Canada – Page 48

Canadian Interest Rate Projections

The following are the projected 3-month interest rates, determined by the 3-month Bankers’ Acceptance Futures… note that these are quoted in 100 minus the percentage rate expected, so 97 would be equal to 3%. My gut instinct would suggest that the March and June contracts are slightly undervalued, but well within a margin of error. Essentially this is a bet on whether the Bank of Canada will stick by its conditional June 2010 deadline before it will consider raising interest rates:

Month / Strike	Bid Price	Ask Price	Settl. Price	Net Change	Vol.
+ 09 DE	99.560	99.565	99.565	0.000	5301
+ 10 JA	0.000	0.000	99.545	0.000	0
+ 10 FE	0.000	0.000	99.525	0.000	0
+ 10 MR	99.510	99.520	99.510	0.010	3909
+ 10 JN	99.330	99.340	99.330	0.000	13737
+ 10 SE	98.910	98.920	98.910	0.000	5674
+ 10 DE	98.450	98.490	98.470	0.050	2102
+ 11 MR	98.120	98.130	98.130	0.040	945
+ 11 JN	97.720	97.820	97.810	0.030	429
+ 11 SE	97.410	97.500	97.500	-0.010	150
+ 11 DE	97.090	97.190	97.260	-0.040	75
+ 12 MR	96.870	96.950	96.960	0.010	7
+ 12 JN	96.670	96.770	96.790	-0.020	46
+ 12 SE	96.550	96.650	96.690	-0.050	32

Half-year fiscal report card for Canada

The September update of the Fiscal Monitor is out. This is the half-year mark for fiscal reporting in Canada. We have as follows, for the first half-year comparing 2008-2009 vs. 2009-2010:

1. Personal income tax collection down 7.5%. This is slightly offset by income tax reductions (by virtue of raising the thresholds for the lower two tax brackets).

2. Corporate income tax collection down 39.5%. This is slightly offset by corporate tax reductions, but this shows that corporate profitability has fallen off a cliff between years.

3. GST collection down 17.9%. This is a good indicator of consumer spending.

4. EI Benefits paid up 50.1%. Probably the best proxy measure for unemployment – these people in the future, assuming they do not get jobs, will be paying less in personal income taxes as well.

5. Budgetary balance of a $28.6 billion deficit for the half-year. Extrapolating this out for a full year will result in a $57 billion dollar deficit for the year, slightly higher than the government’s projection of $55 billion.

Oddly enough, public debt charges (i.e. interest on debt) is down from $16.5 billion to $15.1 billion which is because of the very low interest rates offered by the Bank of Canada on public debt. As the term structure of interest rates is severely low at this point in time, it makes one wonder what will occur if or when interest rates start to rise again. Right now the Bank of Canada will happily take your money at 1.12% for 2 years. It will also take your money for 3.22% for 10 years. At this moment, the Bank of Canada should be trying to sell as much long-dated debt as they can, as they are receiving exceptionally low rates.

Income Trust Taxation in 2011

In Canada, income trust distributions will be taxable to the level where the trust would be roughly equivalent for them to convert into a corporation and distribute dividends from after-tax income. Because a simple corporate structure is easier to understand for most investors, in addition to being cheaper to maintain, it is likely that most conventional income trusts (except for the REITs, which will still have the same tax-free exemptions as existing trusts do) will convert into corporations before the conversion deadline.

There are a whole litany of tax issues involved with conversion (which can be read in the explanatory notes in the July 2008 legislative proposal), but the salient detail is that income trusts by the end of December 2012 will have to convert to corporations in order to prevent a deemed disposition (i.e. tax consequences for unitholders).

In the meantime, trusts will have a distribution tax, both a federal and provincial component. The Federal component will be based on the large corporation tax rate (16.5% in 2011; 15% in 2012 and beyond), while the provincial component will be based on a weighted average where the trust earns its distributable income and the respective province’s large corporate tax rate. In BC, this will be 10%. So in 2011, a trust that operates in BC will have a 26.5% distribution tax put on its distributions; the way to calculate “equivalent distributable income” is by dividing the pre-2011 distribution by one plus the distribution tax.

So for example, if an income trust distributed 100 cents a year of income in 2010, the equivalent will be $1.00*(1/(1+0.265)) or $0.7905/share in 2011; in 2012 this would be $1.00*(1/(1+0.25)) or $0.80/share.

It should be noted that the income coming from trusts will be considered eligible dividends in 2011 and beyond; as a result, the tax treatment to Canadians will more than offset the loss in trust income. At the low tax bracket, the marginal rate for a BC resident for trust income will be 20.06%, while eligible dividend income will be -9.42%. So a $100 trust distribution will end up as $79.94 after taxes for a low income earner, while a $79.05 eligible distribution will yield $89.50 after taxes. At the top tax bracket, $100 of income will end up as $56.30 after taxes, while a $79.05 eligible distribution will end up as $60.15 after taxes.

The take-home message is that once 2011 rolls around, there is going to be no excuse whatsoever to keep income trusts inside the RRSP; they should be immediately removed and placed into a regular taxable account. Alternatively they can be placed inside the TFSA, but one would surrender the tax benefit of the dividend tax credit.

August 2009 Fiscal Monitor Released

The Ministry of Finance released the August 2009 Fiscal Monitor today, which is the best at-a-glance fiscal picture of Canada. I covered the July month in a previous post.

The extra month of data continues to print a grim picture – while personal income taxes in the five months between April and August have dropped about 5% (and this does not account for the fact that the government has been reducing income taxes by increasing the basic rate and also increasing the lower two income thresholds in the previous federal budget), corporate taxes continue to fall off a cliff, down 37% in the equivalent period. Only 2% of that is explained by the small decrease in the corporate tax rate between periods.

On the consumer spending side, GST collections actually increased 6% on a month-to-month basis (which is relatively surprising), but the net collections over the five month period has been down about 20%.

Unemployment insurance benefit payments, another barometer of job loss, is up 54% over the equivalent 5 month period last year.

The total fiscal deficit for the 5 month period is $23.7 billion dollars, which if extrapolated, will suggest a total deficit for the fiscal year of approximately $57 billion.

The two take-home messages of this report is that corporate profits in Canada have dropped dramatically; paradoxically, the phased in reductions in income tax that will occur over the next few years (19% to 18% effective 2010; 18% to 16.5% effective 2011; and 16.5% to 15% effective 2012) will have less of an impact and will likely cause more investment to come into the country. The other message is that personal income tax collection seems to be down slightly, but unemployment is rising, but people continue to spend. It makes one wonder how much of a pool of savings there is for people to draw on when they are not working.

Inevitably, Canada’s fiscal situation is stronger than in the USA. If Canada were running deficits equivalent to the level of the USA’s economic output, we would be on track to run a $180 billion deficit for fiscal 2010.