Taxation – Page 4

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.

Anatomy of a trade decision

As I indicated previously, I am interested in trimming my long-term bond positions since I believe the market for less-than-stellar debt is becoming expensive for the risk taken.

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.

Income trust conversions and RRSPs

On January 1, 2011 there will be a slew of Canadian income trusts that will be converting to corporations. In addition to these, all other income trusts that are not related to real estate will have their distributions taxed. Either way, the dividends or distributions will be considered eligible dividend income for a Canadian investor.

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.

CRA Prescribed rates for Q3-2010

Thanks to the comments from Jeff Usher, it appears my initial thoughts about the CRA prescribed rates were incorrect. I consider myself well-researched in these matters, but once in awhile, things slip and this was one of them. Thank you Jeff.

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%.

CRA Prescribed Rates – Update

Earlier I wrote about CRA Prescribed Rates and how they are used.

Given that it is nearing the end of June, the CRA has not published updated prescribed rates for the third quarter yet. They traditionally publish the next quarter’s rates at the beginning of the month before the next quarter (i.e. for a second quarter announcement, they would announce the prescribed rates at the beginning of March).

I would suspect they are doing this because they are planning on increasing the prescribed rate for interest on loans to 2% from 1% currently. They would want to give as little notice as possible of this, to avoid a scurry of people making quick 1% loans to avoid interest attribution.

So for those of you that take advantage of this process, I would highly advise you to get your paperwork prepared for a quick transaction at the end of June in the event that my suspicions are correct.