How capital gains taxes impact investment decisions

There are four ways that investments are directly taxed in Canada:

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.

The Canadian Dollar see-saw

Attached is a chart of the last six months of trading of the Canadian dollar, relative to the US dollar:

One issue I have with technical trading is that in retrospect it is obvious there are “trends” and “momentum” factors as participants try to load up (or dump) the product in question, but when does the party end? Today? Tomorrow? Next week? How will you know the party ends? Right now, “sell at 98, buy at 95” seems to be the optimal algorithm. We will see if that’s the case or not.

Even though I’ve got exposure to both currencies, I will only be watching this from a distance. It’s very difficult to know whether the Canadian dollar is “fairly” valued or not – how do you even begin to construct a fundamental model? This is why a lot of currency traders are primarily technical – hop on the bandwagon, and hope others are still keeping the cart going before you dump your trade.

Why I will never invest in China

John Hempton has a classic story of his research on an “online” travel agency.

My rule of “Never invest in a jurisdiction that does not have English as its primary language” holds very, very true. I am sure there are a lot of wildly profitable companies in China, just that you can be absolutely sure that minority shareholders’ interests (i.e. the suckers that buy a few hundred shares to have a “China play”) will never be in alignment with the board of directors or management. In this particular case, UTA looks great on paper, but is likely their accounting and reporting is completely crooked.

In their last 10-K filing, you even had the auditors (a firm I’ve never heard of in New Jersey) saying in their audit letter the following:

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following material weaknesses were identified:

The Company’s policy documentation of all controls identified during their assessment and remediation process was incomplete.

Lack of technical accounting expertise among financial staff regarding US GAAP and the requirements of the PCAOB, and regarding preparation of financial statements.

These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2009 consolidated financial statements of the Company as of and for the year ended December 31, 2009.

Translation: “We have no idea whether these guys were lying to us when they provided us with alledged ‘proof’ of the revenues, expenses and balance sheet items you see here. Good luck!”

Suffice to say, I wonder if Hempton (who has probably made a small fortune shorting this thing earlier when the stock was trading higher before writing this huge article on the company) will be able to single-handedly get the stock delisted when his 2,200 readers (at least according to Google Reader) eventually hammer the stock down to the zero it probably deserves.

Just for full disclosure, I am not long or short the stock, nor do I plan on trading the stock. Trading from other people’s research is a great way to lose money – capturing real value in the market is done by performing independent research when nobody else is watching.

You get what you pay for… sometimes

An article (link) on the proliferation of finance-related sites on the internet offering all sorts of advice.

My only comment on this is that you get what you pay for. And even if you pay for it, sometimes you still don’t get what you pay for.

Your only real defense is to be able to ask critical questions and be able to correctly evaluate the people you deal with.

As for the internet, I have a high aversion to people that do not use their real names. A few anonymous sites out there are fairly well written, but when you attach your name to your writing, you are telling the world out there that you are willing to risk your reputation with your written word.