Category: Canada

Pay attention to CRA prescribed rates

With the Bank of Canada raising interest rates, it is likely that the CRA, either starting for the July quarter, but at the latest the October quarter will be increasing the prescribed rate for taxable benefits for employees and shareholders from interest-free and low-interest loans.

A history of this rate is as follows:

Q1-2007: 5%
Q2-2007: 5%
Q3-2007: 5%
Q4-2007: 5%

Q1-2008: 4%
Q2-2008: 4%
Q3-2008: 3%
Q4-2008: 3%

Q1-2009: 2%
Q2-2009: 1%
Q3-2009: 1%
Q4-2009: 1%

Q1-2010: 1%
Q2-2010: 1%
Q3-2010: Should be announced within a week.

The reason why this rate is significant is because issuing a low-interest rate loan is the easiest way to avoid income attribution. Just as an example, if you get your company to loan you money (which you would presumably use for investment purposes), you have to pay the company a 1% interest charge. You would deduct that amount from your income, while the company would include it as interest income on its side of the income statement. Also, spousal loans can be used to avoid income attribution.

While no matter what the rate is there is symmetry (i.e. one party can deduct what the other includes as income, assuming the loaned amount is used for income-generation purposes), higher rates discourage typically discourage borrowing to invest as typically it is the asset-rich entity that loans money out to the asset-poor (and presumably income-poor) entity in order to transfer income to a lower-rate person. If the prescribed interest rate is too high, the loanee will have to take on a higher amount of income at their (presumably) higher marginal rate.

There are rules with respect to the payment of shareholder loans (i.e. you must pay back the principal amount by the end of the following fiscal year or have it be a deemed dividend) but for loans between individuals, there is no duration rule with respect to the amount of interest to be paid – you can make a loan that will expire in 30 years at the rate of 1% for the purposes of the prescribed interest rate rules. Just make sure to document the loan and if there is any question as to the dating of the document, get it notarized or otherwise documented in case if the CRA comes knocking.

Uranium One gets taken over

In a somewhat complex arrangement, Uranium One (which has a primary business of owning and operates several uranium producing mines in Kazakhstan) announced a transaction with its existing 23% owner, JSC Atomredmetzoloto (ARMZ, a Russian corporation that is state-owned by the Russian Atomic Energy Corporation) such that Uranium One will receive an economic stake in two more mines and ARMZ will receive a majority stake in the company.

The salient details are in the press release.

Although I do not have a current position in Uranium One equity or debt, I do keep an active watch of their debentures. They traded up from about 92% to 94% after the announcement. The debentures have a change of control provision, but this is for 2/3rds of the company and not majority ownership.

When dealing with majority-owned companies, you have to be very careful in knowing the motivations of those shareholders – their goals and interests might not line up strategically with the interests of the minority shareholders (which is either to derive an income stream or realize capital gains in the marketplace). As such, you should never own companies that are majority controlled unless if you can answer this question. Some majority owners are there to pillage or otherwise legally transfer the assets of a subsidiary company into a parent corporation and some majority owners like to depress the market valuation of the subsidiary firm just so they can acquire the rest of it. It is rare when the alignment is correct (i.e. the majority owner wants to sell the rest of the stake for a high price, or the majority owner wants to peacefully derive as much long-term income out of their investment).

For shareholders, I would be extremely cautious in the future about Uranium One.

Fortunately, the debenture holders do not really have to care about the motivations of shareholders (other than their willingness to pay off the debt). Even after the proposed special dividend the company is proposing, the corporation will have sufficient liquidity to pay off the $155M of debentures when they are scheduled to mature on December 31, 2011. At a price of 94, they have a current yield of 4.5% and a potential capital gain of 3.9% annualized assuming redemption at maturity.

Both shareholders and debenture holders also realize the same risks with respect to having a Canadian corporation owning and operating mineral rights in foreign countries. I have no idea as to the political stability of Kazakhstan, but would be slightly comforted in knowing there are a few directors on board that speak Russian and would have some clue about the legalities of their political system. However, I would not be comfortable as a shareholder knowing that a Russian government corporation controls the board of directors in the company. Their only vested interest would be to maintain control of the company, and at least this means they should be paying their December 31, 2011 debentures.

The state of the Canadian wireless telecom market

Back in the 1990’s, the players were the telecoms we know today (Telus, Bell) and three companies that the younger generation doesn’t know much of today – CanTel (which was taken over by Rogers), Microcell (which is most known as Fido, but was taken over by Rogers) and Clearnet (which was taken over by Telus).

Putting a long business story short, all the original competitors went away except for Telus, Bell and Rogers. Telus and Bell had their landline markets subsidizing the wireless capital construction, while Rogers had (and still has) their cable business. CanTel, Microcell and Clearnet were exclusively wireless providers and did not have enough financial capacity to remain as businesses. Microcell was the last holdout before it got munched by Rogers in 2004; although it should be noted that Microcell was in dire financial straits well before this date.

Fast forward ten years and the consolidation, and we now have some new entrants into the Canadian wireless market. They are Public Mobile (concentrating exclusively on the low end user of Toronto/Ottawa/Montreal); Wind Mobile (recently introduced in Vancouver and currently concentrating on a broad approach across metropolitan centers in Canada minus Quebec) and Mobilicity (in the same market space as Wind).

I predict that none of these companies will be making any money, but the consumer, over the next couple years, will be receiving some excellent deals for mobile voice/data service.

In particular, Wind Mobile should be a formidable competitor by virtue of having a deep-pocketed parent, Orascom. I am less certain that Mobilicty will last as long, simply because they likely are less capitalized. I have no idea how Public Mobile will do, but they appear to have a very low cost approach which may work simply because the major companies have too much fixed overhead to compete properly (on a cost basis) against Public.

I also highly suspect that the reason why Shaw Cable is waiting so long to get into the mobile market (even though they have made the proper wireless spectrum purchases) is because they want to see who consolidates with who – or maybe consider its entry into the Canadian wireless market through a purchase once Wind and Mobilicity have lost enough money and want to give up.

So my deep suspicion is that Shaw Cable and the retail consumer will be the big winner in the Canadian wireless market over the next few years.

Eating a little bit of crow on interest rates

I strongly thought the Bank of Canada was going to raise 0.5%, and the futures markets were not inconsistent with this belief, but instead, they raised 0.25%. Global factors (including Europe) is likely the reason why they went for the more conservative rate hike. They have also said that future rate hikes are not going to be as quick as the markets anticipated:

In this context, the Bank has decided to raise the target for the overnight rate to 1/2 per cent and to re-establish the normal functioning of the overnight market.

This decision still leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in light of the significant excess supply in Canada, the strength of domestic spending, and the uneven global recovery.

Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.

Now that I have completely destroyed any credibility that I had on the issue of short term interest rates, I will give my new projection:

July 20 (raise 0.25% to 0.75%)
September 8 (raise 0.25% to 1.00%)
October 19 (raise 0.25% to 1.25%)
December 7 (raise 0.25% to 1.50%)

Between now and the end of the year, the prime rate will rise from 2.25% to 3.50%, and your average variable rate mortgage of prime minus 50bps will go from 1.75% to 3.00%.

There is no indication that these quarter point rises will stop in 2011; although the markets are now hinting the short term rate will level off around 2.75% (prime rate of 4.75%). This will clearly be conditional on how fast the economy recovers and the onset of inflation.

Bank of Canada Interest Rate projections

The June 3-month banker’s acceptance futures are trading at 0.89% at present.

This suggests that the short-term interest rates (the target overnight rate) will likely raise 0.5% to 0.75%. However, the banker’s acceptances generally are a quarter point over the prevailing target rate, which suggests the market is pricing an approximate 40% chance that the Bank of Canada will only raise 0.25%.

One month T-bills are at 0.23%, 3-month T-Bills are at 0.47%.

My justification for a 0.5% raise is simple – they want to make a statement.

I rarely have strong feelings about currency trading, but my guess is that the Canadian dollar will spike briefly on the announcement and then will go through a decline.

Most of the media thinks that the Bank of Canada rate increases will result in currency appreciation, but they will get the opposite results – low interest rates causes a lot of currency holding through carry trading. Since traders are on the margin side, a higher rate will result in currency outflows. It is likely the US dollar will be the one to rise relative to the Canadian dollar, so I’d get your cross-border shopping in sooner than later. You can also do “cross-border shopping” by buying US equities. The markets suggest that the US federal reserve will start raising rates around the beginning of 2011.