Partnering like a pro
In this new column, we look at how two professionals benefit from working together — and what you can learn
By Melissa Shin |April 9, 2024
6 min read
News and resources for Canada's top financial advisors
Est. 1998
This course is no longer eligible for CE credits. Go to cecorner.ca to find eligible courses.
While tax-advantaged vehicles such as RRSPs and TSFAs are a sure bet for most investors, they are limited by the investor’s contribution room. Once that has been exhausted, investing in taxable accounts is the next step. At that point, it becomes necessary to take tax considerations into account.
Taxes can have a major impact on investment returns. While few statistics are available in Canada, U.S. studies show that in the ten-year period from 1999 to 2008, taxes reduced the annual return of equity mutual funds by an average of 1.13 percentage points. Bond funds fared even worse because taxes lopped an average of 2.13 percentage points off their annual return.
Why does this matter? Investors typically save for their retirement over long periods of time. Through compounding, a difference of one or two percentage points in the annual return may mean the difference between a comfortable retirement and a frugal one. Tax-efficient investing may lessen the tax bite.
PART 1:
PRINCIPLES OF TAX-EFFICIENT INVESTING
Tax-efficient investing is not about minimizing taxes. If that were the objective, it could be achieved very simply by holding investments which generate no return at all. The aim, rather, is to maximize the after-tax return. Tax efficiency is only part of the story. Advisors should recommend products on the basis of their investment merits and their suitability to the client. While tax considerations should form an integral part of the exercise, a recommendation should not be predicated on tax considerations to the exclusion of other relevant factors. The investment dog should wag the tax tail and not the other way round.
Investment returns can take different forms, depending on the nature of the investment. Cash generates interest income. Bonds generate interest income and, to some extent, capital gains. Stocks generate capital gains and dividends.
The most common forms of investment return are:
- Interest income
- Dividends from Canadian companies
- Dividends from foreign companies
- Realized capital gains, net of realized capital losses
- Unrealized capital gains, net of unrealized capital losses
Each type of return is taxed differently, as shown in Table 1.
Table 1: Tax treatment of investment returns
| Type of Return | Tax Treatment |
|---|---|
| Interest income | Fully taxed at the investor’s marginal tax rate |
| Canadian dividend income | Subject to gross-up and the dividend tax credit |
| Foreign dividend income | Fully taxed at the investor’s marginal tax rate |
| Net realized gains | 50% is taxed at the investor’s marginal tax rate |
| Net unrealized gains | Not taxable until the gain is realized |
Interest and foreign dividend income are taxed as ordinary income. In other words, they are taxed in full at the investor’s marginal tax rate.
Canadian dividend income is subject to separate tax rules, relating to gross-up and the dividend tax credit, which are designed to avoid the double taxation of dividends.
Maximizing capital gains
Capital gains have two relevant characteristics. First, they are more favourably taxed than other types of return, since only 50% of capital gains need to be included in income for tax purposes. Making the most of the favourable treatment of capital gains is an important principle of tax-efficient investing.
Secondly, capital gains are taxed (and capital losses allowed as deductions) only when they are realized, for example, when the related investment is disposed of. As long as the investor continues to hold the investment, tax on the gain is deferred. Since the investor is free to decide when to dispose of the investment, the timing of the payment of tax on capital gains is, to some extent, discretionary.
It is always preferable to pay tax later rather than sooner because the money can be invested during that interval, earning additional returns. The deferral of taxes on capital gains is another important principle of tax-efficient investing.
Implications for asset allocation
Investors’ tax bills depend on the mix of the different types of return they earn on their portfolio. While the lightest burden is borne by investors who earn their return in the form of capital gains—especially if the related taxes are deferred for as long as possible—the biggest impact is on those who earn ordinary income such as interest.
The mix of returns depends to a large extent on the investor’s asset allocation, which is the process of dividing up the portfolio into asset classes such as stocks, bonds and cash. A portfolio with a large allocation to stocks will generate returns mostly in the form of capital gains and dividends. However, one with a large allocation to bonds or cash will generate returns mostly in the form of interest.
Best practice is to perform asset allocation with the use of a computer program known as an optimizer. This tool uses the expected return of each asset class and the related volatilities and correlations to generate efficient portfolios, i.e. portfolios with the least risk for a given expected return. The exercise is usually based on pre-tax numbers.
This approach is fine for tax-exempt investors such as pension funds. For the taxable investor, however, it is the after-tax return that matters, and asset allocation should be performed using after-tax numbers. Because of the favourable tax treatment of capital gains, this will usually result in a larger allocation to stocks when compared with an asset allocation based on pre-tax numbers.
Losing money and still paying tax
When investors hold stocks directly, they realize a capital gain or loss when disposing of their investments. Only then do they pay tax on the capital gain or claim a capital loss. Things get more complicated when stocks are held indirectly through an investment fund. In such cases, investors may have to pay tax on capital gains even if they still hold the units of the fund.
When investment funds realize net capital gains on the disposal of portfolio investments, they routinely distribute the net gains to their investors, in whose hands the net gains are then taxed. This makes sense because, provided certain conditions are satisfied, investment funds may deduct for tax purposes the amount of distributions to their investors. Since most investors pay tax at a lower rate than the fund, the distribution of the net gains reduces the overall taxes payable.
This tax regime may produce disconcerting results for unwary fund investors. For example, in 2008 the markets dropped precipitously and most investors experienced negative returns. Despite their investment losses, many fund investors found themselves in the situation of having to pay tax.
When the markets dropped, most funds experienced net unrealized losses on their portfolio holdings. Those losses more than offset the net gains realized earlier in the year, with the result that the funds experienced negative returns for the full year.
What’s important to note in this situation is that net unrealized losses have no impact on a fund’s immediate tax situation. However, net realized gains are taxed in the same year.
To eliminate their tax liability, the funds distributed their net realized gains. As a result, their investors had to pay tax on capital gains in spite of a negative return on their fund investments.
What lesson can be learned? When investing through investment funds, investors should be wary of distributions. That’s because distributions do not make investors better off; instead, they trigger a tax liability. Investors become better off when the fund earns a return, not when the return is distributed.
Suitability and tax considerations
It’s extremely important that an investment suit the investor’s overall situation. The investor’s objectives and risk tolerance and the tax treatment of the investment have to be carefully weighed in making a determination on suitability.
By way of illustration, the equity portion of a portfolio may be invested in the stocks of either dividend-paying or non-dividend-paying companies. In the latter case, the return takes the form of a capital gain, on which tax is deferred for as long as the stock is held.
An investment in a company that pays dividends makes sense for investors who require current income from their portfolios, such as retirees. It makes less sense for investors with no need for current investment income because, for example, they are gainfully employed. When investors in the latter category buy the stocks of dividend-paying companies, the best thing to do with the dividends is probably to reinvest them in additional shares of the company, thereby benefiting from dollar-cost averaging (buying a fixed dollar amount of a particular investment on a regular schedule, regardless of share price). However, they will be worse off because of the tax on the dividends.
It would be more tax-efficient for these investors to hold the stocks of companies that do not pay dividends and to earn their return in the form of unrealized capital gains. Admittedly, this approach can be more risky. Companies that pay dividends tend to be large and well-established whereas those paying no dividends tend to be smaller businesses in the growth phase.
However, the argument must not be pushed too far. In the wake of the major market correction of 2008, dividend-paying stocks have become increasingly popular with investors. Dividends are sometimes perceived as the proverbial bird in the hand—they are represented by hard cash. “Show me the cash” has become investors’ battle-cry.
On the other hand, unrealized capital gains are perceived as the bird in the bush—they are exposed to the market and may disappear if there is a downturn. The distinction is indeed valid if the investor intends to spend the dividends or to hold them in cash. If the dividends are reinvested, however, they become exposed to the market once again—the bird has flown back into the bush, leaving the investor with a tax bill in hand.
PART 2:
TAX-EFFICIENT INVESTING AND CAPITAL GAINS
As noted above, one of the principles of tax-efficient investing is to defer the payment of tax on capital gains whenever possible—it is always better to pay tax later rather than earlier. In the meantime, the money can be invested to generate additional returns.
Yet there are many reasons why it may be advisable to dispose of an investment, even if this triggers a taxable capital gain. For example:
- It is no longer consistent with the client’s investment objectives.
- It has reached its full potential.
- Its prospects have changed.
- You need to rebalance the client’s portfolio.
Even in such cases, it is possible to defer the tax if the investment takes the form of shares of an investment fund corporation and the investor switches from one fund to another within the corporation.
A mutual fund corporation has several classes of shares, each of which corresponds to a separate fund. The investor can switch from one fund to another simply by switching from one class of shares to another within the corporation. The Income Tax Act (Canada) allows this on a tax-deferred basis. Tax is payable only when the investor redeems shares of a class without reinvesting the proceeds in shares of another class within the same mutual fund corporation.
Capital gains through the back door
Caution is necessary if you advise your clients to invest in shares of a mutual fund corporation. A switch is effectively the redemption of shares of one fund and the simultaneous purchase of shares of another fund. The fund whose shares are being redeemed must pay the redemption proceeds to the fund whose shares are being purchased. To do this, it must have sufficient cash. If the issue of new shares to other investors is insufficient to compensate for the redemptions, the fund may need to sell some of its portfolio investments in order to raise the required cash. As a result, it may realize capital gains, which will be distributed to its remaining investors and taxed in their hands. Make sure your clients are not among those investors.
How to avoid capital gains distributions
The deferral of tax on capital gains is most complex when the investor owns investment funds. This is because, in addition to being taxed on capital gains realized on the disposal of their units, investors are taxed on the net gains distributed by the fund while they are unitholders. The decisions that trigger capital gains distributions are usually made not by the investors, but by the fund’s portfolio advisor.
Investors may avoid paying unnecessary taxes by staying clear of funds that are prone to capital gains distributions. Knowledge of the factors that drive distributions will help weed out tax-inefficient funds.
Active versus passive
An important factor is whether the fund’s portfolio is actively or passively managed. A fund portfolio is actively managed when the advisor tries to outperform a benchmark, such as the S&P/TSX Composite Index, which is a broad index of Canadian stocks. A portfolio is passive when it replicates an index. In this case, the portfolio will hold the same stocks, and in the same proportion, as the index. Funds that track an index are known as index funds. Their return should be equal to that of the index less the fund’s fees and expenses.
When a portfolio is passive, there is no reason to sell portfolio investments except when changes are made to the index. Because index funds trade infrequently, they realize and distribute few capital gains. Their return mostly takes the form of unrealized capital gains.
In attempting to outperform the index, actively managed funds usually trade more frequently than their passive counterparts. To the extent that the trades generate capital gains, the latter will be distributed to the fund’s investors.
As mentioned above, taxable investors should base their asset allocation on expected after-tax returns and related volatilities and correlations. If the assets you are considering for the portfolio include both actively managed funds and index funds, the use of after-tax rather than pre-tax numbers will usually result in a larger allocation to index funds. This reflects the greater tax efficiency of index funds, which is itself a consequence of their low portfolio turnover.
Management style
When the fund portfolio is actively managed, another important factor affecting capital gains distributions is the management style.
For instance:
- The growth style involves investing in the stocks of companies that exhibit above-average sales and earnings growth.
- The momentum style involves investing in stocks that exhibit above-average price increases.
- The value style involves investing in stocks that the advisor believes to be undervalued, taking into account factors such as the price-to-book ratio, the price-earnings ratio and the dividend yield.
Some styles imply more frequent trading than others. The value style assumes the market will ultimately recognize the stock is undervalued, at which time the stock price will rise to its intrinsic value. However, market recognition often takes a long time to occur, if at all. Consequently, funds managed according to the value style tend to trade less frequently than those managed according to the growth and momentum styles. They are therefore less likely to distribute capital gains.
Is the fund experiencing net redemptions?
Although a fund’s capital gains distributions are usually the result of actions taken by the portfolio advisor, they are sometimes driven by the actions of its investors. This is particularly true when redemptions by existing investors exceed the sale of new units. In order to finance the net redemptions, it may be necessary for the fund to sell some of its portfolio investments, thereby possibly triggering capital gains.
The Income Tax Act (Canada) includes the Capital Gains Refund Mechanism (CGRM), which allows the fund to retain the capital gains attributable to the redemption of units without having to pay tax. The CGRM uses a formula to calculate the relevant gains and admittedly is not a perfect mechanism, especially when the market value of the investments has dropped well below the original cost. Some capital gains may still need to be distributed to the unitholders and will be taxed in their hands.
The portfolio turnover rate and its limitations
Many investors use the portfolio turnover rate as an indicator of a fund’s tax efficiency. Higher portfolio turnover is usually associated with tax inefficiency. The implied assumption is that a fund with a high turnover triggers frequent capital gains, which are distributed to unitholders.
While there is some truth in this assumption, it would be simplistic to equate a high turnover rate with tax inefficiency. Portfolio turnover may be good because, in some instances, it enables a fund to improve its tax position. Tax-loss harvesting is a case in point.
There is a potential for tax-loss harvesting whenever the current price of an investment is less than its original cost. The sale of the investment triggers a tax loss that may be applied against capital gains realized on the sale of other investments, thereby reducing the net capital gain on which tax is assessed. This trading activity increases the portfolio turnover. However, the result is to improve the portfolio’s tax position rather than to hurt it.
The portfolio turnover rate may be used as a screening device, but it isn’t a substitute for a proper analysis of the fund’s circumstances.
Do fund investors pay tax twice on capital gains?
Because they pay tax both on the capital gains realized when redeeming their units and on the gains distributed by the fund, many investors are convinced they are taxed twice on the same gains. In actual fact, no double taxation is involved. However, when a fund distributes a capital gain, it does accelerate the payment of tax by its investors. The latter must pay, in the year of the distribution, the tax they would otherwise pay in the year they redeem the units. Investors are, of course, worse off when they pay taxes earlier than later.
A fund usually distributes capital gains in the form of additional units. The issue of new units is immediately followed by a consolidation of the units, such that the total number of units outstanding and the unit price remain the same. Unlike a cash distribution, there is no transfer of value from the fund to the investors. The sole object of the exercise is to transfer the liability for the tax on realized capital gains from the fund to its investors.
For tax purposes, the adjusted cost base of the investor’s units is increased by the amount of the distribution. When the investor ultimately redeems the units, the capital gains will be reflected in the net asset value of the fund and therefore in the redemption proceeds. The amount of the distribution is thus reflected in both the redemption proceeds and the adjusted cost base and therefore cancels itself out (see Case Study: Capital gains taxation, below).
Case study: Capital gains taxation
Take the example of an investor who owns units of an investment fund with a tax cost of $1,000. At the end of 2010, the market value of the units is $1,500. As far as the investor is concerned, there is an unrealized capital gain of $500.
The fund sold some portfolio investments in 2010. As far as the fund is concerned, the related capital gains have been realized and they are duly distributed at year-end. Our investor’s share of the capital gains distribution is $200, which is taxed in the same year. At the same time, the amount of the distribution is added to the adjusted cost base of the units, which becomes $1,200, or ($1,000 plus $200).
In 2011, the investor redeems all the units. The fund has made neither profit nor loss in the meantime, and the market value of the units is still $1,500. For tax purposes, the investor’s capital gain is $300, represented by proceeds of $1,500 less the adjusted cost base of $1,200. The investor is taxed on that gain in the same year.
| Year | Amount of Tax |
|---|---|
| 2010 | $200 |
| 2011 | $300 |
| Total Taxation | $500 |
The investor is taxed on the capital gains as follows:
If the fund had not made a distribution in 2010, the investor would have realized a capital gain of $500 (proceeds of $1,500 less adjusted cost base of $1,000) at the time of redeeming the units in 2011, and would have been taxed on that amount in 2011. The distribution in 2010 accelerated the payment of tax by the investor on capital gains of $200.
Importance of proper tax records
The adjusted cost base of the units held by the investor is increased by the amount of the capital gains distributions. It is this step-up in the tax cost that prevents the same gain from being taxed twice when the investor ultimately redeems the fund units.
What if the tax records of the investor are deficient? What if the investor omits to add the amount of the capital gains distributions to the adjusted cost base of the units? In these cases, there would indeed be double taxation at the time of redeeming the units. This double taxation would be the result of the absence of proper tax records on the part of the investor. We can only guess at how much tax is overpaid each year for this reason.
Why are capital gains taxed on the redemption of fund units?
If the fund distributes its capital gains each year, why is there another gain (or loss) when investors redeem their fund units?
The capital gains distributed by the fund are the net gains it realizes year by year on the portfolio investments sold during the year. In addition, when investors redeem their units, there will be unrealized gains on the portfolio investments the fund holds at that time. The unrealized gains are reflected in the fund’s net asset value, which is the price that investors receive when they redeem their units. The gains are still unrealized as far as the fund is concerned (because the fund still holds the investments in its portfolio) but they have now been realized by the investors (because the latter have redeemed their units). It is on those gains that investors pay tax when redeeming units of the fund.
As seen in the case study, the capital gains distribution of $200 in 2010 corresponds to net gains realized by the fund on the sale of portfolio investments in 2010. On the other hand, the capital gain of $300 realized by the investor in 2011 on the redemption of units corresponds to net unrealized gains on the fund’s portfolio of investments at the time of the redemption.
PART 3:
TAX-EFFICIENT INVESTING AND DIVIDENDS
Tax-efficient investing, as it relates to dividends, revolves around the following questions:
- What are the relevant considerations when deciding whether to invest in the stocks of dividend-paying or non-dividend-paying companies? We addressed this question above.
- Is it preferable to invest in dividend-paying stocks rather than bonds, on the grounds that dividends are more lightly taxed than interest? We will address this question here.
First, we need to provide some background on the tax treatment of dividends. Companies pay dividends to their shareholders out of their after-tax income.
The sequence of events is as follows:
- The company pays income tax on its income.
- The company then pays dividends to its shareholders out of the after-tax net income.
- Shareholders pay tax on the dividends.
In the absence of special measures, the same income would be taxed twice — once in the hands of the company and again in the hands of the shareholders.
Taxing the same income two or more times would be unfair. It would also have the undesirable result of discouraging savings and investment. The Income Tax Act (Canada) includes a number of mechanisms, known as flow-through mechanisms, to avoid multiple taxation of the same income. A flow-through mechanism taxes the income of a business entity as if it had been earned directly by the investor. Consequently, the business entity and the investor pay the same amount of tax overall, as though the investor had earned the underlying income directly.
The flow-through mechanism used to avoid the double taxation of dividends is known as the imputation system.
Why dividends are not taxed twice
The objective of the imputation system is to integrate the personal and corporate tax systems such that dividends are taxed only once. The mechanics of the system are:
-
- Calculate the corporate income out of which the dividend was paid. This is achieved by grossing up the actual amount of the dividend received by the shareholder. The gross-up percentage depends on the rate of tax paid by the company.
- Shareholders are taxed on the grossed-up amount. This is their notional share of the company’s before-tax income corresponding to the dividend received. Shareholders pay tax on the taxable amount of the dividend at their marginal rate of tax.
- The system recognizes that the company has already paid tax on its income. This tax is considered to be a prepayment of tax by the company on behalf of its shareholders. The latter may deduct their share of this tax in the form of a dividend tax credit calculated as a percentage of the grossed-up dividend.
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It is inappropriate to compare $1 of dividends received with $1 of interest income.
This is because dividends are paid out of after-tax income, while interest is paid out of before-tax income. The corporate tax reduces the amount available for distribution by way of dividends. In our example, Company B could afford to pay $5 of interest but Company A could only afford to pay $4 of dividends.
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Dividends appear to be more lightly taxed than interest because of the dividend tax credit.
In actual fact, the dividend tax credit does not constitute a gift from a benevolent government intent on encouraging Canadians to invest in the shares of companies. It merely credits shareholders for tax already paid on their behalf by the company. The dividend tax credit does not constitute an additional benefit to investors—all it does is prevent double taxation.
-
Look beyond visible taxes. In particular, be wary of embedded taxes.
These taxes may be relatively painless because the investor may not even be aware of them. However, they are just as harmful to the investor’s financial situation. A company belongs to its shareholders and corporate taxes are effectively paid out of shareholders’ pockets.
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The payment of interest on the due dates is a contractual obligation of the company.
Dividends are always discretionary.
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Interest is paid at a known, fixed rate.
Dividends may rise or fall, depending on the fortunes of the company, and may drop all the way to zero.
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Bonds have a known maturity date on which they will be worth a known amount (the principal amount), subject to the solvency of the company.
Stocks do not have a maturity date and their future value is never known in advance. It could be higher or lower than today’s value.
-
Stocks have a greater potential for capital gains or losses than bonds.
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In a bankruptcy, bondholders rank ahead of shareholders.
- the importance of asset location (not to be confused with asset allocation)
- tax-efficient ways to gain exposure to bonds
- the mechanics of tax-loss harvesting and the associated pitfalls
- the issues with the pricing of investment fund units stemming from the treatment of tax assets and liabilities
- the need to keep track of a fund’s tax overhang
- cutting-edge developments in tax-efficient investing
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Let’s illustrate these mechanics with a hypothetical, scaled-down example (“Tax treatment of dividends”).
Tax treatment of dividends
The company
A company’s income before taxes amounts to $100 and it pays tax at the rate of 20%. Its tax expense is therefore $20 and its after-tax net income is $80. The company pays the $80 to its shareholders by way of a dividend.
If we didn’t know the company’s before-tax income, we could calculate it by grossing up the dividend by (20/80) or 25%.
| Actual amount of dividend | $80 |
| Gross-up (25% × $80) | $20 |
| Company’s income before taxes | $100 |
Note the amount of the gross-up is equal to the amount of tax paid by the company.
In an ideal system, the dividend tax credit would be equal to 20% of the grossed-up dividend. The rate of the dividend tax credit would thus be equal to the corporate tax rate and the amount of the dividend tax credit would be equal to the amount of the gross-up, which would itself be equal to the amount of tax paid by the company.
The shareholder
Consider the case of a shareholder who receives a $4.00 dividend and whose marginal rate of tax is 45%. We first calculate the taxable amount of the dividend:
| Actual amount of dividend | $4 |
| Gross-up (25% × $40) | $1 |
| Taxable amount of dividend | $5 |
The gross-up of $1.00 corresponds to the tax paid by the company on behalf of the shareholder. The taxable amount of the dividend ($5.00) corresponds to the corporate before-tax income underlying the dividend.
Next, we calculate the income tax payable by the shareholder on the dividend.
| Income tax on taxable amount of dividend | $2.25 |
| Deduct: Dividend tax credit (20% × $5) | $1 |
| Net tax payable by the shareholder | $1.25 |
Finally, we calculate the dividend tax credit and deduct it from the income tax otherwise payable.
How does the imputation system integrate the personal and corporate tax systems? Note the overall tax paid by the company and the shareholder:
| Tax paid by the company on behalf of the shareholder | $1 |
| Tax paid by the shareholder | $1.25 |
| Overall tax paid | $2.25 |
Had the investor owned the business directly rather than through a company, the business would have earned a before-tax income of $5.00, on which the investor would have paid tax of $2.25 ($5.00 times the marginal tax rate of 45%). This is exactly the same as the overall tax paid under the imputation system.
This example depicts a rather idealized world where the personal and corporate tax systems are perfectly integrated. In such a world, there is indeed no double taxation of dividends. This result is achieved by setting the appropriate rates for the gross-up and the dividend tax credit.
In real life, the rates are such that the integration of the two systems is imperfect, leaving an element of double taxation.
Dividends versus interest
It is commonly believed that dividends are taxed more favourably than interest income. In the example above, the shareholder received $4.00 of dividends and paid tax of $1.25. The implied tax rate is 31.25% ($1.25/$4.00). If the shareholder had instead received interest of $4.00, the tax would have been $1.80 ($4.00 times the marginal tax rate of 45%), instead of $1.25. Therefore, the argument goes, dividend income is taxed more favourably than interest income.
While true, it’s not the whole truth. Comparing $1 of dividends received with $1 of interest is like comparing apples with oranges, because dividends are paid out of after-tax income whereas interest is paid out of before-tax income.
Consider two companies which are identical except for their capital structure. They generate the same income before interest and tax. Company A is financed entirely by means of share capital and therefore has no interest expense. It pays out the whole of its net income after tax to its shareholders by way of dividends. Company B has nominal share capital and is financed almost entirely by means of bonds. Are the investors who receive dividends from Company A better off after tax than those who receive interest from Company B (below)?
Table 2: company income under dividends and interest
| Payments | Company A | Company B |
|---|---|---|
| Income Before Interest & Tax | 5 | 5 |
| Less: Interest Expense | 0 | 5 |
| Income Before Tax | 5 | 0 |
| Less: Income tax (20%) | 1 | 0 |
| Net Income | 4 | 0 |
| Less: Dividends | 4 | 0 |
| Retained Earnings | 0 | 0 |
Let’s see what happens to each company’s income:
Assume, as above, that the investors pay tax at the marginal rate of 45%. We showed in the previous example that the overall tax paid by Company A and its shareholders is $2.25.
Company B paid $5 of interest to its bondholders. This amount of interest is deductible for tax purposes and reduces its taxable income to nil, such that there is no corporate tax to pay.
However, the bondholders must pay tax of $2.25 ($5 * 45%) on their interest income. This is identical to the overall tax paid by Company A and its shareholders. Clearly, the overall tax burden is the same for the two companies and their investors.
Another way to look at the picture is as follows. The shareholders of Company A receive $4 of dividends on which they pay tax of $1.25, leaving them with $2.75. The bondholders of Company B receive interest of $5 on which they pay tax of $2.25. The net result is they are in pocket by $2.75, just like the shareholders of Company A.
The key points to remember:
In practice, the imputation system does not fully integrate the personal and corporate tax systems, resulting in a residual amount of double taxation of dividends. This means the overall tax rate is actually higher on dividends than on interest.
Suitability considerations
At the beginning of this lesson, I pointed out that tax considerations are only part of the story. Suitability to the client is paramount and involves a proper analysis of his or her investment needs and the relevant investment considerations:
Basically, bondholders benefit from greater certainty and priority over shareholders but are denied direct participation in the upside.
When they are suitable to the client, it is entirely proper to recommend dividend-paying stocks. Just don’t do it under the delusion that the client pays less tax when receiving dividends instead of interest.
Foreign dividends are taxed twice
The imputation system applies only to Canadian dividends. It does not apply to dividends from foreign companies. Those dividends are indeed taxed twice. First, the foreign company pays tax to the foreign Government. It then pays dividends to its shareholders, including Canadian shareholders, out of its net after-tax income. The dividends are taxed as ordinary income in the hands of Canadian shareholders at their marginal rate of tax. There is no gross-up or dividend tax credit.
This is not to say you should not invest in foreign stocks. Foreign stocks are desirable because they improve the diversification of a portfolio. However, you should be aware that when you invest in foreign stocks, you are paying income tax twice on the same profits.
Withholding tax
Withholding tax is usually deducted from foreign dividends before they are paid to Canadian shareholders. The withholding tax is not an expense to the Canadian taxpayer because it may be claimed on the personal tax return as a foreign tax credit. However, there is a cash flow disadvantage. The withholding tax is deducted when the dividends are paid, whereas the foreign tax credit is only received much later, after the tax return is filed the following year.
Note the foreign tax credit relates only to the withholding tax deducted from foreign dividends. It does not relate to income taxes paid by the foreign company on its income. There is no way for Canadian taxpayers to get credit for those taxes.
What next?
There is, of course, much more to tax-efficient investing than I have been able to cover in this short lesson.
If this lesson has made you better aware of the importance of tax-efficient investing, I will have achieved my objective.
This course is no longer eligible for CE credits. Go to cecorner.ca to find eligible courses.
While tax-advantaged vehicles such as RRSPs and TSFAs are a sure bet for most investors, they are limited by the investor’s contribution room. Once that has been exhausted, investing in taxable accounts is the next step. At that point, it becomes necessary to take tax considerations into account.
Taxes can have a major impact on investment returns. While few statistics are available in Canada, U.S. studies show that in the ten-year period from 1999 to 2008, taxes reduced the annual return of equity mutual funds by an average of 1.13 percentage points. Bond funds fared even worse because taxes lopped an average of 2.13 percentage points off their annual return.
Why does this matter? Investors typically save for their retirement over long periods of time. Through compounding, a difference of one or two percentage points in the annual return may mean the difference between a comfortable retirement and a frugal one. Tax-efficient investing may lessen the tax bite.
PART 1:
PRINCIPLES OF TAX-EFFICIENT INVESTING
Tax-efficient investing is not about minimizing taxes. If that were the objective, it could be achieved very simply by holding investments which generate no return at all. The aim, rather, is to maximize the after-tax return. Tax efficiency is only part of the story. Advisors should recommend products on the basis of their investment merits and their suitability to the client. While tax considerations should form an integral part of the exercise, a recommendation should not be predicated on tax considerations to the exclusion of other relevant factors. The investment dog should wag the tax tail and not the other way round.
Investment returns can take different forms, depending on the nature of the investment. Cash generates interest income. Bonds generate interest income and, to some extent, capital gains. Stocks generate capital gains and dividends.
The most common forms of investment return are:
- Interest income
- Dividends from Canadian companies
- Dividends from foreign companies
- Realized capital gains, net of realized capital losses
- Unrealized capital gains, net of unrealized capital losses
Each type of return is taxed differently, as shown in Table 1.
Table 1: Tax treatment of investment returns
| Type of Return | Tax Treatment |
|---|---|
| Interest income | Fully taxed at the investor’s marginal tax rate |
| Canadian dividend income | Subject to gross-up and the dividend tax credit |
| Foreign dividend income | Fully taxed at the investor’s marginal tax rate |
| Net realized gains | 50% is taxed at the investor’s marginal tax rate |
| Net unrealized gains | Not taxable until the gain is realized |
Interest and foreign dividend income are taxed as ordinary income. In other words, they are taxed in full at the investor’s marginal tax rate.
Canadian dividend income is subject to separate tax rules, relating to gross-up and the dividend tax credit, which are designed to avoid the double taxation of dividends.
Maximizing capital gains
Capital gains have two relevant characteristics. First, they are more favourably taxed than other types of return, since only 50% of capital gains need to be included in income for tax purposes. Making the most of the favourable treatment of capital gains is an important principle of tax-efficient investing.
Secondly, capital gains are taxed (and capital losses allowed as deductions) only when they are realized, for example, when the related investment is disposed of. As long as the investor continues to hold the investment, tax on the gain is deferred. Since the investor is free to decide when to dispose of the investment, the timing of the payment of tax on capital gains is, to some extent, discretionary.
It is always preferable to pay tax later rather than sooner because the money can be invested during that interval, earning additional returns. The deferral of taxes on capital gains is another important principle of tax-efficient investing.
Implications for asset allocation
Investors’ tax bills depend on the mix of the different types of return they earn on their portfolio. While the lightest burden is borne by investors who earn their return in the form of capital gains—especially if the related taxes are deferred for as long as possible—the biggest impact is on those who earn ordinary income such as interest.
The mix of returns depends to a large extent on the investor’s asset allocation, which is the process of dividing up the portfolio into asset classes such as stocks, bonds and cash. A portfolio with a large allocation to stocks will generate returns mostly in the form of capital gains and dividends. However, one with a large allocation to bonds or cash will generate returns mostly in the form of interest.
Best practice is to perform asset allocation with the use of a computer program known as an optimizer. This tool uses the expected return of each asset class and the related volatilities and correlations to generate efficient portfolios, i.e. portfolios with the least risk for a given expected return. The exercise is usually based on pre-tax numbers.
This approach is fine for tax-exempt investors such as pension funds. For the taxable investor, however, it is the after-tax return that matters, and asset allocation should be performed using after-tax numbers. Because of the favourable tax treatment of capital gains, this will usually result in a larger allocation to stocks when compared with an asset allocation based on pre-tax numbers.
Losing money and still paying tax
When investors hold stocks directly, they realize a capital gain or loss when disposing of their investments. Only then do they pay tax on the capital gain or claim a capital loss. Things get more complicated when stocks are held indirectly through an investment fund. In such cases, investors may have to pay tax on capital gains even if they still hold the units of the fund.
When investment funds realize net capital gains on the disposal of portfolio investments, they routinely distribute the net gains to their investors, in whose hands the net gains are then taxed. This makes sense because, provided certain conditions are satisfied, investment funds may deduct for tax purposes the amount of distributions to their investors. Since most investors pay tax at a lower rate than the fund, the distribution of the net gains reduces the overall taxes payable.
This tax regime may produce disconcerting results for unwary fund investors. For example, in 2008 the markets dropped precipitously and most investors experienced negative returns. Despite their investment losses, many fund investors found themselves in the situation of having to pay tax.
When the markets dropped, most funds experienced net unrealized losses on their portfolio holdings. Those losses more than offset the net gains realized earlier in the year, with the result that the funds experienced negative returns for the full year.
What’s important to note in this situation is that net unrealized losses have no impact on a fund’s immediate tax situation. However, net realized gains are taxed in the same year.
To eliminate their tax liability, the funds distributed their net realized gains. As a result, their investors had to pay tax on capital gains in spite of a negative return on their fund investments.
What lesson can be learned? When investing through investment funds, investors should be wary of distributions. That’s because distributions do not make investors better off; instead, they trigger a tax liability. Investors become better off when the fund earns a return, not when the return is distributed.
Suitability and tax considerations
It’s extremely important that an investment suit the investor’s overall situation. The investor’s objectives and risk tolerance and the tax treatment of the investment have to be carefully weighed in making a determination on suitability.
By way of illustration, the equity portion of a portfolio may be invested in the stocks of either dividend-paying or non-dividend-paying companies. In the latter case, the return takes the form of a capital gain, on which tax is deferred for as long as the stock is held.
An investment in a company that pays dividends makes sense for investors who require current income from their portfolios, such as retirees. It makes less sense for investors with no need for current investment income because, for example, they are gainfully employed. When investors in the latter category buy the stocks of dividend-paying companies, the best thing to do with the dividends is probably to reinvest them in additional shares of the company, thereby benefiting from dollar-cost averaging (buying a fixed dollar amount of a particular investment on a regular schedule, regardless of share price). However, they will be worse off because of the tax on the dividends.
It would be more tax-efficient for these investors to hold the stocks of companies that do not pay dividends and to earn their return in the form of unrealized capital gains. Admittedly, this approach can be more risky. Companies that pay dividends tend to be large and well-established whereas those paying no dividends tend to be smaller businesses in the growth phase.
However, the argument must not be pushed too far. In the wake of the major market correction of 2008, dividend-paying stocks have become increasingly popular with investors. Dividends are sometimes perceived as the proverbial bird in the hand—they are represented by hard cash. “Show me the cash” has become investors’ battle-cry.
On the other hand, unrealized capital gains are perceived as the bird in the bush—they are exposed to the market and may disappear if there is a downturn. The distinction is indeed valid if the investor intends to spend the dividends or to hold them in cash. If the dividends are reinvested, however, they become exposed to the market once again—the bird has flown back into the bush, leaving the investor with a tax bill in hand.
PART 2:
TAX-EFFICIENT INVESTING AND CAPITAL GAINS
As noted above, one of the principles of tax-efficient investing is to defer the payment of tax on capital gains whenever possible—it is always better to pay tax later rather than earlier. In the meantime, the money can be invested to generate additional returns.
Yet there are many reasons why it may be advisable to dispose of an investment, even if this triggers a taxable capital gain. For example:
- It is no longer consistent with the client’s investment objectives.
- It has reached its full potential.
- Its prospects have changed.
- You need to rebalance the client’s portfolio.
Even in such cases, it is possible to defer the tax if the investment takes the form of shares of an investment fund corporation and the investor switches from one fund to another within the corporation.
A mutual fund corporation has several classes of shares, each of which corresponds to a separate fund. The investor can switch from one fund to another simply by switching from one class of shares to another within the corporation. The Income Tax Act (Canada) allows this on a tax-deferred basis. Tax is payable only when the investor redeems shares of a class without reinvesting the proceeds in shares of another class within the same mutual fund corporation.
Capital gains through the back door
Caution is necessary if you advise your clients to invest in shares of a mutual fund corporation. A switch is effectively the redemption of shares of one fund and the simultaneous purchase of shares of another fund. The fund whose shares are being redeemed must pay the redemption proceeds to the fund whose shares are being purchased. To do this, it must have sufficient cash. If the issue of new shares to other investors is insufficient to compensate for the redemptions, the fund may need to sell some of its portfolio investments in order to raise the required cash. As a result, it may realize capital gains, which will be distributed to its remaining investors and taxed in their hands. Make sure your clients are not among those investors.
How to avoid capital gains distributions
The deferral of tax on capital gains is most complex when the investor owns investment funds. This is because, in addition to being taxed on capital gains realized on the disposal of their units, investors are taxed on the net gains distributed by the fund while they are unitholders. The decisions that trigger capital gains distributions are usually made not by the investors, but by the fund’s portfolio advisor.
Investors may avoid paying unnecessary taxes by staying clear of funds that are prone to capital gains distributions. Knowledge of the factors that drive distributions will help weed out tax-inefficient funds.
Active versus passive
An important factor is whether the fund’s portfolio is actively or passively managed. A fund portfolio is actively managed when the advisor tries to outperform a benchmark, such as the S&P/TSX Composite Index, which is a broad index of Canadian stocks. A portfolio is passive when it replicates an index. In this case, the portfolio will hold the same stocks, and in the same proportion, as the index. Funds that track an index are known as index funds. Their return should be equal to that of the index less the fund’s fees and expenses.
When a portfolio is passive, there is no reason to sell portfolio investments except when changes are made to the index. Because index funds trade infrequently, they realize and distribute few capital gains. Their return mostly takes the form of unrealized capital gains.
In attempting to outperform the index, actively managed funds usually trade more frequently than their passive counterparts. To the extent that the trades generate capital gains, the latter will be distributed to the fund’s investors.
As mentioned above, taxable investors should base their asset allocation on expected after-tax returns and related volatilities and correlations. If the assets you are considering for the portfolio include both actively managed funds and index funds, the use of after-tax rather than pre-tax numbers will usually result in a larger allocation to index funds. This reflects the greater tax efficiency of index funds, which is itself a consequence of their low portfolio turnover.
Management style
When the fund portfolio is actively managed, another important factor affecting capital gains distributions is the management style.
For instance:
- The growth style involves investing in the stocks of companies that exhibit above-average sales and earnings growth.
- The momentum style involves investing in stocks that exhibit above-average price increases.
- The value style involves investing in stocks that the advisor believes to be undervalued, taking into account factors such as the price-to-book ratio, the price-earnings ratio and the dividend yield.
Some styles imply more frequent trading than others. The value style assumes the market will ultimately recognize the stock is undervalued, at which time the stock price will rise to its intrinsic value. However, market recognition often takes a long time to occur, if at all. Consequently, funds managed according to the value style tend to trade less frequently than those managed according to the growth and momentum styles. They are therefore less likely to distribute capital gains.
Is the fund experiencing net redemptions?
Although a fund’s capital gains distributions are usually the result of actions taken by the portfolio advisor, they are sometimes driven by the actions of its investors. This is particularly true when redemptions by existing investors exceed the sale of new units. In order to finance the net redemptions, it may be necessary for the fund to sell some of its portfolio investments, thereby possibly triggering capital gains.
The Income Tax Act (Canada) includes the Capital Gains Refund Mechanism (CGRM), which allows the fund to retain the capital gains attributable to the redemption of units without having to pay tax. The CGRM uses a formula to calculate the relevant gains and admittedly is not a perfect mechanism, especially when the market value of the investments has dropped well below the original cost. Some capital gains may still need to be distributed to the unitholders and will be taxed in their hands.
The portfolio turnover rate and its limitations
Many investors use the portfolio turnover rate as an indicator of a fund’s tax efficiency. Higher portfolio turnover is usually associated with tax inefficiency. The implied assumption is that a fund with a high turnover triggers frequent capital gains, which are distributed to unitholders.
While there is some truth in this assumption, it would be simplistic to equate a high turnover rate with tax inefficiency. Portfolio turnover may be good because, in some instances, it enables a fund to improve its tax position. Tax-loss harvesting is a case in point.
There is a potential for tax-loss harvesting whenever the current price of an investment is less than its original cost. The sale of the investment triggers a tax loss that may be applied against capital gains realized on the sale of other investments, thereby reducing the net capital gain on which tax is assessed. This trading activity increases the portfolio turnover. However, the result is to improve the portfolio’s tax position rather than to hurt it.
The portfolio turnover rate may be used as a screening device, but it isn’t a substitute for a proper analysis of the fund’s circumstances.
Do fund investors pay tax twice on capital gains?
Because they pay tax both on the capital gains realized when redeeming their units and on the gains distributed by the fund, many investors are convinced they are taxed twice on the same gains. In actual fact, no double taxation is involved. However, when a fund distributes a capital gain, it does accelerate the payment of tax by its investors. The latter must pay, in the year of the distribution, the tax they would otherwise pay in the year they redeem the units. Investors are, of course, worse off when they pay taxes earlier than later.
A fund usually distributes capital gains in the form of additional units. The issue of new units is immediately followed by a consolidation of the units, such that the total number of units outstanding and the unit price remain the same. Unlike a cash distribution, there is no transfer of value from the fund to the investors. The sole object of the exercise is to transfer the liability for the tax on realized capital gains from the fund to its investors.
For tax purposes, the adjusted cost base of the investor’s units is increased by the amount of the distribution. When the investor ultimately redeems the units, the capital gains will be reflected in the net asset value of the fund and therefore in the redemption proceeds. The amount of the distribution is thus reflected in both the redemption proceeds and the adjusted cost base and therefore cancels itself out (see Case Study: Capital gains taxation, below).
Case study: Capital gains taxation
Take the example of an investor who owns units of an investment fund with a tax cost of $1,000. At the end of 2010, the market value of the units is $1,500. As far as the investor is concerned, there is an unrealized capital gain of $500.
The fund sold some portfolio investments in 2010. As far as the fund is concerned, the related capital gains have been realized and they are duly distributed at year-end. Our investor’s share of the capital gains distribution is $200, which is taxed in the same year. At the same time, the amount of the distribution is added to the adjusted cost base of the units, which becomes $1,200, or ($1,000 plus $200).
In 2011, the investor redeems all the units. The fund has made neither profit nor loss in the meantime, and the market value of the units is still $1,500. For tax purposes, the investor’s capital gain is $300, represented by proceeds of $1,500 less the adjusted cost base of $1,200. The investor is taxed on that gain in the same year.
| Year | Amount of Tax |
|---|---|
| 2010 | $200 |
| 2011 | $300 |
| Total Taxation | $500 |
The investor is taxed on the capital gains as follows:
If the fund had not made a distribution in 2010, the investor would have realized a capital gain of $500 (proceeds of $1,500 less adjusted cost base of $1,000) at the time of redeeming the units in 2011, and would have been taxed on that amount in 2011. The distribution in 2010 accelerated the payment of tax by the investor on capital gains of $200.
Importance of proper tax records
The adjusted cost base of the units held by the investor is increased by the amount of the capital gains distributions. It is this step-up in the tax cost that prevents the same gain from being taxed twice when the investor ultimately redeems the fund units.
What if the tax records of the investor are deficient? What if the investor omits to add the amount of the capital gains distributions to the adjusted cost base of the units? In these cases, there would indeed be double taxation at the time of redeeming the units. This double taxation would be the result of the absence of proper tax records on the part of the investor. We can only guess at how much tax is overpaid each year for this reason.
Why are capital gains taxed on the redemption of fund units?
If the fund distributes its capital gains each year, why is there another gain (or loss) when investors redeem their fund units?
The capital gains distributed by the fund are the net gains it realizes year by year on the portfolio investments sold during the year. In addition, when investors redeem their units, there will be unrealized gains on the portfolio investments the fund holds at that time. The unrealized gains are reflected in the fund’s net asset value, which is the price that investors receive when they redeem their units. The gains are still unrealized as far as the fund is concerned (because the fund still holds the investments in its portfolio) but they have now been realized by the investors (because the latter have redeemed their units). It is on those gains that investors pay tax when redeeming units of the fund.
As seen in the case study, the capital gains distribution of $200 in 2010 corresponds to net gains realized by the fund on the sale of portfolio investments in 2010. On the other hand, the capital gain of $300 realized by the investor in 2011 on the redemption of units corresponds to net unrealized gains on the fund’s portfolio of investments at the time of the redemption.
PART 3:
TAX-EFFICIENT INVESTING AND DIVIDENDS
Tax-efficient investing, as it relates to dividends, revolves around the following questions:
- What are the relevant considerations when deciding whether to invest in the stocks of dividend-paying or non-dividend-paying companies? We addressed this question above.
- Is it preferable to invest in dividend-paying stocks rather than bonds, on the grounds that dividends are more lightly taxed than interest? We will address this question here.
First, we need to provide some background on the tax treatment of dividends. Companies pay dividends to their shareholders out of their after-tax income.
The sequence of events is as follows:
- The company pays income tax on its income.
- The company then pays dividends to its shareholders out of the after-tax net income.
- Shareholders pay tax on the dividends.
In the absence of special measures, the same income would be taxed twice — once in the hands of the company and again in the hands of the shareholders.
Taxing the same income two or more times would be unfair. It would also have the undesirable result of discouraging savings and investment. The Income Tax Act (Canada) includes a number of mechanisms, known as flow-through mechanisms, to avoid multiple taxation of the same income. A flow-through mechanism taxes the income of a business entity as if it had been earned directly by the investor. Consequently, the business entity and the investor pay the same amount of tax overall, as though the investor had earned the underlying income directly.
The flow-through mechanism used to avoid the double taxation of dividends is known as the imputation system.
Why dividends are not taxed twice
The objective of the imputation system is to integrate the personal and corporate tax systems such that dividends are taxed only once. The mechanics of the system are:
-
- Calculate the corporate income out of which the dividend was paid. This is achieved by grossing up the actual amount of the dividend received by the shareholder. The gross-up percentage depends on the rate of tax paid by the company.
- Shareholders are taxed on the grossed-up amount. This is their notional share of the company’s before-tax income corresponding to the dividend received. Shareholders pay tax on the taxable amount of the dividend at their marginal rate of tax.
- The system recognizes that the company has already paid tax on its income. This tax is considered to be a prepayment of tax by the company on behalf of its shareholders. The latter may deduct their share of this tax in the form of a dividend tax credit calculated as a percentage of the grossed-up dividend.
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It is inappropriate to compare $1 of dividends received with $1 of interest income.
This is because dividends are paid out of after-tax income, while interest is paid out of before-tax income. The corporate tax reduces the amount available for distribution by way of dividends. In our example, Company B could afford to pay $5 of interest but Company A could only afford to pay $4 of dividends.
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Dividends appear to be more lightly taxed than interest because of the dividend tax credit.
In actual fact, the dividend tax credit does not constitute a gift from a benevolent government intent on encouraging Canadians to invest in the shares of companies. It merely credits shareholders for tax already paid on their behalf by the company. The dividend tax credit does not constitute an additional benefit to investors—all it does is prevent double taxation.
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Look beyond visible taxes. In particular, be wary of embedded taxes.
These taxes may be relatively painless because the investor may not even be aware of them. However, they are just as harmful to the investor’s financial situation. A company belongs to its shareholders and corporate taxes are effectively paid out of shareholders’ pockets.
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The payment of interest on the due dates is a contractual obligation of the company.
Dividends are always discretionary.
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Interest is paid at a known, fixed rate.
Dividends may rise or fall, depending on the fortunes of the company, and may drop all the way to zero.
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Bonds have a known maturity date on which they will be worth a known amount (the principal amount), subject to the solvency of the company.
Stocks do not have a maturity date and their future value is never known in advance. It could be higher or lower than today’s value.
-
Stocks have a greater potential for capital gains or losses than bonds.
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In a bankruptcy, bondholders rank ahead of shareholders.
- the importance of asset location (not to be confused with asset allocation)
- tax-efficient ways to gain exposure to bonds
- the mechanics of tax-loss harvesting and the associated pitfalls
- the issues with the pricing of investment fund units stemming from the treatment of tax assets and liabilities
- the need to keep track of a fund’s tax overhang
- cutting-edge developments in tax-efficient investing
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Let’s illustrate these mechanics with a hypothetical, scaled-down example (“Tax treatment of dividends”).
Tax treatment of dividends
The company
A company’s income before taxes amounts to $100 and it pays tax at the rate of 20%. Its tax expense is therefore $20 and its after-tax net income is $80. The company pays the $80 to its shareholders by way of a dividend.
If we didn’t know the company’s before-tax income, we could calculate it by grossing up the dividend by (20/80) or 25%.
| Actual amount of dividend | $80 |
| Gross-up (25% × $80) | $20 |
| Company’s income before taxes | $100 |
Note the amount of the gross-up is equal to the amount of tax paid by the company.
In an ideal system, the dividend tax credit would be equal to 20% of the grossed-up dividend. The rate of the dividend tax credit would thus be equal to the corporate tax rate and the amount of the dividend tax credit would be equal to the amount of the gross-up, which would itself be equal to the amount of tax paid by the company.
The shareholder
Consider the case of a shareholder who receives a $4.00 dividend and whose marginal rate of tax is 45%. We first calculate the taxable amount of the dividend:
| Actual amount of dividend | $4 |
| Gross-up (25% × $40) | $1 |
| Taxable amount of dividend | $5 |
The gross-up of $1.00 corresponds to the tax paid by the company on behalf of the shareholder. The taxable amount of the dividend ($5.00) corresponds to the corporate before-tax income underlying the dividend.
Next, we calculate the income tax payable by the shareholder on the dividend.
| Income tax on taxable amount of dividend | $2.25 |
| Deduct: Dividend tax credit (20% × $5) | $1 |
| Net tax payable by the shareholder | $1.25 |
Finally, we calculate the dividend tax credit and deduct it from the income tax otherwise payable.
How does the imputation system integrate the personal and corporate tax systems? Note the overall tax paid by the company and the shareholder:
| Tax paid by the company on behalf of the shareholder | $1 |
| Tax paid by the shareholder | $1.25 |
| Overall tax paid | $2.25 |
Had the investor owned the business directly rather than through a company, the business would have earned a before-tax income of $5.00, on which the investor would have paid tax of $2.25 ($5.00 times the marginal tax rate of 45%). This is exactly the same as the overall tax paid under the imputation system.
This example depicts a rather idealized world where the personal and corporate tax systems are perfectly integrated. In such a world, there is indeed no double taxation of dividends. This result is achieved by setting the appropriate rates for the gross-up and the dividend tax credit.
In real life, the rates are such that the integration of the two systems is imperfect, leaving an element of double taxation.
Dividends versus interest
It is commonly believed that dividends are taxed more favourably than interest income. In the example above, the shareholder received $4.00 of dividends and paid tax of $1.25. The implied tax rate is 31.25% ($1.25/$4.00). If the shareholder had instead received interest of $4.00, the tax would have been $1.80 ($4.00 times the marginal tax rate of 45%), instead of $1.25. Therefore, the argument goes, dividend income is taxed more favourably than interest income.
While true, it’s not the whole truth. Comparing $1 of dividends received with $1 of interest is like comparing apples with oranges, because dividends are paid out of after-tax income whereas interest is paid out of before-tax income.
Consider two companies which are identical except for their capital structure. They generate the same income before interest and tax. Company A is financed entirely by means of share capital and therefore has no interest expense. It pays out the whole of its net income after tax to its shareholders by way of dividends. Company B has nominal share capital and is financed almost entirely by means of bonds. Are the investors who receive dividends from Company A better off after tax than those who receive interest from Company B (below)?
Table 2: company income under dividends and interest
| Payments | Company A | Company B |
|---|---|---|
| Income Before Interest & Tax | 5 | 5 |
| Less: Interest Expense | 0 | 5 |
| Income Before Tax | 5 | 0 |
| Less: Income tax (20%) | 1 | 0 |
| Net Income | 4 | 0 |
| Less: Dividends | 4 | 0 |
| Retained Earnings | 0 | 0 |
Let’s see what happens to each company’s income:
Assume, as above, that the investors pay tax at the marginal rate of 45%. We showed in the previous example that the overall tax paid by Company A and its shareholders is $2.25.
Company B paid $5 of interest to its bondholders. This amount of interest is deductible for tax purposes and reduces its taxable income to nil, such that there is no corporate tax to pay.
However, the bondholders must pay tax of $2.25 ($5 * 45%) on their interest income. This is identical to the overall tax paid by Company A and its shareholders. Clearly, the overall tax burden is the same for the two companies and their investors.
Another way to look at the picture is as follows. The shareholders of Company A receive $4 of dividends on which they pay tax of $1.25, leaving them with $2.75. The bondholders of Company B receive interest of $5 on which they pay tax of $2.25. The net result is they are in pocket by $2.75, just like the shareholders of Company A.
The key points to remember:
In practice, the imputation system does not fully integrate the personal and corporate tax systems, resulting in a residual amount of double taxation of dividends. This means the overall tax rate is actually higher on dividends than on interest.
Suitability considerations
At the beginning of this lesson, I pointed out that tax considerations are only part of the story. Suitability to the client is paramount and involves a proper analysis of his or her investment needs and the relevant investment considerations:
Basically, bondholders benefit from greater certainty and priority over shareholders but are denied direct participation in the upside.
When they are suitable to the client, it is entirely proper to recommend dividend-paying stocks. Just don’t do it under the delusion that the client pays less tax when receiving dividends instead of interest.
Foreign dividends are taxed twice
The imputation system applies only to Canadian dividends. It does not apply to dividends from foreign companies. Those dividends are indeed taxed twice. First, the foreign company pays tax to the foreign Government. It then pays dividends to its shareholders, including Canadian shareholders, out of its net after-tax income. The dividends are taxed as ordinary income in the hands of Canadian shareholders at their marginal rate of tax. There is no gross-up or dividend tax credit.
This is not to say you should not invest in foreign stocks. Foreign stocks are desirable because they improve the diversification of a portfolio. However, you should be aware that when you invest in foreign stocks, you are paying income tax twice on the same profits.
Withholding tax
Withholding tax is usually deducted from foreign dividends before they are paid to Canadian shareholders. The withholding tax is not an expense to the Canadian taxpayer because it may be claimed on the personal tax return as a foreign tax credit. However, there is a cash flow disadvantage. The withholding tax is deducted when the dividends are paid, whereas the foreign tax credit is only received much later, after the tax return is filed the following year.
Note the foreign tax credit relates only to the withholding tax deducted from foreign dividends. It does not relate to income taxes paid by the foreign company on its income. There is no way for Canadian taxpayers to get credit for those taxes.
What next?
There is, of course, much more to tax-efficient investing than I have been able to cover in this short lesson.
If this lesson has made you better aware of the importance of tax-efficient investing, I will have achieved my objective.
