The questions for this course were written by John Campbell, Tax Group Leader and CA with Hilborn Ellis Grant LLP in Toronto. Reach him at 416-364-6398 or firstname.lastname@example.org.
Part 1: Accounting for Tax
Some tax-efficient investments aren’t worth the risk
By Brynna Leslie
Tax should never be the primary driver for decision-making on a portfolio, but a properly structured portfolio always takes tax into account.
Regardless of asset class—money market funds, fixed income, or equity—clients can find ways to earn money in a tax-efficient way. Planning to reduce the tax burden must first coincide with the risk objectives and risk tolerance of your client, says Matthew Harvey, owner of Harvey Financial Solutions Inc., in Kincardine, Ont. “Investment strategies that take tax into account can be complicated and risky,” says Harvey. “Many of them are designed for the financially mature individual—affluent, high-income, and high-net-worth. Clients should not sacrifice expected rates of return just for a tax benefit.”
Nowhere is this truer than with labour-sponsored investment funds (LSIFs). Through LSIFs, federal and provincial governments use tax incentives to encourage investment in small- to medium-sized Canadian start-ups. Federal rules allow investment up to $5,000 per year in these funds, and that investment is eligible for a 15% federal tax credit, and an additional 15% provincial tax credit in some provinces.
Ontario recently increased the investment cap to $7,500 per year, and it offers an additional 5% tax credit on investments in research-oriented LSIFs. Like flow-through shares, the idea is these funds will grow over time. But they have initial investment risks that would deter most individuals. Typically, there is a lock-in period of eight years for these funds, so selling early means shareholders will not be eligible for the tax benefits. LSIFs are also known as labour-sponsored venture capital corporations (LSVCCs), or simply retail venture capital.
When they emerged a decade ago, fund managers salivated at the prospect of offering clients an investment fund that would see up to 35% in annual tax credits per year. Managers initially had a two-year window to invest the funds however they liked, contributing to the early euphoria.
“LSIFs looked great,” says Harvey. “Managers were able to throw the investments into some mild equity and bonds and watch it grow, while their clients got thousands of dollars back from the government.”
But then things changed. A mandate came down that the investments had to be transferred into a government-specified group of funds. “The fund managers were essentially handcuffed,” says Harvey. “They had to find companies that hadn’t been around that long, within a very small region in Canada, or in a particular province.” By then, investors were already locked into the program.
As a result, many have come to see LSIFs as high-risk venture capital.
“You have to be prepared to lose the capital,” says Harvey, who hasn’t sold any LSIFs since he became licensed to do so six years ago. “You have to have a reasonable expectation of losing it. [Otherwise], LSIFs may not be for you.”
Corporate class funds
Unlike LSIFs, corporate class funds (CCFs) have a much broader appeal. Some say they are the mutual fund world’s answer to the tax-efficient competitiveness of ETFs. Corporate class structures are set up as mutual fund corporations with multiple share classes. These instruments are good for people who want to buy and sell often to switch into a different fund or class share, without realizing regular income as a result.
Under a single corporate umbrella, traders can sell units of an equity fund to buy a bond fund when it’s deemed favourable, for example, and normally not realize capital gains in the transaction. “It’s a rollover at the same tax base,” says Nicholas Miazek, a consultant at T.E. Wealth in Calgary, Alta. “For a client that’s rebalancing to a more conservative asset mix later in life, it’s not going to trigger a taxable event.”
CCFs have appeal for a wide range of investors. A growing number of Canadian seniors, for example, are selling their homes and realizing the equity. They’re ideally situated to use CCFs for both income protection and a decent tax shelter. “All of a sudden, these seniors find themselves with half a million dollars in cash, but if it earns interest, it may disqualify them for government benefits they’re receiving,” explains Harvey.
While income from the sale of a principal residence is not taxable, the interest they’d earn if they put the money into a savings account is. Likewise, mutual funds typically distribute income evenly among shareholders—in the form of dividends, income or capital gains—as the funds are bought and sold.
But within the CCF, shares are generally traded within the same group of corporate funds, so investors don’t realize any income—and are not taxed—until they choose to redeem their individual shares.