Canada – Page 47

TFSA account transfers

If you are considering changing where your TFSA account is, it is probably easier to liquidate around this time of year (mid December) and withdrawal all the funds from your account and deposit the cash to a new account early in January of the next year. Assuming you have $5,100 in a TFSA account on December 15, 2009, if you withdraw it before the end of the year, your TFSA contribution room on January 1, 2010 will be $10,100 ($5,100 plus $5,000) and you can open up an account wherever you want and deposit it. In fact, you can open up an account and just fund it exactly at the beginning of the year.

If you withdraw the $5,100 on January 1, 2010, you will have to wait until January 1, 2011 in order to be able to bring the $5,100 of capital into the TFSA tax shield.

The true value of the TFSA won’t be felt until years later when everybody will have contribution rooms sufficiently high that you will be able to shield considerable amounts of savings – assuming interest rates ever rise to respectable levels again (e.g. 5%), in 10 years, you will be able to shield $50,000 at 5% interest, or about $2,500 of tax-free income a year. This essentially will create a risk-free situation for most ordinary people to shield interest income from the government.

The TFSA is truly a financial instrument of lower-income Canadians, while the RRSP is the preferred vehicle for higher-class Canadians. Unlike the USA Roth IRA, the Canadian TFSA is a heck of a lot more flexible – you do not have to wait until you are 59.5 years old to withdraw funds without tax penalty.

What ever happened to Menu Foods?

Menu Foods was a company that ran into a huge amount of trouble for distributing pet food that contained Melamine, which caused kidney problems in pets, sometimes leading to death. The first precautionary recall was in March 2007 and then it took another month for them to isolate what exactly was causing the problem. It was through a supplier, ChemNutra Inc., who used wheat gluten that was imported from Xuzhou Anying Biologic Technology Development Co. in Wangdien, China. The whole history of the case is documented on the company’s website here.

These series of events took the company’s units from seven dollars a share to about one dollar less than a year after the news broke. Financially, the company is not on solid ground – although it was somewhat profitable before this incident (making about $24 million in distributable cash in calendar 2006), its balance sheet was quite leveraged, with a net debt of about $100 million.

Fast forward a few years, it still has the debt – some $105 million. The only difference is that $75 million matures in October 2010. The company breached its covenants in 2007 (primarily due to the aforementioned recall) and as a result had to cut its distributions to zero and pay its creditors a rate of LIBOR plus 5.8%.

Lately, however, the company seems to have recovered from its near-death experience: they have settled the lawsuit, and they are now generating cash again – about $11.1 million in free cash in the first 9 months of 2009. Their units, in response, have gone up from about 80 cents at the beginning of the year to $2.50 currently; at 29.3 million units outstanding, that is approximately a market value of $73 million.

The primary hurdle for Menu Foods at this point seems to be the renegotiation of their $75 million debt. If they can achieve this, then unitholders will be sitting pretty and perhaps distributions could continue after they have continued to deleverage their balance sheet. It is interesting to note that a company that was originally on its deathbed is now positioned to survive, in no part due to investors’ risk preferences being expanded in the zero interest rate environment.

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.