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.

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.

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.

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.

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.

As such, a common tactic is to look for securities that have not fared well during the year and purchase them close to year-end as there is likely to be more supply pressure.

It is also possible that this year there will be supply pressure on the income trusts that will be converting to corporations on January 1, 2011. As it is financially optimal for Canadians to be transferring these securities outside of registered accounts and into non-registered accounts, it will not be surprising to see some anomalous price action as the year comes to a close. Even though assets can be transferred between non-registered and registered accounts (by doing an equal-value asset swap in an RRSP, but not TFSA) there is likely to be extra volume seen on the exchanges.

1. Interest income – treated as fully taxed income;
2. Eligible Dividend income – treated as income multiplied by a gross-up factor (2010: 44%, 2011: 41%, 2012: 38%), and the net amount is reduced by a dividend tax credit (2010: 25.88% of actual dividend);
3. Non-Eligible Dividend income – treated as income multiplied by a gross-up factor (25%), and the net amount is reduced by a (lower) dividend tax credit (2010: 16.6667% of actual dividend);
4. Capital gains taxes – taxed at half the rate as ordinary income.

For this post, I will just concentrate on capital gains.

The cost basis of an investment should only be considered in the context of taxation. In all other circumstances, fair market value must be considered. The only value that the cost basis of your investment has is with respect to how much of a penalty (for gains) or reward (for losses) you will incur if you dispose of it. In a registered account (e.g. RRSP/TFSA), the cost basis of an investment is irrelevant.

Let’s take a hypothetical investment between two securities. Security ABC is a perpetual bond, paying $10 per unit. Security DEF is a perpetual bond of the same issuer, with substantively the same seniority/call provisions as ABC, paying $8 per unit. Your marginal rate (to make the math easy) is 50%.

Let’s pretend you bought ABC for $80, netting a pre-tax yield of 12.5% and after-tax yield of 6.25%. If ABC is now trading at $100/share, what price does DEF have to be in order for the decision to be a net positive? Assume frictionless trading costs, and capital gains taxes are payable immediately upon disposal.

I will answer this in a non-algebraic format to make this “readable”:

Step 1: Calculate how much capital you have at work. The answer is $100, not $80.
Step 2: Calculate how much capital you will have at work after disposal. Since your gain is $20, you will be taxed 50% of $10, which is $5. So the answer is $95 of capital.
Step 3: Factor in the yield differential. For this to be a break-even transaction, your $95 in after-tax dollars must equal the income of the prior portfolio, mainly $10. $10/$95 = 10.53%, so you must buy DEF below $76/unit in order for your transaction to make financial sense.

Note that if the market was efficient, when you bought ABC at $80/unit, you were receiving a 12.5% pre-tax yield. At this same time, DEF should have been trading at $64/unit. So when ABC appreciated 25% to $100/unit, DEF should have appreciated 25% to $80/unit. Instead, the frictional cost of the capital gains tax has required the optimal re-allocation of capital to $76/unit. If DEF, for example, was trading at $78/unit, it would be capital-efficient to swap out of ABC to DEF on a pre-tax basis (ABC = 10.0% pre-tax, DEF = 10.26% pre-tax), but not an after-tax basis.

This is why capital gains taxes result in capital mis-allocation. The larger the capital gain tax, the higher the mis-allocation. It gives investors an incentive to hold onto winning investments longer than they should.

Note this argument works in the other direction – if you had a capital loss situation on ABC, you would have received an incentive for purchasing a less efficient DEF to capture the proceeds of the capital loss despite taking a lesser percent yield.

Although I am adverse to income taxes, you should never let income taxation be the overriding factor in the decision to sell – valuation should be the primary consideration, along with your portfolio considerations, and then income taxes should be a secondary consideration.

An example today was trimming a trust preferred (which held a corporate bond) position in Limited Brands (NYSE: LTD) that I have held onto since late 2008. The security is due to mature in 23 years from now (March 1, 2033) and pays a 7% coupon semi-annually. The underlying company’s equity is trading relatively high, has a moderate amount of debt ($2.6 billion debt vs. $1.2 billion cash on hand), good income ($560M in the last 12 months) and an excellent brand name. So the underlying company, in the short and medium run, is likely to be solvent and be able to raise money and retain their cash generation abilities. It would not surprise me if they were able to be solvent in 23 years to pay off the underlying debt. My cost basis on the units are 35 cents on the dollar, which represents one of the best trades I have done in some time, but this will also represent a large capital gain when liquidating.

Back then, 35 cents on the dollar meant you got to collect a 20% current yield, and another 4.5% implied capital gain by waiting patiently. Now, the market has taken all of those coupon payments and gains and transformed them into a higher unit price – so instead of waiting 20+ years to realize that money, you can do it now. What I am trying to say here is – your cost basis is irrelevant except for factoring in the cost of capital gains taxation. The current market value that you can liquidate the securities with is the relevant factor – if I have $X that I can liquidate from this security, can I deploy it elsewhere more efficiently than the implied 7.7% it is paying me?

So why trim the position? 7.7% sounds pretty good over 23 years, doesn’t it?

There are a few reasons.

- The valuation appears high. At the current trading price (94 cents on the dollar) it is significantly higher than the underlying bond’s price that is available through TRACE. At 94 cents, your current yield is 7.4%, and your implied capital gain (which is the 6 cents of appreciation you earn upon maturity) is another 0.3%, so your total yield is 7.7%. While a 7.7% yield is about 4% higher than you can get with underlying treasury bonds, it still is not a sufficient threshold.

- I want to increase my cash balances. While I believe the next big macroeconomic move in the economy will be an inflationary cycle, it will completely depend on the timing of US politics. Right now the US economy is dominated by political considerations and this is why most businesses are choosing to hoard cash – since in times of political uncertainty you do not know the return on investment. A more business-friendly administration would result in a large inflationary spike. Right now we have the exact opposite of a business-friendly administration.

- I want to shorten the duration and term of my bond portfolio, for pretty much the point I made above.

- I do not need the yield, but apparently others do. They are willing to pay for liquidity, so I am willing to give it to them for a cost – they have to meet my asking price on the exchange.

- I am afraid that interest rates, while very low by historical standards, may increase. I am also not concerned to waiting a longer period of time for those rates to rise, and get to hold onto my capital in the meantime to perhaps deploy to a better area.

- Maybe the underlying business will face a downturn. It is in the consumer fashion industry, and while the Victoria’s Secret brand is unlikely to degrade anytime soon, maybe consumers will be a little more fickle in the future. I have no clue when it comes to retail fashion which trends will stay and which will not and can only evaluate these companies from a financial perspective. A great example is Coach (NYSE: COH), which to my neanderthal male mind, mainly makes handbags and accessories. But somehow this company produces insane amounts of cash. Will this trend continue? Who knows. But what I see financially there is a cash machine. I generally ask fashion conscious women for insight on these various names once in awhile to see what the intangible aspects of the brands are.

I am giving up a further potential upside of about 6% capital appreciation (since the trust preferreds contain a call provision they will not trade much above par value) in exchange for the safety and security of cold, hard cash. Right now I do not have any targets for my cash, so I will continue to be patient. Eventually the equity markets will contract and some opportunities will present themselves. It is unlikely it will ever be like late 2008 for awhile, but we will see.

This means that for those investors that have these instruments in an RRSP that what was previously given off as income will now be heavily favoured with respect to taxation, and will be relinquishing the tax benefit by keeping these securities. The obvious action would be to swap these securities with equivalent cash at the beginning of 2011. You can then populate the RRSP by purchasing the relevant income-bearing securities when the market timing is convenient.

A middle-income bracket investor in BC (between $41k and $72k) that is able to shift $1,000 of dividend income from the RRSP to a non-registered account, and swapping into the RRSP $1,000 of straight income will be saving approximately $284.10 at tax time.

It is worth thinking about this procedure throughout the second half of 2010 and see if one can purchase income-bearing instruments if/when the market conditions are appropriate. It is also a good time to think about portfolio balancing.

What is making life difficult for most income investors is that income investing (such as going for dividends or securities with larger-than-GIC yields such as preferred shares) is coming back in vogue with the retail investing arm. Such securities are being purchased without consideration of underlying value in the company’s ability to pay such income. An example would be the equity of Rio-Can, which is the largest Canadian REIT; although I believe their income payouts (6.88% on a $20.05 unit price at present) is stable, in terms of valuation, investors are purchasing something that appears to be more than fully valued and will likely not provide material upside on income payouts.

If/when the debt market seize up again, such securities will look significantly more attractive than they are today. Chasing yield when the going is good involves much more risk than chasing yields in the middle of a crisis.

The CRA, on June 28, 2010, published the third quarter prescribed rates.

Apparently the reason for the delay is that Bill C-9 implemented a reduced rate of accrued interest for corporate overpayment of tax. Corporations were using the CRA as a savings account, where they were getting higher rates of interest than the banks. In the previous quarter, this amount was 3%, but going forward it will be 1%.