Entries from October 2019 ↓

The big bite

Justin Trudeau may be the prime minister. But Jag Singh may up being the finance guy. As mentioned here a few days ago, it’s the sum of all fears – that a minority left-lib government will cave to the far-lefties in order to retain power. T2 says no coalition. But he cannot govern without support. Facts are facts.

This terrifies Nate.

“I have a question about the inclusion rate on capital gains and possible government future changes,” he writes me. “If the Libs and NDP passed changes to the inclusion rate would it be effective immediately?  Just wondering the likely outcome. Pam and I have about 2-plus million in unrealized capital gains in real estate most of which is on one property. Selling sooner would be a big difference? I wonder about selling to myself or into a limited company thereby triggering capital gains tax –   sounds crazy but the extra tax is around $500,000 plus for all our buildings? Ouch.”

Yup, big ouch. The tax hit on dumping those properties would be 50% higher in this scenario. But is this a realistic possibility?

First, how are capital gains taxes calculated?

When an asset is sold, the difference between its market value (selling price) and what you invested in it (the ACB – adjusted cost base) is called a capital gain. In the case of real estate the ACB includes the purchase price plus the cost of all improvements made while you’ve owned it. That number is reduced if you claimed capital cost allowance annually or deducted the improvements from taxes owed. (Never, ever let your accountant claim CCA on a leased condo, by the way…)

If you sell for a profit over the ACB then half that gain is tax-free. Yay! The other half is added to your taxable income for the year in which the sale occurs. Clearly that can push you into a higher tax bracket, so just imagine if the capital gains inclusion rate moves from 50% to 75%.

Example: Nate, who has an income of $100,000, sells and realizes a million in profit on his properties. Under the current rules $500,000 is added to his income and his 2019 tax total (for Ontario) is $153,000. If the cap gains tax were bumped to 75%, his tax would jump to $220,000.

Of course, the dollar-is-a-dollar crowd argues investors today (in investment real estate, stocks or ETFs etc) get an outrageous advantage in having only half the gains taxed while working schmucks are fully exposed to tax on employment income, rent, pensions or interest on their pathetic GICs. Sadly, this is growing in our tilting society.

“When you go to work, you’re taxed on almost all of your income,” says Jag. “It doesn’t make sense that someone making their money from investments is taxed on only half.”

Says the lobby group, ‘Canadians for Tax Fairness’: “This costs the government $10 billion that could boost their inadequate investment in child care. It would create more jobs, boost participation of women in the labour force and increase tax revenue over time. Budgets are about priorities. When 92% of the benefit of this protected loophole goes to the top 10% it makes one question their stated commitment to tax fairness and helping the “middle class”. “

The current 50% inclusion rate has been in place for two decades. Bumping it up by half, the NDP claims, would bring in $3 billion that Ottawa can spend on social programs. The socialists claim 88% of the cap gains benefit goes to the top 1%, and “this is unfair for people who are trying to build a better future for their families.”

Let’s not forget that the Liberals themselves have toyed with diddling with capital gains. A controversial plan to restrict this in terms of farm families (and others) was abandoned after sharp criticism, and the party’s 2015 platform included a commitment to review every tax advantage investors ( aka ‘the rich’) enjoy over employees. This was the philosophy at the heart of Morneau’s attack on the self-employed and private corps last year.

Why should capital gains receive special tax treatment?

Simple, so people invest. Doing so involves inherent risk, since assets can fall in value as easily as they increase. Taxing gains less and allowing losses to be deducted from profits recognizes that risk. It encourages people to put money into businesses, creating jobs. Or into the capital markets, strengthening the overall economy. Or into rental real estate, providing housing. Or financing government debt, so politicians can overspend. Current laws also keep us competitive with the US (even though cap gains are taxed less there), since money has no patriotism.

“If we raise the capital gains tax rate that’s just going to encourage more people to look at the American market to start businesses or to develop things down there as opposed to here if that happens,” says tax academic Jack Mintz. “It’s not good to start looking at hiking more taxes on investors at this point.”

In any case, is this change possible?

My answer to Nate: an unqualified maybe. T2’s been coy so far about how far into the sheets he’ll crawl with the Dippers. Obviously the Libs need money. The projected deficit numbers are horrendous, and if a recession materializes we’re pooched. Meanwhile Trudeau has shown – with his special tax bracket for high income-earners, his attack on stock options and his assault on business owners and professionals – that he’s no friend of the investor class.

Selling now and paying on 50% to avoid selling later at 75% is a strategy. It’s called ‘insurance.’

And yes, the tax change would be effective the night it was introduced. In 20 weeks.

US withholding taxes

RYAN By Guest Blogger Ryan Lewenza

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As Canadians we pay a lot in taxes. When you consider personal, sales, and property taxes and social security contributions, it really starts to add up, and I would argue, one reason why Canadians are finding it more difficult to make ends meet. Now we are incredibly lucky to live in such a great country like Canada where we, generally, have a good health care and education system, a robust social safety net including unemployment insurance, childcare benefits and pension benefits for seniors, and generally a peaceful and prosperous place to live. Given all this we should pay a healthy amount of taxes (how much we pay in taxes is for another day), but when we can, we should look to minimize taxes in every way (legally) we can. So today I cover a small but not insignificant tax that investors can try to minimize, known as withholding taxes on foreign investments.

When investing in stocks an important component of returns are dividends. Dividends paid by Canadian corporations can be eligible for the dividend tax credit, which reduces the taxes paid on the dividends. In contrast, dividends received from US or international equities are not eligible for the dividend tax credit and additionally are levied a ‘withholding tax’ from the countries where the companies are domiciled. This withholding tax therefore reduces the net dividends received by the investor and lowers the overall rate of return. Today I’ll cover ways to minimize this tax and improve after-tax returns on foreign investments.

The impact of US and international withholding taxes is complicated so some background is needed. There are three critical pieces to this puzzle.

First, with ETFs (the only vehicle we and all our readers should invest in) there are three different ETF structures related to foreign-based ETF investments. They include: 1) a US-listed ETF (the S&P 500 ETF (SPY-N) is an example of this), 2) a Canadian-listed ETF that holds a US-listed ETF (the iShares Core S&P 500 Index ETF (XSP-T) in an example of this), and 3) a Canadian-listed ETF that invests in the underlying US or international stocks directly (the BMO MSCI EAFE Hedged ETF (ZDM-T) is an example of this). Now that that is clear as mud, we need to move on to the different types of withholding taxes.

Second, for foreign withholding taxes there are two ‘levels’ of this tax. The ‘level one’ withholding tax is the tax that the US government levies on Canadian investors who hold US equities. This is currently 15% and is withheld before the dividend hits the account. The ‘level two’ withholding tax applies to international stocks that are held in a Canadian-listed ETF. In this case the Canadian investor pays two different withholding taxes of roughly 30%. The first one is withheld by the US government on the international company dividend (you don’t actually see this) and then the US government withholds their 15% (you see this in your account). This is the worst of all the options.

Finally, where the ETF is held (i.e. in an RSP or taxable account) will determine what the investor ends up actually paying. So it’s the combination of the ETF structure and the type of account that will determine the amount of withholding taxes paid.

Putting this all together here are the key takeaways on how to minimize the withholding tax for ETF investors:

  • For a US-listed ETF it’s best to hold this in an RSP/RIF or a taxable account. The US government has a tax treaty with Canada where they will not withhold taxes on US dividends if held in an RSP account. For the taxable account you still pay the withholding tax at source but when you file your taxes at year-end you can offset this withholding tax against your overall taxes owed thus recouping some of this tax.
  • For TFSA and RESP accounts it’s generally best to hold Canadian-listed international ETFs as US-listed ETFs offer no tax advantages in these accounts.
  • Lastly when purchasing a Canadian-listed ETF that invests in international stocks (non-US), try to focus on the ETFs that invest directly in the underlying international stocks versus holding another international ETF. This will avoid that double taxation.

Admittedly, this isn’t the most exciting blog topic but hopefully you’ve learned a few things about withholding taxes and minimizing this drag on returns. Also sticking it to Uncle Sam is always a plus!

The last point I’ll leave you with is that withholding taxes is just one consideration when determining where to hold certain ETFs. You also have to consider things like currency transactions, how the funds are spread across each account, which accounts hold US dollars, the tax rates on other investments like bonds, and the potential growth rate of each investment.

Meaning, sometimes we’ll hold a US-ETF in a TFSA, for example, because the other factors like the potential growth of the investment will outweigh the hit of US withholding taxes.

So the main takeaways above are things to strive for but don’t lose perspective of all the other factors that go into where you should hold certain investments. Don’t lose the forest for the trees as they say!

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.