Reader alert: This is part 5 of a five-part series.
• Part 1: Tackling tax-efficient investing
• Part 2: Capital gains mean tax-efficient investing
• Part 3: Tax-efficient investing and dividends
• Part 4: Magic of tax-efficient bond investing
• Part 5: Tax-efficient investor behaviour

This is the last in a series of articles on tax-efficient investing. This series has merely scratched the surface of the topic, but demonstrates your clients’ portfolios can reap substantial benefits from a tax-aware approach.

In this final article, I discuss some aspects of tax-efficient investor behaviour I did not cover in earlier articles: tax-loss harvesting, navigating the subtleties of fund pricing, and a tax-aware approach to portfolio management.

Harvesting tax losses

Harvesting tax losses is an important principle of tax-efficient investing. It is applicable whether the investor holds individual stocks and bonds or investment funds.

There are opportunities for tax-loss harvesting whenever the current price of an investment is lower than its tax cost. By disposing of the investment, it is possible to realize a tax loss, which may be offset against capital gains realized on the disposal of other investments. This will reduce the overall tax payable by the investor.

Beware the superficial loss rule

If the investor believes the investment being disposed of has little potential, the disposal proceeds are simply reinvested in another, more promising investment. However, if the investor believes the drop in value is temporary and the investment will recover, it will be necessary to re-establish the position by buying the investment back.

In so doing, it’s important to guard against the superficial loss rule. Under this rule, if the investor or an affiliated person reacquires the same investment within 30 days of the disposal date, the loss will not be deductible. Instead, it will be added to the adjusted cost base of the investment that has just been bought. Consequently, the investor should not buy the investment back during the 30-day period in any account, including registered ones.

One way to avoid the application of the superficial loss rule is to hold the sale proceeds in cash during the 30-day period and then buy the investment back. However, this approach exposes the investor to the risk that the price of the investment may go up during that time. If this happens, the investor will lose because of a lack of exposure to the investment.

To manage this risk, the investor may reinvest the proceeds temporarily in a similar investment. This could be the stock of another company in the same industry or a broader investment such as a sectoral index fund. The expectation is the price of the new investment will move in tandem with that of the original investment.

Of course, the new investment would not be a perfect substitute for the old. If it were, the investor would run afoul of the superficial loss rule. However, this approach enables the investor to manage the risk associated with being completely out of the market during the 30-day period. At the end of the period, the investor will liquidate the new investment and use the proceeds to re-establish the position in the original investment.

Subtleties of fund pricing

A fund’s net asset value (NAV) per unit systematically excludes certain tax liabilities and assets. The units are overpriced to the extent the NAV excludes tax liabilities and underpriced to the extent that it excludes tax assets.

Off-balance-sheet liabilities

A fund’s assets consist mainly of its portfolio of investments. For pricing purposes, the latter are stated at their fair value. If the fair value of an investment is higher than its cost, there is an unrealized gain.

When a business revalues an asset and there is an unrealized gain, it simultaneously recognizes in its financial statements the tax that would become payable if the asset were sold at the fair value. Investment funds are different in that they do not recognize in their financial statements the tax liability associated with unrealized gains. Nor is the liability reflected in the fund’s NAV.

Why? The liability isn’t expected to be the fund’s, but rather that of the unitholders. When the investment is ultimately sold and the gain is realized, the fund will distribute the gain to its investors, who will be responsible for paying the tax thereon. The tax can be quite large, especially if the fund has a low portfolio turnover and has held its investments for a long time.

You can avoid falling into this trap by looking at the fund’s tax overhang, also known as the potential capital gains exposure. The tax overhang is not disclosed in the fund’s public filings, but it may be easily calculated from publicly available data.

We first calculate the unrealized gain on the portfolio of investments, which is simply the difference between the fair value of the portfolio and its cost. We obtain the tax overhang by dividing the unrealized gain by the fund’s net assets and expressing the result as a percentage. The higher the figure, the larger the investor’s exposure to potential capital gains distributions by the fund.

In the U.S., investors have a straightforward way to gauge a fund’s tax overhang. U.S. mutual funds are required to disclose:

  1. the return before taxes
  2. the return after taxes on distributions
  3. the return after taxes on distributions and the redemption of fund units

I explained in “Capital gains mean tax-efficient investing” (AER, February 2011) the taxes on the redemption of fund units relate to the unrealized gains on the portfolio investments held by the fund on the date of redemption. The difference between returns 2 and 3 represents the impact on the fund’s return of the tax overhang. Unfortunately, Canadian mutual funds aren’t required to disclose after-tax returns, so we can’t use this method here.

I’ve said a low portfolio turnover may indicate tax efficiency. I’m now saying funds with a low turnover are potential tax traps. How may we reconcile the two statements?

If a fund holds its investments for long periods, its capital gains will remain unrealized and it will have few gains to distribute. Investors who invest early in the fund will benefit from its tax efficiency. Provided the fund is properly managed, they will see their investment grow on a tax-deferred basis.

However, as the fund accumulates unrealized gains over time, it becomes a tax trap to late investors. When the fund ultimately realizes its gains, those investors will need to pay tax on gains that accrued before they became investors. If you are a latecomer, it pays to watch for tax overhangs. Many advisors will not recommend a fund to their clients unless it has a fairly lengthy track record, by which time it may have accumulated a substantial tax overhang.

I’ve noted it may be tax-inefficient to be among the last investors to leave an investment fund. The corollary? When buying into an investment fund, it may be tax-efficient to be among the early investors. The early bird catches the worm and the early investor catches the benefits of tax efficiency.

Off-balance-sheet assets

Unrecognized assets are the flip side of unrecognized liabilities. Investment funds are not allowed to distribute losses to their investors. In practice, they usually carry the losses forward and offset them against future gains, in the case of capital losses, and future income, in the case of non-capital losses.

A potential benefit is associated with tax losses. The benefit will materialize if and when the fund offsets the losses against future income or gains. This will reduce the income or net gain that the fund distributes in the future to its investors and consequently the taxes they pay. Because the tax benefit will accrue to the investors rather than the fund, it is not recognized in the fund’s financial statements, nor reflected in the fund’s NAV.

Information about losses carried forward is disclosed in the notes to the financial statements. By relating the losses to the fund’s net assets, you can obtain a good idea of their materiality. Funds that realized large losses during the 2008 meltdown may be able to offset them against future gains, if any — at which time unitholders will derive a “free lunch.”

HNW clients and tax-efficient investing

Portfolio advisors, particularly in the high-net-worth market, are now explicitly taking into account the consequences of their decisions on clients’ tax situations.

For example: Kimberley’s portfolio includes shares of ABC Ltd. (ABC), which she purchased years ago. The adjusted cost base of the shares is $100,000 and their current market value is $250,000.

Kimberley’s marginal tax rate is 46%. She’s pleased ABC has done well, but her portfolio advisor has concluded ABC will experience a slower rate of growth in future. The advisor also believes XYZ Ltd. (XYZ), a company with a similar risk profile, will experience superior growth. Should the portfolio advisor sell the shares of ABC and reinvest the proceeds in those of XYZ?

If the shares are held in a tax-advantaged account, such as an RRSP or a TFSA, it makes sense to sell ABC and buy XYZ, other things being equal.

If the shares are held in a taxable account, the analysis becomes more complex. No taxes are immediately payable if the portfolio advisor continues to hold the shares of ABC. However, if the advisor replaces ABC with XYZ, the sale of ABC will trigger a capital gain of $150,000 on which the investor will need to pay immediate taxes of $34,500. It is profitable to purchase XYZ only if the incremental return is sufficient to cover the cost associated with the acceleration of tax payments. This complex calculation involves factors such as:

  • the incremental return of XYZ shares over ABC shares
  • the after-tax return $34,500 will earn if Kimberley is not immediately required to pay the taxes owing
  • how long she will hold XYZ
  • the investor’s expected tax rate when she sells XYZ

This tax-aware approach is rarely used, even in the HNW market. This may change as advisors and investors become more cognizant of the importance of after-tax returns. In the U.S., the mandatory disclosure of after-tax returns by mutual funds has raised awareness of the impact of taxes on returns. If a similar requirement were introduced in Canada, it would probably have the same beneficial effect.

  • ANDRÉ FOK KAM, CA, MBA is a consultant to the financial services industry. He authored the Tax-efficient Fund Investing Course offered by the IFSE Institute. He is a member of the Independent Review Committee of the Standard Life Mutual Funds.