration. For example, if you chose well and invested in something that returned 10% a year for 20 years (note this is exceptionally difficult to do!), spontaneously liquidated at the end of 20 years, you would have $566,733 at the end of the day. In the RRSP account, after withdrawal, you would have $473,639 after-tax.

Also note that if the investment is determined to be grossly over-valued at a point in time, that the penalty of “spontaneous liquidation” in an RRSP is zero, while the tax liability in a non-registered account increases as the value of the investment increases – there is a significant penalty for realizing a capital gain and an investor has to factor this into their calculations (which I did on this post). I find it personally very frustrating to hold onto investments that have appreciated beyond what I consider to be its fair value, but “prevented” from doing so because of the capital gains taxes that would be incurred as a result.

Financial modelling of the RRSP vs. non-registered scenario as I outlined above is not a trivial issue to answer. The specific variables involved include (but certainly are not limited to):
a. When you need money out of your RRSP (a function of age and personal situation with respect to financial needs);
b. Your tax situation for the next X years (including how the government will change rates over that period of time, how much other income you will generate during that time);
c. Your method of investment (as it impacts how taxes are applied, expectations of future returns).

One other component of before-tax and after-tax calculations concerns the implied rent in a rent-vs-own scenario in a real estate purchase. For an individual, a rent payment comes from after-tax funds, which means that if your rent payment is $10,000/year, the before-tax income required to generate such a rent payment, using a 30% marginal rate, would be $14,286 before-tax.

Assuming a GIC returns 10%, one would intuitively think that they would be indifferent if they invested $100,000 in a residential property vs. the GIC (note this excludes all other costs, such as maintenance, insurance, property taxes, etc.) since the “return on investment” is $10,000/year. However, either the GIC rate must be translated into the 7% after-tax figure ($10,000*10%*(1-0.3)), or the after-tax rental amount must be translated into the $14,286 pre-tax figure ($10,000/(1-0.3)).

It is important when doing these financial calculations that all figures are translated into either before-tax or after-tax numbers, otherwise there will be significant errors in comparative calculations.

TFSAs to increase?

One of the campaign trail promises was to double TFSA contribution limits to $10,000/year if/when the budget is balanced.

Given the existing projections of the federal government, this may not happen for a few years, if ever.

However, an increase in TFSA contribution limits would make them much more significant vehicles for investing than present. It is a much more functional solution than giving some form of relief on capital gains taxes – effectively the TFSA becomes the conduit for this, or for relieving people from paying taxes on interest income.

Because of the contribution limit rate, TFSAs disproportionately favour lower net worth individuals – for example, if your net worth was $20,000, you could invest it all tax-free but if your net worth was $1,000,000 then it would be a drop in the bucket. It is a surprisingly egalitarian method to allowing tax-free compounding of capital.

The only negative part of the TFSA is that you can’t write off capital losses – so make those choices carefully.

Canadian Tax Expenditures and Evaluations Report

The Ministry of Finance released their Tax Expenditures and Evaluations Report for 2010. Although this reading is quite technical for most people, there are a few takeaways in terms of the changes of government tax policy.

For large corporations:

Due to corporate tax reductions, retained earnings and equity will be the most efficient way (with respect to total tax burden) to raise capital, although it is very close with raising debt capital. In the USA, equity is much more expensive than debt, mainly due to deductibility of interest (while dividends are punished by relatively high rates of taxation).

On small business corporations:

Equity and retained earnings remain cheaper than debt financing, once again due to low tax rates. When factoring in the lifetime capital gains exemption for the sale of eligible small business shares, the total tax burden decreases even further.

Further in the report is an interesting analysis on the elasticity of tax rates and actual reported tax collections.

An extra $100,000 for TFSA room?

The Senate Standing Committee on Banking, Trade and Commerce is one of the more functional committees in Parliament that hasn’t dissolved into a partisan morass.

In one of their recent reports (October 19, 2010), one of the committee recommendations was that Canadians should receive a $100,000 contribution room to their TFSAs:

The federal government amend the Income Tax Act to establish, in addition to the existing annual contribution room, an amount for lifetime contributions to a Tax-Free Savings Account. The amount of the lifetime contribution room, which should be increased annually in accordance with changes in the Consumer Price Index, should initially be $100,000.

Moreover, the existing ability to carry forward unused annual Tax-Free Savings Account contribution room should continue.

Although this policy is unlikely to be enacted by the government, if they did it would be a non-trivial method of sheltering income. The actual committee report (page 35 onward) goes on to state that most Canadians are very unaware of how to use TFSAs, and that such accounts are typically used to store GICs or other equivalently conservative investments, rather than stocks or bonds.

Anybody investing in the marketplace should be trying to maximize their TFSA as quickly as possible, as it is truly the only “free lunch” that the government gives to people in terms of taxation. Mathematically speaking, the power of compound interest kicks in if you can competently manage the investment portfolio for a long duration of time. Assuming the government does not change the tax advantage of the TFSA, it removes one of the largest risks of financial planning, mainly the future income tax rate.

End of year tax planning notes

Now is about the time to think about how your portfolio should look at the beginning of 2011.

In general, it is usually a wise decision to realize capital losses if you have capital gains to offset them with (i.e. in 2007, 2008, 2009 or 2010 tax years). Each realized loss dollar will result in a “refund” of half your marginal rate for that year. One usually wants to back capital losses into the earliest possible year (2007) if available, but if you have a lumpy income stream, then the high marginal rate year would be the correct decision.

Conversely, if you anticipate lumpy income in the future, realizing capital gains in the current tax year if the current year is a low income year may be optimal – these sorts of optimization calculations are never easy to perform.

The big change from previous years is the looming conversion of income trusts to corporations. Most income trusts will be distributing income until the last possible moment. For most, this means trust holders at the end of the year will be receiving income distributions. For those holding trusts in registered accounts (RRSP, TFSA, etc.), the optimal time to move them out of the registered accounts is at the beginning of 2011 and into non-registered accounts. This assumes, of course, that there are substitute investments that bear income that can be placed into the sheltered account.

You can perform this by doing an asset swap in the case of an RRSP; just that non-registered assets that are swapped into the RRSP will have a deemed disposition – a capital gain will be realized at this point. Capital losses are not allowed to be recognized with an asset swap, so if you plan on swapping assets that are in a current loss position, you will have to wait 31 days before repurchasing in order to avoid the so-called “wash rule”.

Tax planning is quite complicated, but in terms of portfolio management, it involves in placing as much income (interest income, REIT income, and solely in the case of an RRSP and not TFSA, US corporate dividends) as possible into sheltered accounts, and as much tax-advantaged income (eligible Canadian dividends, capital gains) outside the registered account. Unlocking the assets from an RRSP in a tax efficient manner is also a non-trivial issue to examine, which strongly depends on personal circumstances. The TFSA is a simple matter with our existing rules – it should always have something inside it.