In the last episode, we covered the types of accounts that we can hold investments in Canada. Each account has specific features and rules that dictate how they should be used. Most of the account types – called registered accounts – also have limited contribution room. The one account type that is unconstrained by contribution room is the taxable investment account.
Unlimited contribution room might sound great, but unlike registered account a taxable investment account is fully exposed to taxes on investment returns. In this episode we dig into the nuances of taxable investing. You can grow a massive dragon-sized hoard, but must be aware of how that attracts the tax-hobbits.
[0:00:02] BF: Welcome to the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, portfolio manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka the Loonie Doctor.
[0:00:17] MS: Welcome back. In our last episode, we covered the registered account types that are available to Canadian investors. Those registered accounts are basically government-registered tax shelters and they include accounts like RRSPs, TFSAs, FHSAs, RESPs, RDSPs. If you don’t know what all those letters are, go back and listen to that episode, because it’s really important. They have special tax benefits and there are some restrictions, but there may even be some grants.
[0:00:45] BF: Yeah, and the biggest restrictions for most registered accounts are going to be the contribution limits. Most high-income Canadians are going to be able to fill up their registered accounts very quickly and they’re probably still going to have money beyond that, that they want to invest for their future financial security. That means, once your registered accounts are full, using non-registered, or taxable investment accounts, people often get hung up when it comes to investing in their taxable accounts.
[0:01:07] MS: One of the big reasons why that happens is that people are afraid of making a mistake and then having bad tax consequences due to that mistake, or they’re afraid of investing and simply having to pay more tax than they need to. However, the reality is that missing time invested in the market is going to be a much more costly mistake. We hope that this episode is going to give you some of the confidence to push forward and then get moving into that direction if you need to.
[0:01:34] BF: Yeah, exactly. We use the push on terra money scope to get a look at the first part of the investment taxation in the last episode with the registered accounts. Today, we’re going to advance it further, shining a light into investing using personal taxable accounts. Then in the next episode, we’re going to delicately manoeuvre through the basics of investment taxation using a private corporation.
[0:01:52] MS: Yeah, and it’s pretty easy to get disoriented in the bowels of investment taxation. We are actually going to not only take a look at the main lumen, we’re going to get into some of the nooks and crannies, like different income types, attribution rules, and tax loss harvesting. Those all form the base for not only just investing when it’s exposed to tax, but you can actually use it for some tax planning with your investments on top of that.
[0:02:16] BF: Yeah, definitely. We will get into that later. All right, with the bite block in, there isn’t much else to say, except.
[0:02:27] MS: Okay, so we’re going to get started. The first question, of course, is why bother with a taxable investment account? We touched a little bit about that in the intro. In the last episode, we talked about all the common registered investment accounts. They all have tax sheltering, some tax to furrow, and some even have grants. Why would you bother with taxable investments on top of that? We mentioned in the preop, some of those accounts have contribution limits and most tying professionals and business owners are going to need to invest money beyond that to meet all of their saving requirements. That’s going to force them into using taxable accounts.
However, beyond that, using taxable accounts in the mix with your other registered accounts can come with some opportunities. We’re going to explore some of those today, as we’ll also unpack how investment taxation works. Yes, you will have to pay taxes. However, even with registered investment accounts, you’re paying some taxes as well. There’s going to be foreign withholding taxes that may not be recoverable. With tax-deferred accounts, you’re going to pay tax eventually anyways. Like with an RRSP and even with an RESP, where it’s contributed with after-tax money, it’s going to be taxed in the hands of the student.
Growing your pot of after-tax money can help to hedge against some of that higher future income tax. If the income tax rates rise in the future, then tax deferral is not always a good thing. RRSP could leave you potentially exposed to that, same with the corporation. This allows you to have more options when you go to draw down your portfolio in the future. Even if you are drawing it down while you’re alive, it can leave you more options when you’re doing your estate planning as well.
Sometimes you can even use a taxable account to efficiently income split while you’re alive, too, and you’re saving money along the way. For the people that are more adventurous, there’s advantages with using a taxable account when you’re taking risks. You share some of that risk for the capital growth and the capital losses with the government. If you are going to use something like leverage to invest, you may also be able to deduct the interest against your marginal tax rates. There’s some tax opportunities there as well.
[0:04:32] BF: Yeah, that’s right. Hopefully, dangling all those little tidbits will help motivate you to hunker down and tolerate this procedure. We’re going to start with discussing some basics about investment income and taxess to understand how all this stuff works. Then we’ll get into the attribution rules as they apply to income splitting using investments. Then finally, we’ll cover a couple of the common missteps that people can make using taxable accounts.
As Mark and I mentioned in the last episode, people often get paralyzed when it comes to getting invested in their taxable accounts, or they focus on the wrong things. Shining a light into this will hopefully make it less scary to get you going, avoid simple mistakes, and maybe take advantage of opportunities that you hadn’t considered.
[0:05:10] MS: Yeah. We’re going to get started with the basics of taxes and investing. The first thing to know is that investment income actually comes in multiple different forms. Each form, which we’re going to detail in a minute, has different tax attributes associated with it. As a foundation for taxable investing, we’re going to go through the main types of investment income. That’s going to include interest income, Canadian dividend income, foreign dividend income, and realized capital gains. Those will be the big categories. Before we get there, we need to have some important background.
This may seem like we’re poking the money scope into a little diverticulum, but it will make the rest of the episode easier to understand. Probably easier to understand than the medical terms that I occasionally drop, like diverticulum, which is just a little outpouching in your intestines, your colon. Why don’t we get started with the first one? Let’s talk about tax integration.
[0:06:02] BF: Okay. Tax integration is the theory that no tax advantage or disadvantage arises from earning income in a corporation. It’s the theory that the Income Tax Act is neutral to the form of economic organization used to earn income. That’s a lot of words there. Perfect tax integration just means that the total tax payable by a corporation and by its shareholders is equal to the taxes that would have been paid by the individual shareholders themselves if they had earned the income personally.
Then the way that this theory is expressed in practice, the way that it actually works, practically speaking, is that at the level of the individual investor, different types of income receive different tax treatment, such that the individual’s taxes are integrated with the company they’re receiving income from.
[0:06:45] MS: Yeah. Basically, whether you earn income directly, or through a company, it should in theory be taxed exactly the same. Just to be clear, this whole idea of tax integration is not only for private corporations. That’s where we often talk about it when we’re incorporated. Just like investing using a private corporation, it also applies to publicly traded companies as well. Any Canadian investing in a Canadian company, those big Canadian companies that are publicly traded are going to pay likely eligible dividends from their after-tax corporate profits. There’s some tax paid there, then that’s accounted for.
Those taxes paid by the company are accounted for, and then those eligible dividends when they’re taxed at the personal level account for some of that so that you’re not going to get taxed twice in theory. We’re going to detail how that works. Similarly, interest income is a deductible expense for a company. When a company is going to pay out interest, that’s going to be fully taxable in your hands. The end receiver pays the taxation burden of interest income.
Now, foreign companies are a little bit different, because they’re not part of Canada’s tax system. Tax integration was set up for Canada’s tax system, but foreign companies are outside of that. When you receive foreign dividends, there is no credit at the personal level for the taxes that were already paid by that company. They’re going to pay business taxes wherever they are and then you’re going to pay tax on the dividends as regular income.
Plus, the other thing is that most companies will actually tax those dividends paid by the companies that are housed there before they allow them to be paid out to foreign investors. It’s a way of trying to prevent tax evasion. That’s called foreign withholding tax. You can sometimes get some of that foreign withholding tax back if you pay Canadian tax. That way, you’d avoid double taxation and there’s no tax evasion going on. But it doesn’t always work out that way. I would say, with integration out of the way, I think we’re ready to dive into some of the details of the different types of investment income and how they’re taxed.
I would say, to note, that we’ll be focusing on the discussion of tax treatment investments held in a personal taxable account. That’s where the tax integration is most clean. Just with an individual person, rather than a corporation. However, we will reference registered accounts, and corporate accounts occasionally. We’re going to get into the full details of corporate investing through using a corporate investment account in a future episode. It’s a bit more complicated, but it does build on the knowledge base from this episode, even though we’re going to do that in a separate episode. Want to try to reduce the risk of intracranial hemorrhage from too much information being crammed in there at once.
[0:09:22] BF: That’s absolutely right. Always safety first with the Money Scope.
[0:09:26] MS: That’s right.
[0:09:27] BF: We’ll also start with what’s usually the safest investment income stream, which is interest income. As you mentioned earlier, Mark, interest income is fully taxable to the receiver, since it is tax-deductible to the payer. If a corporation issues a bond and then makes an interest payment, they get to deduct that payment from their income for tax purposes. Then when you get paid that interest, the whole amount is added to your taxable income for that year. You’re typically going to receive interest from things like bonds and GICs. One interesting nuance with GICs is that you have to pay taxes on the interest accruing each year. Even if you don’t actually receive the interest, the accrued interest on the GIC is taxable.
[0:10:03] MS: Yeah. They get their taxes on time, whether you like it or not.
[0:10:07] BF: Yeah.
[0:10:08] MS: We’ll start off here with some Canadian dividend income as well. That was the simple one out of the way. Canadian and dividends are a little bit more complicated. Canadian dividend income, it has an interesting system to try to achieve this integration between the company that’s giving the dividend, the taxes they’ve paid and what you’re going to pay. There’s a gross-up and a credit. That seems like an overly complicated way of making the taxes the same, but this is the basic idea. The gross-up means that they’re going to multiply the dividend by a factor.
Now for a large company, it’s a factor of 1.38. If you had a $1,000 dividend, it’s going to be $1,380. That’s to simulate the income that was there with the company before it paid the taxes. That gets grossed up in your personal hands and gets matched against your personal tax bracket. It’s trying to simulate what the company had earned at that point. You get paid those taxes from that taxable tax bracket, but you also get a dividend tax credit, which you get to apply against the taxes that you’re actually going to have to owe and pay. That tax credit is to account for the taxes that were already paid by the corporation. They gross it up to simulate the pre-tax money and then give you a credit to account for the taxes paid by the company that gave the dividend.
[0:11:30] BF: Yeah, and that order is important. When you actually go and look at the income tax forms, the order that happens, which is the gross-up first and then the credit later is really important, because some income-tested benefits, like old age security, OAS, as an example, are tested against your net income that the gross-up of Canadian dividends drives up your net income more than other types of income. The credit does not offset it at that point of the tax return.
As an example, a $1,000 in Canadian-eligible dividend income is going to count as $1,380 of income for income-tested benefit and clawback purposes. The combined effect of the gross-up in the tax credit is designed to make the total taxes that you pay plus the tax of the corporation that had paid the dividend to you has already paid, similar to what you would have paid in taxes if you had earned the income personally. But tax integration is not perfect. It does generally result on dividends in a little bit more combined tax between the corporation and yourself than if you had earned that income personally directly.
That’s easily missed when the corporate taxes on dividends are ignored, which is common. The personal level of taxation on Canadian dividends is low compared to income, but the integrated tax rate on dividends is actually nothing special relative to earning income. The separation of those two ignoring the corporate side of the taxes is called mental accounting. That’s something that we’ll come back to later.
[0:12:49] MS: Yeah. That’s important. I mean, one of the issues with the tax integration is that it’s not perfect and it generally does not favour earning money through a corporation. It generally favours earning it personally. The other nuance that’s important when you’re thinking about this is that not all corporations are paying tax at the same rate. There’s two main categories. One would be the small business deduction rate, which is lower. The other would be the general business rate, which is higher. Now we will get much deeper into that in later episodes on financial planning with the corporation, but for now that is important to know about, because the dividends that are paid from profits taxed at that small business rate, because the rate is lower, require more tax to be paid at the individual level. Those are called non-eligible dividends.
The small business rate limit is only about $500,000. It’s decreased based on passive income and taxable capital in Canada. Suffice to say that large publicly traded corporations are paying tax at the general tax rate, so they’re typically going to be paying out eligible dividends to their shareholders. We’re talking about Canadian dividends in this episode. We’re talking about Canadian-eligible dividends that the corporations already paid the higher general corporate tax rate for. Non-eligible dividends are going to be more of a factor when we’re talking about small corporations.
The other issue I’d say to be aware of is that while the gross-up is the same everywhere across the country, the tax credit part, when that gets applied, actually varies by province. Provinces that have higher corporate taxes will have a higher personal tax credit to make up for that. That’s what is applied at your level. That applies regardless of which province the company is domiciled in.
[0:14:28] BF: Right. Yeah. One important concept that straddles taxes and portfolio management is that idea that I talked about mental accounting. The idea of separate income and capital in thinking about total returns. That’s the thing that I mentioned earlier about mental accounting by separating personal and corporate taxes. When you receive a dividend from a company, the value of that company declines by the amount of the dividend. This means that a dividend does not make you any better off. It’s like moving your money from one pocket, your capital account to your other pocket, your income account. It’s similar to corporate and personal taxes. When a corporation pays taxes, the value of the corporation decreases by the taxes paid. The fact that you get credit for this does not offer benefits when the combined tax rate is considered.
Now, I mean, the fact that you get a credit for it in Canada, because of tax integration, that is good. I’m not saying that’s not a good thing. The fact that you don’t get that from a foreign company, I mean, hey, that’s not ideal either. It’s not like there’s no benefit to the integration in taxes, but what we’re talking about is avoiding double taxation. We’re not talking about any magic. There’s no reduction in income taxes paid. It’s just avoiding being taxed twice. I think that due to that, due to the fact that there’s no magic here, there’s no free money, any fixation on dividend stocks for the sake of their dividends, or the special tax efficiency of Canadian dividends just doesn’t make sense. Investment returns should be thought of from the perspective of total returns, which is the net change in your wealth considering income and capital together.
[0:15:57] MS: Wait. Hold on a second. I just had to administer some extra Valium to the dividend investors. People do get stuck on this concept, and some people get really worked up about this idea of dividends, specifically in focusing on that. I think it’s really important to understand this. When a company has profits, it can decide how to use them. It can reinvest them to hopefully grow the company’s future profits. That’s one of the options they have. They can decide that they’re going to buy back stock. When they buy back stock, that means there’s less stock out there, so the value of each remaining share goes up instead. It improves the capital gain that you’d be getting.
Or they can decide to pay out that profit as a dividend. That’s the third choice. when they do that, of course, when they pay that out, it reduces the assets of the company by the amount of money that you just paid out. The capital value of the company will drop when money and capital is moved out of it. It’s not that decision out of those choices that matters. It’s the increase in the value of the company’s future income, which is expressed as its share price, plus the dividends that are paid along the way. That’s the total return. That’s what actually matters.
Now, that’s a dividend growth, maybe a marker for other company attributes that are actually related to increased expected returns in the future. They are actually valuable. An example would be profitability, conservative growth in the book value of the assets they have. A high dividend yield may also be related to a company having a low relative price. The yield is the dividends paid out divided by the price. If the price is low, that’s going to make the yield higher. Maybe a price issue. We do know that profitability can reserve an investment and low relative price are all related to higher expected returns. Dividend-paying stocks are part of that. They’ve had historically a strong performance.1 That’s led to this focusing on dividends as a popular strategy. It’s a shortcut.
The problem here is that while dividends are a proxy for higher expected return stocks, there’s lots of companies with all those same positive attributes that actually don’t have high dividend yield. There’s more of those than on the other side. There’s also companies that have high dividend yield but don’t have those attributes that we’re looking for for the higher expected returns. It’s a bit of a shortcut, but it’s not perfect. If you want the higher expected returns, you can actually target those positive factors directly, instead of indirectly looking at the dividends. That would lead to a much more diversified portfolio and a better focus on the factors that help you with that return premium.
Plus, as we’re going to get to capital gains are taxed even more favourably than dividends, I mean, even eligible dividends. Canadian dividends are good, but capital gains are better. Of course, foreign dividends have even more tax on them. Focusing on the dividend yield itself could lead to an inferior portfolio, both from the perspective of the total expected return and the after-tax expected return.
[0:18:56] BF: Yeah, that’s a super important point. It’s like, dividends are a noisy and tax efficient proxy for factors that actually matter to the differences in expected returns between stocks. We’re talking about expected returns here. We did an episode on investing basics and we talked about index funds and that’s still probably a good way to invest. The fact that some stocks have higher expected returns, that’s a whole other thing. We don’t want to distract people from low-cost index funds. That’s still the way to go. There’s a whole bunch of financial theory out there about how you can optimize around the edges. Anyway, if you’re going that route of trying to increase a portfolio’s expected returns, dividends are a noisy proxy for more reliable ways to accomplish that.
That was a fun detour into the intersection of taxes and portfolio construction and behavioural finance. Foreign dividends are generally taxed similar to regular income, like interest income, in the sense that they’re fully included in income dollar for dollar as they’re received, but there is an important wrinkle with foreign dividends. You mentioned earlier, Mark, that foreign companies are often required to withhold tax to their local tax authority when they pay a dividend to a foreign investor. That’s called a foreign withholding tax.
Canada has tax treaties with a long list of countries designed to avoid double taxation on foreign withholding tax. The result is that when you pay withholding tax to a foreign tax authority, you often get to use the foreign taxes paid to reduce your Canadian taxes. That’s the foreign tax credit. The foreign tax credit causes issues for people investing in a corporation, and we’ll talk about that in a future episode on investing in a corporation. The integration, I guess, on foreign dividends is pretty weird, pretty uncomfortable when we get to investing in a corporation.
[0:20:40] MS: We’ll have to push the scope gently.
[0:20:41] BF: Yeah, we will. We will. Safety first. Now, paying foreign taxes can also be a problem in registered accounts, like the RRSP and the TFSA, because there’s no taxable income in those accounts, so you can’t get a foreign tax credit to recoup the tax that was collected offshore. The US is the one exception, where a US listed assets held in an RRSP account in Canada are exempt from withholding tax on US dividends. That means holding a US listed stock, or ETF in an RRSP account makes it exempt from the US level of withholding tax.
Now, an important note there is that holding a Canadian-listed ETF that owns US stocks in an RRSP account is not exempt from US foreign withholding tax. In that case, the foreign withholding tax will be collected and it’s not recoverable at all.
[0:21:28] MS: Yeah. That’s an important point. We talked about foreign withholding taxes and the benefit of US-listed ETFs in an RRSP in the last episode. However, for taxable accounts, that doesn’t really matter. You could use a Canadian-listed ETF that holds US ETFs without getting an extra layer of non-recoverable foreign withholding tax. The main benefit of using a US-listed ETF, maybe that there’s a slightly lower management fee just because of the size and volume of the way that ETF is managed. I would also say that there are some Canadian-listed ETFs that hold non-North American stocks directly. That is an area where there could be some form of withholding tax issues.
If you have a Canadian-listed ETF that holds non-North American stocks directly, then the foreign withholding tax should be recoverable. If it’s a US-listed ETF that then is also holding non-North American stocks, then there might be some unrecoverable foreign withholding tax, because you’ve got that second layer that’s there. That may offset the fact that the fees are a little bit lower. All that to say, which is complicated, you don’t need to make it complicated. You don’t need to make your investing complicated with a US-dollar personal taxable investing account, just because you’re trying to use US-listed ETFs.
I mean, the main reasons that I can think of where you might want to use a US dollar account is if you happen to spend a lot of US dollars. It’s just a way of keeping it there without doing a lot of foreign exchange. Or, if you want to use one of these niche factor weighted ETFs that invests in some of these other factors we were talking about, most of those are only available on the US exchanges. Those would be the only two reasons I could think of to do that.
[0:23:06] BF: Those are probably good reasons. It’s definitely the thing that when we start talking about tax optimization, I think this is definitely an area where people can get hung up on trying to optimize for the lowest fees possible, or the lowest withholding tax possible, or the factor tilts. Because the US is such a larger market for investment products, there’s just so much more stuff available there. Yeah, I think, it can add a layer of complexity that in some cases is maybe worthwhile, but in a lot of cases, it’s going to be more work than it’s worth.
[0:23:34] MS: Yeah. They’re going to have to be very selective. If you’re worried about missing out, don’t be. You’re not really missing out on anything.
[0:23:40] BF: Yeah.
[0:23:41] MS: Okay. All right. Let’s round out this segment on income with another kind of income. Net rental income. People that are investing in real estate, the net rental income is another form of investment income. That net rental income is fully taxable as income, just like how interest would be your income from your other sources. It does come with one other unique property compared to other investment income. Net rental income is actually included in the calculation of your earned income for the purpose of calculating your RRSP room, whereas the other forms, investment income or not. It does have that advantage.
[0:24:17] BF: Yeah. I think that’s right. All right. So far, we’ve covered types of investment income, which are typically paid as cash payments from companies to their stock and bondholders, or in the case of rental income, paid as cash payments by tenants, less your expenses for operating the property. You have very little control over the timing of these types of income since you’ve got to pay tax on them in the year that they are received. No, I mean, with people who invest in real estate might be thinking that you can do all sorts of stuff. There’s a whole area of tax planning with rental properties that’s just beyond the scope of what we’re talking about here.
Anyway, you still have not a whole lot of control over the timing of income payments. That means that they introduce something called tax drag, which is a concept that we will come back to in more detail later. The last type of investment income that we want to talk about is realized capital gains. The reason I just talked about tax drag and income is that you don’t have control over the timing of that, whereas with capital gains, you do have a little bit more control over the timing because it only happens when you sell an appreciated asset.
When you purchase an investment, the average cost, plus its expenses related to acquiring the asset is called the adjusted cost base, or the ACB. If the asset later increases in value, the increase above the cost base is called a capital gain. When you sell the investment to access the cash, you’re doing something called realizing the capital gain. Now, that realized capital gain is taxable at the time that you make the sale, in the tax year that you make the sale, not immediately when you sell it.
If you don’t sell, you’re doing something that we call deferring that tax liability into the future to when you do eventually sell it. By not selling an asset, you’re not making the tax liability go away, you’re just deferring it to the future. We call it capital gain that has not yet been realized, an unrealized capital gain. At this time that we’re recording here in Canada, only 50% of a realized capital gain is included in your taxable income, making realized capital gains relatively tax efficient, because only half the gain is included in your income. It is important to note though that 50% inclusion rate has changed over time and it’s definitely not guaranteed in the future.
I think every year since I’ve been working in financial services, when the budget comes out, the federal budget, I always hear rumblings about, “Oh, here they’re going to increase the inclusion rate.” It hasn’t happened yet, but it wouldn’t be too crazy if it did happen. As recently as the 1990s, the capital gains inclusion rate was higher than it is now. It was at 75%. That raises an important point, which is that deferring taxes into the future is generally a good thing. Paying taxes later rather than now is generally good, but it can become bad if future tax rates end up being meaningfully higher than the taxes you would have paid now.
[0:26:53] MS: Yeah. That’s really hard to speculate on. I mean, I’ve been speculating on it too, because we have deficits and today’s deficits are tomorrow’s taxes. The question is just when is tomorrow going to arrive and how is that going to be dealt with, right? We can all guess and guess completely wrong. I wouldn’t use that as my main criteria for selling something. I would say, the other side of realizing capital gains is that actually works the other way, too. You could have realized capital losses.
If you sell an investment for less than its cost basis, that’s a capital loss. You can use those capital losses to offset realized capital gains. You can apply that, take that capital loss, you can apply it back three tax years to recoup taxes that you paid on other capital gains that you’d had. Or, if you had no realized gains that you needed to carry it back for, you can actually carry it forward, so that when you do realize capital gains in the future, that then you can apply that against those gains and not have to pay tax until you’re into a net positive position. You can do that carry forward indefinitely.
This makes investments in a taxable account a little bit less risky, which is not immediately apparent to everybody. The fact is that you’re essentially sharing losses with the government because, with losses, you’re decreasing your tax bill. Now, of course, they also get a share of the profits, but they’re going to get that share pretty much with anything you do. Even though it’s not part of tax integration, there are reasons why capital gains are taxed this way from a practical standpoint. We’re always speculating about what’s going to happen with capital gains taxes, but there are reasons why they’re taxed the way they are, which is a barrier to making completely radical changes to them.
One of the things is that you don’t actually have the money until you realize the gain. If we were to tax unrealized capital gains, then business investors could be forced to sell part of their business every year to pay the tax, because they don’t have money to pay for the unrealized gain that’s getting taxed. You can’t grow business if you have to sell some of your equipment every time you start to grow a little bit. It’s just not a way that we’re going to be able to have the economy function. There’s practical issues with it, too. You have to be able to value your business every year to know how much tax is owed on it. That’s not easy for a non-publicly traded company. You truly don’t know what any company is worth until it’s actually sold. That’s why it’s the realized part of capital gains that are taxed, not the unrealized part.
The other issue is that they’re only partially taxed. There’s a couple of reasons why that is. One is inflation. If you hold an investment for many years, part of its increase in value is likely actually due to inflation. It’s not that you have more income after-tax that you can spend, more buying power. You don’t. Some of that is just inflation. It’ll be worth more in nominal dollars, but not actual buying power. Taxing the whole capital gain would be functionally taxing that inflationary increase, as well as the increase in your buying power. That doesn’t really make any sense and isn’t fair.
The second reason, which I think is more subjective is that we need investors to be willing to risk their capital to grow the economy. This is recognized to be a way that we grow. Having a lower inclusion rate and sharing some of that risk when you’re risking your capital helps to incentivize investor behaviour. This helps to have us invest to grow the economy. While future capital gains treatment is uncertain, it’s a constant source of speculation, particularly when we see government deficits ballooning, there are barriers to treating capital gains exactly the same as other kinds of investment income.
[0:30:26] BF: Yeah, they definitely are. We touch on this later in the episode, but in the US, they have a very different system, where there’s a difference between the capital gains rate, depending on how long you’ve held the asset for. They differentiate between long-term capital gains, which have a lower tax rate and short-term capital gains. That’s incentivizing long-term investment and disincentivizing short-term trading. There’s lots of different ways that a change to the capital gains tax rate could materialize in Canada.
You said it earlier, Mark, it’s really hard to speculate on how that’s going to affect things in the future, but I think it is worth just keeping in the back of our minds as we’re doing tax planning that it could happen in the future, that capital gains, tax rates are a little bit different than they are now.
All right, so moving on from capital gains, we’re going to start talking about something called attribution. A really important point to understand with respect to the taxation of investment income is who has to actually pay the tax bill. For example, if you open a joint investment account, can you just split the investment income 50-50 with your spouse? Or if you give your child money, who pays tax on any income that they earn? The answers to these questions are a little bit complicated, but they are important. We’re going to dig right into them.
In Canada, investment income is attached to individuals, rather than households. Even if you file your tax return with a spouse, there’s no joint tax return in Canada, everything’s attached to each individual. With our progressive taxation system, that can end up making a really big difference if income is attributed to tax in the hands of a high-income spouse, versus a low-income house. As a household, you’d rather split your income equally. But if all of the income is attributed to the higher-income spouse, you end up paying overall more tax as a household.
If the incomes of both partners are similar, or if they’re both in the top tax bracket, then it doesn’t actually really make much of a difference. For anybody in between, there can be a pretty big tax advantage to having investment income attributed to the lower-income spouse, or even more so to a minor child with no other income. Of course, as nice as it would be to be able to just flip income to the lower earner, there are rules in place in Canada to prevent us from doing that and those are called the attribution rules, which is what we’re going to dive into now.
[0:32:28] MS: That’s right. Yeah. These attribution rules come into play when you give your spouse or a minor money. It’s not even just giving the money. If you loan the money, that counts, too. We’ll just go through a few highlights of how that works. Now, for the ease of discussion, we’ll just assume that it actually makes sense to try and do this, so it makes sense to try to shift income from you with a high income to a relative with a lower income. As you mentioned, if you’re both in the same tax bracket, or both in the highest tax bracket, it doesn’t really matter anyway.
The way that this can work with a spouse, or a common-law partner is if you give money, stocks, rental property, or any of those types of things to a lower-income spouse, then any of the income that comes from that, whether it’s dividends, or interest, or rent or royalties, all of that would be attributed to you. That would be taxed at your tax rate. Now, if the property also gains in value from the time of purchase, all those capital gains, which we just finished talking about, those capital gains would also be attributed to you.
You can avoid that capital gains being attributed to you if you file a special election with your tax return for the year that the gift is given.2 What happens there is you end up paying tax. The special election ends up with you paying capital gains tax as if you had sold whatever it is that you’re giving at fair market value. You just pay the tax now and then any appreciation that happens moving forward from that would then be attributed to the spouse.
Now, another notable nuance with who gets attributed to the income is income generated from income. Now, this gets a bit confusing, because we’re starting to move down generations of income. This would be what’s called second-generation income. The income from a loan, or a gift to be attributed to you, but if that income is invested second-generation income, that second-generation income is not attributed to you. It would be attributed to whoever the lower-income person is. We’ll talk about more of that in a few minutes.
[0:34:23] BF: Yeah, the second-generation income stuff is pretty interesting. I want to talk a little bit about attribution with a non-arm’s-length minor child. The same attribution rules are applied to a non-arm’s-length minor child. The gift is considered to be sold by you at fair market value when given. You would pay any capital gains taxes at that time on the disposition. Any capital gains moving forward are going to be taxed in the hands of the recipient, rather than the contributor. That’s interesting. With a minor child, if you give a gift, capital gains accrue to them, as opposed to attributing back to you, like with a spouse.
If the recipient is a minor, if they’re under 18, then you have to report any income. That’s dividends, interest, rent, and royalties generated by the asset back to you so that it’s attributed back to you. With the minor non-arm’s-length minor child, the capital gains attribute to them, but income attributes back to you. Then once they turn 18, the income can then be attributed to them. That’s maybe also worth mentioning that in Canada, you can give a gift to an adult child. If you have a child who’s a minor, there are attribution considerations. But if you have an adult child, if they’re above the age of majority, you can give them a gift and there’s no attribution. There’s no gift tax, anything like that. That’s fairly common. One of those things that is a thing in the US, but not in Canada and then people hear about it from American sources and think it’s a thing in Canada, but it’s not.
[0:35:43] MS: Yeah. We’ve managed to avoid that so far.
[0:35:45] BF: Yeah, true. Never know. Like with the capital gains stuff, it can always change.
[0:35:49] MS: Yeah.
[0:35:49] BF: Then just with a spouse, the income generated from second-generation income is not attributed back to you.
[0:35:56] MS: Yeah. That second-generation income is a pretty confusing point for a lot of people. I think we should spend a little bit more time just talking about that. What that means is the second-generation income is if the recipient gets paid income, let’s say, rent or dividends, then that first-generation income that they’re getting would be attributed to you, taxed at your higher tax rate. However, if the recipient took that income that they got and reinvested it, well, the income generated from reinvesting that income is what’s called second-generation income, and that second-generation income would be taxed in their hands.
As you can imagine, that’s likely not going to be very much money at the beginning. Let’s say, I gave my wife a $100,000 to invest and it earns 2% in dividends. $2,000. She would get that $2,000, but I would pay tax on that, because that $2,000 is attributed to me. If she then took that $2,000 and invested it and it earns 2% of that $2,000, that’s $40, that $40 of second-generation income would be taxed at her rate. The dividends from the shares bought by the original $100,000 would be taxed at my rate.
As you can probably already tell from me trying to describe, this is a bit of a bookkeeping quagmire. A lot of people just forget about it, but really with large sums of money over a long enough investment timeframe, this second-generation income can really become quite significant.
[0:37:22] BF: Yeah. You might have to set some of the tax savings aside to buy a nice gift for your accountant, though, as they pull their hair out. Although you could probably use accounts, right? Like, actual accounts to move different buckets of money into to make the accounting relatively easy?
[0:37:35] MS: Yeah. That would probably a simple way to deal with it.
[0:37:37] BF: Yeah. That was gifts. Attribution with respect to gifts. Now, loaning money to a non-arm’s-length partner, or minor has to meet certain criteria to avoid attribution. You can do it, but it has to be done a very specific way. You can’t just give an interest-free loan. You can’t write down in a piece of paper, “This is a loan. You have to pay it back,” and then there’s no attribution. That’s too easy. That would be treated like a gift by CRA and all of the attribution that we just talked about would apply.
To avoid attribution, and this is very legitimate above-board planning that a lot of people do. The way to get around it is to make a loan at the CRA-prescribed interest rate. That rate right now is 5%. It was lower, like 1% to 2% for many, many years. It’s called prescribed rate loan planning, was very attractive and very common. At 5%, it’s a little bit less. A lot less attractive.
Anyway, so you can lock in the prescribed rate in perpetuity when you make a loan. When I mentioned a minute ago that the prescribed rate used to be lower at 1% to 2%, people that made loans at that time are still locked in those loans, as long as they don’t repay them. If you’d loaned money to a spouse at 1%, a few years ago, that loan is still at 1%, which is pretty attractive.
[0:38:48] MS: Yeah. I don’t think they have to actually pay down the amount they owe either so that you could just carry that amount of money at 1% or 2% forever.
[0:38:56] BF: Yeah, yeah. Exactly. As long as you don’t formally repay the loan, that can just keep on trucking, which is pretty sweet if you got the loan done when rates were low. Now, to make this work, you have to document the loan with a promissory note. You can’t just move the money. It has to be formally documented. The recipient has to pay interest on the loan from their own funds to avoid attribution. They need an income to do that. The interest payment could be deductible against their income if they’re investing in something expected to produce a taxable income, which is that’s the CRA true definition.
My understanding from talking to people who work in tax is that the expectation of earning income is pretty broad. Unless, a company says, “We will never, ever, ever pay a dividend,” then owning a stock that could potentially pay a dividend in the future likely qualifies. Of course, get your tax advice before doing something there.
[0:39:50] MS: Yeah. I think the other wrinkle that comes with that, too, is the amount of income that you would expect to earn does not have to exceed the interest that you’re paying. You could be expecting to earn 1% in dividends, but paying 5% interest. That’s okay.
[0:40:05] BF: Yeah. Okay from the deductibility perspective. But that’s like, the loans right now, you end up in a pretty tax-inefficient situation by doing that swap, because then the higher income spouse gets all the income.
[0:40:14] MS: Yeah.
[0:40:14] BF: You also probably don’t want to do it on a tax-sheltered account, because then again, the interest is not deductible. Like with the TFSA, as we talked about in that episode, you can just give a spouse money to put in their TFSA anyway, so there’s no need for the prescribed real loan planning. Then I just alluded to this, but the person making the loan has to claim the interest collected as income and pay tax on it. If you made a loan today at 5% to a lower-income spouse, the 5% that the lower-income spouse pays to the higher-income spouse is fully taxable. Deductible to a lower income spouse, but if they’re only earning 1% income and have no other income, it’s not super valuable. No, not going to work out so well.
The strategy of loaning money to a lower-income spouse or child is usually only worthwhile if the prescribed rate is low and the income yield is high. There’s got to be a positive difference between those two for this to be really attractive. This can also be done through a family trust, which can get very interesting, particularly, again, when the prescribed rate was lower. In this case, instead of loaning money to a spouse, or to a child, a family trust is set up and a loan is made at the prescribed rate to the trust. The high-income spouse would make this loan to the trust. Then all of the income that the trust earns can be distributed across the beneficiaries of the trust.
This is really interesting if you have, for example, a spouse and a few children, you can make a loan to the trust. Then each year at the end of the year, you have discretion as the trustee. And so, you’d sit down with your accountant and your financial planner, or whatever, and you would decide, this child gets this much income, this child gets this much income and the spouse gets this much income and whatever other beneficiaries you’ve designated can also be allocated income. That just distributes the tax liability for the household across many people. It can be pretty compelling planning.
However, trusts do have a cost to set up and they also have ongoing accounting costs. When the prescribed rate was 1%, this planning was really interesting. It still can be, but it is quite a bit less obvious now with the prescribed rate at 5% at the time that we’re recording. Then another important consideration is where the money’s coming from. For example, if you have to take extra money out of your corporation, taxable money out of your corporation and pay personal tax on it at a high tax rate, and then lend the money to a spouse or to a trust, it gets a lot less interesting really quickly, because you’re losing that tax deferral. Then that loss of deferral and paying those high personal taxes can easily be more than the future savings that you would get by doing the prescribed rate loan planning.
It’s really, if you have a pile of personal after-tax cash available to loan, then this type of prescribed rate loan planning that we’re talking about and the prescribed rate is low. It’s not now. Then, that’s really when this is most interesting.
[0:42:56] MS: Yeah. That’s loaning money from a high-income spouse out to other family members. The other place that the attribution rules can come into play is if the lower-income spouse wants to get a loan from a third party, like a bank, or whatever, to invest, they can come into play if that loan is secured against the higher-income spouse’s credit, so against their income, or their assets. If your spouse or child obtains a loan based only on that guarantee of your strength of the guarantee of the loan, then attribution rules would apply.
For example, if I had a line of credit that was based on my income and we used that to invest, then that would be attributed to me. However, an interest to wrinkle is a loan secured against a jointly loaned asset may not always trigger the attribution rules.3 For example, a lower-income spouse may be able to use a home equity line of credit, or the money from refinancing a mortgage against the matrimonial home to invest. Now, they need to be clearly the one that’s accessing the cash. They have to invest it to earn income and they have to pay all of that interest from their own income.
Just like it would be with a loan from a higher income to a lower income spouse, there has to be a really clear paper trail that’s there. There’s also quite a few nuances to how that works. You definitely would want to consult with your tax professional if you’re considering that, because there’s a bunch of little wrinkles here and there that would all have to be done and lined up perfectly.
[0:44:20] BF: Yeah. This is one of those funny ones, where there are a few articles and even a technical interpretation from CRA talking about this specific type of planning. But then you talk to an accountant about it and they’re like, “Well, technical interpretations aren’t legislation and this, this, this and this could happen that would change it.” It’s like, okay, yeah. Definitely worth getting tax advice for doing that type of planning.
[0:44:40] MS: It’s interesting, because you talk to a different accountant and it’s like, “Oh, yeah. that’s no problem.” It’s an interesting one.
[0:44:46] BF: Yeah. Tax is a funny thing. It’s like some kind of social science or something, I guess. There’s legislation and then there’s the way that the legislation is interpreted. Not everybody has the same interpretation. Yeah, anyway. As you can tell from that short discussion we just had and this whole segment, the complexity and nuances of the attribution rules make it so that you probably want to talk to your accountant before considering any strategy. The accountant should be able, like the comments we were just making, the accountant should be able to lay out for you why a strategy does, it doesn’t make sense and how much risk there is within this strategy.
That’s one of the things with taxes, that there’s – like with investing, you can choose how much risk you want to take in tax. An accountant might say, “We could do this strategy and it’s very conservative. We could do this one that’s technically legal, but quite aggressive and could result in this, this, this problem down the road.” Anyway, so that’s the type of advice that you ideally get from an accountant when you’re thinking about using prescribed rate loan planning, or second-generation income planning to split income with a spouse or minor child. That’s really both to make sure that it makes sense for your specific situation and to make sure that you put all the appropriate tracking and documentation in place, so that you can defend yourself if CRA did ever come asking questions.
[0:45:54] MS: Yeah. I think the other area of risk when we’re talking about loans and investing is the loan itself and investing. It’s one thing if it’s a loan within your family. But if you’re taking out a loan from a third party to invest, then really, you’re using leverage to invest. I think that’s the next area for us to talk about is leverage investing in a taxable account. It’s called leverage investing because using debt to invest actually acts like a lever. It’s going to magnify both the gains and the losses of the investing. You’d really want to make sure that if you were to take out a loan from a third party to invest, that leverage investing actually suits both your situation. It’s going to be helpful to you and you can handle it, and also, your risk tolerance, because gains and losses can really affect our risk tolerance.
If it does suit you, then doing this in a taxable account, instead of a registered account, at least allows the interest to be deductible against income. There is that advantage. It’s not just against investment income. When you deduct it against income, it’s your taxable income from all its various sources that it gets deducted against. Now, in contrast, if you were to take out a loan to invest in a TFSA, or an RRSP, then it’s not going to be deductible, because that’s a tax-sheltered investment.
Another important nuance is that the investment must be expected to produce taxable income. We talked a bit about that already. I think the area where people do get confused with that, though, is by taxable income. We’re talking about rent, interest, dividends, royalties. It’s not a capital gains. If it was something that said they will never produce income but just have capital gains, there are some funds that may have that as part of their prospectus and there’s some stocks that say they will never, ever pay out distributions, those probably wouldn’t qualify, or at least to read that gray area to have interpretation, but it’s probably up to interpretation.
The other important point is that the income does not have to exceed the interest. We talked a little bit about that already. For example, you could have an ETF that’s yielding 1% and 9% capital gains for a total return of 10% a year. That’s okay, and you could still deduct the 5% interest from your income, even though you have 1% taxable interest, or taxable income that you’re receiving now and 5% that you’re deducting against your income now and down the road, you’re going to get actually most of that money is a more favourable capital gain. There’s a bit of a tax arbitrage that can happen there.
Now, that may all seem great. Yes, using leverage to invest can increase returns. However, it also increases the risks and people, I think, can underappreciate that. It’s not only the risk of making an emotionally driven error but also the consequences of what happens when you do make that error. We’re going to dig into those considerations more in one of the cases in the case conference supplement to this episode.
[0:48:38] BF: Yeah. When it comes to leverage, with other strategies that dance with the attribution rules, if you’re considering a leverage investing strategy, it really makes sense to get professional advice for sure on the tax side and potentially on the investment and financial planning side as well, just because it’s leverage. You can leverage your gains. You can leverage your losses. You also leverage the impact of a mistake, so it’s worth getting advice on some level.
[0:49:03] MS: Yeah, definitely.
[0:49:04] BF: Yeah. We’re going to talk a little bit now about individual versus joint investment accounts. Non-registered investment accounts don’t have limitations on when, or how much you can contribute. That’s in contrast to the registered accounts that we covered in a prior episode. The main wrinkle to be aware of are the attribution rules that we just talked about. The investment income will be taxed in the hands of whoever it is attributed to. For couples, you can also consider whether to use a joint account or an individual one. Now this is important. We just talked about attribution. A lot of the time, couples will think that if they open a joint account, the investment income is just shared between them, about 50-50, for example. But that’s not how it works, because of the attribution rules that we just talked about.
A joint investment account has pros and cons. On the pro side, it’s seamless if one of the partners passes away and the surviving spouse has right of survivorship. That means, if you have a joint account and one spouse passes away, the account just keeps on trucking, if the second spouse has a right of survivorship on the account. Ownership of an individual investment account can also be transferred to a surviving spouse without triggering capital gains taxes. That’s not unique to a joint account, but it may not be automatic and requires the account is locked into the surviving spouse within 36 months. That means it’s for their sole usage, which is usually not a big deal, but it’s just something to be aware of.
There could be some delays in accessing the funds if it gets caught up in settling their estate. Since it will pass through the estate, there will be probate costs, or a state administration costs, which is their formal name in Ontario. With a joint account, technically the income gets attributed proportionally to the couple’s contributions. Again, that’s the not 50-50 thing. It’s whoever put the money in. This means, keeping track of who contributed to that account, which can be a bit of a household of track. It’s only likely to cause problems in extreme cases. Like a spouse with no income, having all the taxable income from a large joint account attributed to them, but it is still worth having a record of contributions, so that if CRA ever comes back and said, “Why is this spouse getting 30% and this spouse getting 70% of the account?” If you have it all documented, that just makes your life a whole lot easier.
[0:51:13] MS: Yeah. On the other side, having an individual account attributed solely to a lower-income partner could be an advantage if they have the lower income. It’s easy to track because it’s going to be purely their account. I mean, it has those probate issues potentially, but it would be easy to administer and use while everyone’s alive. If you have that in the lower-income spouse’s name, then all that investment come would have less tax drag each year. It would be simple to track, they’d have less tax drag. As long as the money is contributed, and clearly comes from their income, then you could do that.
That usually means they have an individual personal banking account. That’s where their income goes into, and it goes from that personal account into their individual, personal taxable account. Now, the main pitfall, of course, would be if one spouse needs the money immediately after the death of the other, and there are those issues of transfer that we talked about. My wife and I actually do use this route. I cover most of our costs of living. I contribute to our TFSAs and my own RRSP, and my wife’s salary goes into her own personal account and she contributes to her own RRSP. That’s something that the individual has to contribute to their own RRSP. The rest, if we have leftover money, gets invested in her taxable account, that’s attributed to her.
It’s a longer-term strategy to build up that type of account, so we now have passive income from her account to supplement her income. Then I can draw income from my corporation. For most people, this probably doesn’t matter that much, because after the age of 65, it may not matter because you can split income from RRFs, from your RRSP and you can split income from a corporation at that age. However, it does give us more options if we retire early. It also has given us good options if we want to have a big splurge and we have this lower taxed pot of money that we can draw from to buy a motorhome, or when we moved between houses, we were able to draw that money without triggering a lot of tax.
[0:53:10] BF: One of the things we’ve done in a lot of cases actually, to accomplish the same thing where you have separate accounts, while still using joint accounts is the first name on the joint account can be different. You can have one spouse have a joint account with their name first and then another joint account with the other spouse’s name first, so that it’s clear who owns which joint account, and that you still have the bypassing probate, you still have the right to survivorship, but you also have clear ownership of the two accounts for accounting purposes.
[0:53:38] MS: Yeah, that’s a really good tip. We’ll have to do that transition over time.
[0:53:42] BF: Yeah, yeah. We usually, to avoid the estate planning issues while still getting the accounting stuff, we don’t usually do individual accounts. We just do joint accounts with different first names on the account. Just makes it super easy. Because I think the tax slips go into the first name of the account, so it gets pretty confusing if you have one first name who the income is not attributed to, because then they get the tax, anyway.
[0:54:05] MS: Yeah, but it would solve that accounting issue of having the joint account and knowing who contributes to what.
[0:54:10] BF: Yeah, exactly. Makes it pretty easy.
[0:54:13] MS: Nice.
[0:54:14] BF: Yeah. All right. We’re going to move on now to some common missteps. We’ve already discussed some of the nuances that can catch people, like the attribution rules, but there are a couple more common areas where people slip up, or get off track on the tax topic.
One big one is superficial capital losses. As we mentioned earlier, capital gains are taxed favourably at half the usual income rate and they’re only taxed when realized. We can defer capital gains until we sell an asset. Plus, you can use capital losses to offset capital gains.
The government essentially takes on some of the risk when you risk capital because if you lose money in a taxable investment, you get to reduce your taxes. The government is sharing in your downside risk. Now, they also share on the upside, because when you sell an asset that’s appreciated, they take a piece of it. Pretty interesting to think about though, that risk-return characteristics of assets are different depending on the type of account that they’re in. We talked about this, I think, in the registered account episode, where if you’re going to speculate, don’t do it in your TFSA, do it in your taxable account, because you’re probably going to lose money and you’d rather do that where the government shares in the loss.
[0:55:18] MS: Yeah. Share the pain.
[0:55:19] BF: Yeah, exactly. Now, one hazard to be aware of when using capital losses to offset capital gains is this superficial loss rule. A superficial loss means that you realize a loss, but rebought the identical investment within 30 days before or after the sale window. That’s really a 60-day window before and after. If you realize a superficial loss, then it cannot be used to offset a realized capital gain. What it does do is it gets added to the adjusted cost base of the investment. That means you’re not getting tax deferral now, but when you eventually do dispose of that property, the superficial loss will be factored in to reduce the taxes at that point.
You don’t get to claim a loss today to reduce your taxes, but you will pay less tax in the future because it’s added to your adjusted cost basis. These rules are designed to prevent people from just harvesting losses for purely tax purposes. They don’t want you just selling an asset to get a tax benefit and then buying the same asset back. CRA, and I think the Department of Finance like to see an economic motivation for transactions to happen. That’s what they’re suggesting in this case. You have to be buying a different asset. There has to be an economic reason for the transaction, not just a tax reason.
Now, an interesting planning idea related to superficial losses is that you can actually transfer losses to your spouse using the superficial loss of rules. It’s neat. It’s a planning strategy that not everybody knows about. A capital loss is only useful if you have a realized capital gain to offset. If you sell shares at a loss and then your spouse buys back the same shares within 30 days before or after you sell the shares, it will be deemed a superficial loss. But wait, that would normally be bad news. In this case, it actually means that your spouse now has shares with a capital loss, because they’ve just bought these shares at whatever the market price is, but their adjusted cost base gets boosted up by the superficial loss amount.
This assumes that the shares haven’t significantly appreciated in price since they were purchased by the spouse. Assuming that doesn’t happen, if the spouse holds the shares for 30 days and then disposes of them, they get to claim the loss, because their adjusted cost base was bumped up by the superficial loss. Effectively, that series of transactions results in transferring the capital loss from one spouse to the other, this would only make sense to do if one spouse doesn’t have capital gains and has no expectation of capital gains in the near future, and the other spouse does have taxable capital gains to offset. Anyway, an interesting little planning strategy.
[0:57:40] MS: Yeah. You can shift that over to make it useful for yourself. I guess, the other thing when they start to get into these types of maneuvers, there is actually also a way that you could lose the ability to apply that superficial loss against a future capital gain. Because the thing here is that the superficial loss rules apply across all of the accounts that you own. That also includes your tax-sheltered accounts. If you sold an investment at a loss in your taxable account and then bought the identical investment in your RRSP, or your TFSA within that 60-day window, you would not be able to use that loss in your taxable account, because it’s now a superficial loss.
It’s not like you gain anything, because it’s now going to be in a registered account where you’re not going to have capital gains taxes. It’s not like it’s going to help you by raising your adjusted cost base. That doesn’t really benefit you in a registered account. You’ve essentially wasted that capital loss from a tax standpoint by doing that.
Now, I know this is the letter of the law and I’m a bit paranoid about making these types of mistakes and getting called on it by CRA. However, Ben, how often do you actually see that type of thing play out in practice? I’m not sure if you can really answer that.
[0:58:49] BF: Well, it’s not common is the thing, right? I think if you go through a thorough audit, stuff like this could get caught, but that doesn’t mean you shouldn’t be careful about it. Whenever we’re doing a transaction that involves a capital loss, we’re always super cautious about it for these exact reasons. It’s the thing where there’s a good chance nothing happens. But if it does three years down the road, or whatever, you get audited and realize that you made a mistake, that’s one of those things. It’s easy to miss and then they don’t seem like a big deal until you get audited. But if you can avoid – I mean, it’s a mistake. If you can avoid it, that’s obviously better.
[0:59:19] MS: Yes. It’s all fun and games, until someone loses an eye. I used to hear that a lot as a kid.
[0:59:25] BF: Yeah. No, it’s exactly right. You do your tax return. You think you did a good job and it’s usually fine, but it can happen where a few years later, CRA comes back and says, “Oh, you did this wrong. You owe us whatever, money and interest and penalties.”
[0:59:39] MS: Yeah. It’s just important to be aware of. You can avoid it all together.
[0:59:42] BF: Yeah, definitely. Understanding the superficial loss rules can help prevent you from wasting a capital loss, as we just discussed.
Some people try to harvest losses to increase their tax deferral. This is more commonly discussed in the US. But in the US, they’ve got a difference in tax rates between long-term and short-term capital gains. That means that if you hold an asset for, I think it’s two years and then sell it, it becomes a long-term capital gain, which attracts a lower tax rate than a short-term capital gain, where if you’d sold it sooner.
Reducing short-term capital gains by harvesting losses in exchange for long-term capital gains, that’s favourable, even if your tax bracket stays the same. That’s an American thing, not Canadian. Then again, in the US, they use tax lot accounting, meaning that different lots of the same shares can have different cost basis, so you can be selective with which shares that you sell to make loss harvesting more attractive. Again, that’s a US thing. Up in Canada, up here in Canada, we have average cost-base accounting. You don’t get to pick and choose which shares you’re going to sell. All of your shares at the same cost base based on the average cost base of all of your purchases.
Then another big one in the US is the step up in basis on death. Meaning, that there won’t be a big tax bill at death for shares with low-cost bases in the States. But then in Canada, so to go through all of those items I just mentioned for the States, in Canada, there’s no difference between long-term and short-term capital gains. The only planning element there is deferring realized capital gains to a future year with a hopefully, lower tax bracket, but the capital gains rate doesn’t change. It’s always 50% of the income rate. Then we use average cost base accounting, like I mentioned, and we don’t have a step up in basis on death.
If you end up with a huge deferred capital gain at death, it can be very expensive, especially if it ends up pushing you into a higher tax bracket than you would have been in otherwise. Loss harvesting can still be useful in Canada, but it is much less obvious as a strategy than it is in the US. Sometimes the capital loss means that you lost a bet, like say, you bet on an individual stock in your taxable account, but not in your TFSA, because you listen to us. You want to sell it after you lost the bet. That’s fine. In other cases, you may hold a long-term investment, like an index fund as part of your asset allocation that happens to be at a loss position at a point in time.
You allocate it to the Canadian equity index with a bunch of new money that you invested a year ago, and it just happens that the Canadian market’s down since then. In that case, you probably don’t want to eliminate your exposure to Canadian stocks. It’s not like, “Oh. Well, I lost the bet on Canada. I’m going to bail on that.” No, you still want to have it as part of your long-term asset allocation. You can still harvest a loss in this case without triggering a superficial loss by selling the Canadian index, and then buying a similar, but not identical asset to replace it. With ETFs, it could be two ETFs, both Canadian equity, but tracking a different index. Then when you’re outside of the superficial loss window, you could even switch back to your original fund, if you like it better, if you want to go back to it.
[1:02:36] MS: That’s a great point that I think we should probably expand a little bit more on that. Let’s just say an example, you’re starting investing with an ETF and it covers the FTSE developed index, and then that dropped and you have this unrealized capital loss. Well, you could realize that loss and then buy an ETF that tracks the MSCI world index. They’re very similar. Both cover the broad world markets. They have an extremely high correlation to each other. However, there are differences between the holdings and weightings of those holdings, so they’re not identical.
Now, the other thing that comes with that and that this is important is that if you were to try to pair two ETFs that cover the same index, they would be considered identical. If they take ETFs from say, Vanguard, or BlackRock, or BMO, or something and you used that as your switch, but they all cover the same index, then that actually would be considered to be identical and constitutes a superficial loss. You’d have to choose something that has a slightly different index. This strategy could work with very broad market ETFs because they’re going to be relatively correlated and very similar, but not identical.
The narrower the market is that you’re targeting, the more material differences start to arise. For example, if you were switching between the MSCI Europe Asia Far East index and the FTSE developed excluding North America index, there’s actually about a 10% difference in holdings. Some of that’s important. It’s like, Korea’s 15% of the MSCI index and it’s not in the FTSE index at all. Instead, FTSE puts that into their emerging markets index. You could have pretty material differences where you get double, or no exposure to different areas of the market if you’re not careful when you start getting into more narrow market ETFs.
The extreme of this, of course, would be just like everything else. The extreme risk is when you start to harvest and switch around with individual stocks, because they all have their idiosyncratic specific risks, like they do with everything in general. This type of tax lost harvesting is one of these things that’s often touted as a value add by portfolio managers. However, I’ve honestly given up on doing it for the most part for a bunch of reasons. Ben, what are your thoughts on that?
[1:04:47] BF: Yeah. I mean, listen, it introduces complexity and room for execution errors. It also introduces future tax rate risk, since you’re lowering your adjusted cost base on the shares, which means more capital gains in the future. Listen, deferring capital gains to the future is a good thing, assuming your tax rate stays the same or goes down. All else equal, that is a positive thing to do. However, there’s zero guarantee at all whatsoever that your tax bracket will stay the same. Even given your tax bracket, we don’t know if tax rates are going to be different in the future.
If you look at the history of tax rates, they’ve actually been fairly volatile in Ontario. There’s no guarantee that you’re going to lower tax rate in the future, which I think it introduces a risk, a unique type of risk when you’re doing this type of strategy, to defer tax of the future and any tax deferral strategy has that risk. Even if you do gain from it, it’s not a risk-free gain. We do loss harvesting at PWL sometimes, but it’s not something that we say is a value-add. We don’t put it in our literature, saying that this is something that we do, that you can’t do yourself, or whatever, that’s going to make you better off. We don’t market it.
There are cases where it’s more obvious than others. If someone has a current year capital gain and say, there’s an economic reason to change the portfolio holdings, well, hey, well, take advantage of that. If they have a loss and a gain to offset in the past three years, or in the current year, because you can carry a loss back three years or four indefinitely. There’s an economic reason to realize the loss, we’ll do it for sure. If there’s not an economic reason, we might still do it, but it has to be really obvious and they’ve also got to be in a high tax bracket now and bonus points if we expect them to be in a lower tax bracket in the future. Because then, even if tax rates increase, as long as they’re in a lower bracket in the future.
Anyway, when March 2020 happens, we do have a process where we go through client accounts, identify opportunities for realizing losses. We go through all the filters that I just mentioned, and we will do it, but it’s not something that we’re doing every day for every client, because it doesn’t always make sense.
[1:06:47] MS: Yeah. Well, you’re doing it for cases where there’s pretty concrete benefit either right now, or in the next year, so it’s not deferring a bunch of taxes for some point 10 years down the road. It’s going to be pretty close time frame.
[1:06:59] BF: Oh, yeah. I mean, if you’re booking losses and you don’t have gains to offset now, to me, it’s a waste, because you’ve got transaction costs, too, which we haven’t even mentioned yet. Let alone risk. There’s also transaction costs, which it means like spreads on ETFs if you’re trading ETFs. It’s not something that you should do just because you have a loss, I don’t think.
[1:07:14] MS: Yes. I agree.
[1:07:15] BF: Yeah. All right, so we’ve honed in on a lot of details about investment taxes in this episode. We thought it was really important to pull the money scope back a little bit at the end of the procedure to get perspective on the big picture. Remember that the base of the portfolio period is time in the market. You don’t want to put off using your taxable accounts, just because you’re worried about optimizing some small tax detail.
[1:07:36] MS: Yeah. Remember that you should choose your investments based on building a diversified portfolio. If you want to hone in on some specific factors that may increase in expected returns, we talked a bit about that, but then you would hone in on those factors. Rather than just what kind of income is paid, like dividends, for example, it’s the total market return that’s going to matter for you. Similarly, don’t avoid the best investments that suit your situation, just because they are going to generate some taxable income.
[1:08:03] BF: Yeah. Now, as keen listeners have probably figured out just through the course of this discussion, it could be possible to try and match different types of investment income to different account types. If you have an asset that you know pays a high dividend yield, or pays a high-income yield, or if it’s more likely to produce capital gains, it might make more sense to fit one of those assets into a different account type. That’s an idea called asset location. You could also refer to it as tax optimization.
It’s actually a lot more complicated than it seems at first blush. We’ll expand on that further in another episode. The bottom line on asset location, just while we’re talking about it, is that the potential impact is small. It’s hard to predict when balancing against the uncertainty of future taxes, income, and potential errors from making a strategy too complex to execute reliably. It is an optional strategy, definitely optional. We will cover it in a future episode because there’s potentially a benefit. On top of that, it’s really interesting.
[1:08:58] MS: Yeah. It’s like your appendix, not so much in that it’s so interesting, but it’s a little worm at the end of your colon and it’s there. It’s only an issue even worth considering for some people. Even then, it can be surprisingly tricky to manage. That would actually require a different type of scope anyway. Let’s pull this one out.
Great. We’ll have our post-op debrief. In this episode, we discussed the various forms of investment returns that they can take. There’s debt interest instruments that can pay us interest. When a company makes a profit, it might pay a dividend. It might reinvest the money to grow future earnings, or it may buy back stock. That’s all captured in the price, and the combination of share price and income is the total return.
[1:09:42] BF: Yeah. Even though the total return is what matters for risk and return on investment, how we get paid does make a difference to how much growth we see after taxes. Interest is taxed as income. Canadian dividends are taxed at a lower rate to account for taxes already paid by the company. That’s part of tax integration. Foreign dividends are taxed as income. Plus, they may have some foreign withholding tax complexities.
[1:10:06] MS: Yeah. The thing to know about investment income is that it’s taxed every year. In contrast to that, capital gains are only taxed when they’re realized, and at half the usual tax rate. In a taxable account, you can also use some of those capital losses to offset capital gains if that applies to your situation. If you are trying to do that, just be aware of the superficial loss rules. If you’re trying to tax loss harvest, and particularly avoid doing a superficial loss from a taxable account and then buying the identical security in a tax shelter.
[1:10:37] BF: Yeah. In that case, it’s just a denied loss, not even superficial at that point. It’s just gone. Another important aspect to tax planning for your investment income is to understand who’s going to pay the tax bill. That’s the attribution rules. The attribution rules prevent us from gifting or loaning money to a lower-income spouse, or minor child to invest into an income at their lower tax bracket. There are some nuances that we can use to tax plan in a legal way to more tax efficiently grow our family’s investments over the long run.
[1:11:05] MS: Yeah. Most of us will need to use taxable accounts in addition to our registered tax shelters. Not only does that allow us to invest more, but by understanding how it works, we actually have some tax planning opportunities, like we’ve mentioned in this episode. We touched on a number of them, but we’ll do a deeper dive into some more tax planning after we spend some time on the other big type of taxable investment account. That’s the investments held by a corporation. That’ll be the third part of our journey through the guts of investment accounts.
In the meantime, please join us for our case conference and we’ll illustrate some of the concepts from this episode with some common scenarios, or dilemmas.
