How a kind gesture on your part can actually lead to a tax hit


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As the Christmas season approaches we’ll be having a couple of parties at our home. There are certain topics that are taboo when it comes to starting conversations with guests. Talking about the state of someone’s finances, condition of their marriage, their incontinence, life expectancy or physical ailments didn’t work well for me last year. And I don’t like to talk much about the Income Tax Act either – particularly subsection 56(2). Not that most guests would mind having a conversation about it (I read parts of section 80.01 to guests last year), but that particular provision gets my blood boiling. Let me explain.

The law

What you should understand about subsection 56(2) of the Act is that it deals with what are called “indirect payments.” The subsection is meant to catch situations where you should receive and face tax on certain amounts, but you direct the payments to someone else with the intention of avoiding tax.

If 56(2) applies, it can cause an amount, that you do not receive, to be added to your income. Specifically, you’ll face tax if four conditions are met: (1) There’s a payment or transfer of property to someone other than you, (2) the payment or transfer takes place at your direction or concurrence, (3) there’s a benefit to you, or that you intend to confer on the other person, and (4) you would have been taxed on the amount if the payment or transfer had been made to you rather than the other person.

The examples

Okay, I get it. The subsection is important in certain situations. What if, for example, you’re an independent salesperson and you’re owed commissions, but you direct the payer of the commission to make payment to someone else instead – perhaps your spouse. In this case, you should pay the tax, and 56(2) will ensure that happens. Or take another example where you’re the shareholder of a corporation and you cause your company to make a gift to your Aunt Bessie (who is not a shareholder or employee).

Or perhaps you own a rental property and instruct your tenant to pay the rents to your corporation even though you own the property personally. Or maybe you direct your business to pay a salary to your spouse when she didn’t truly provide any services to the business. Subsection 56(2) can apply in all of these cases. The list of examples is endless.

The story

Earlier this year, a taxpayer wrote the Canada Revenue Agency a letter asking for the taxman’s views on a matter that involved 56(2). Here’s the story: An employee – let’s call him Mr. Donor – would like to donate some of his vacation time to a co-worker – call him Mr. Friend – who is experiencing hardship and needs the additional time off to deal with personal family matters. It’s clear that vacation time has monetary value. In this case, the employees have the option to take their vacation time (and be paid for it, of course) or take cash instead of the time off. It’s also fair that someone should pay tax on that value received from the employer.

CRA responded to the taxpayer’s letter (in document 2013-0514321E5) by suggesting that Mr. Donor would face tax on the value of the donated vacation time under 56(2). The taxman also said that it’s possible that Mr. Friend would also face tax on the value of that vacation time, although they’d likely be willing to forgo taxing Mr. Friend to avoid double-taxing the amount. Given this response, I wouldn’t blame Mr. Donor if he decided not to donate his vacation time after all.

The moral

You’ll notice that the conditions for 56(2) to apply (noted above) say nothing about the intent to avoid tax – but really should. In the story above, Mr. Donor, who was willing to donate his vacation time to his co-worker, was not trying to avoid tax. He was trying to help a friend and co-worker. In fact, avoiding tax was not even on his radar. Yet, according to CRA, 56(2) will apply to tax Mr. Donor on the value of the vacation time. I bet the co-worker who received the vacation time would be willing to pay tax on the compensation he receives when taking those vacation days. And that would be fair. Instead, CRA plans to penalize the donor. The problem is that subsection 56(2) of our tax law isn’t well-written.

So, the moral of the story? Be aware that 56(2) is out there, and be careful any time you transfer or direct payments, property, or something of value to another person, because you might just face tax.

Article:  The Globe & Mail


Seven important tax tips to consider before year-end

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What’s on your to-do list before year-end? At my house, we talked about this over dinner last weekend. My son, Win, turned 16 recently and so driving as much as possible is on his list. I’m not sure he’s really ready for the road.

I asked him a simple question: “Who has the right of way when four cars approach a four-way stop at the same time?” To which he responded: “The guy in the pickup truck with the gun rack and bumper sticker that says ‘I gave up anger management.”

My father, on the other hand, has different plans before year-end. High on his list is to review his investment portfolio. Not exciting, maybe – but it could be profitable. I shared with him seven ideas to consider before year-end. If you’re an investor, you’d be wise to consider these, too.

1. Time the sale of your winners.

It’s almost always better to pay tax later, rather than sooner. If you’re thinking of taking some profits on the winners in your portfolio, consider waiting until January to sell. This will push the payment of your tax bill on the sale to the spring of 2016.

On the other hand, if you have unused or accrued capital losses, consider selling your winners today and offset your capital gains with your allowable capital losses. You can reinvest the proceeds and your new investment will have a higher adjusted cost base (ACB) than your current winners. You get the benefit of this “step-up” in ACB without triggering tax when your capital losses offset your gains.

2. Sell your losers to save tax.

If you’ve got investments that have dropped in value, consider selling these to realize the capital losses before year-end (place trades by Dec. 24 if you want them to settle in 2014). This makes the most sense if you reported capital gains on your 2013, 2012 or 2011 tax returns. You’ll be able to carry your capital losses back up to three years to offset gains in those years and recover taxes you paid. Or perhaps you have capital gains this year that you can apply those capital losses against. Don’t jump to sell your losers if you don’t have capital gains to offset and you still like the prospects of the investment.

3. Make use of a TFSA.

If you haven’t already set up a tax-free savings account, do it before year-end. The ability to contribute starts when you turn 18, so perhaps a child of yours should open an account. The contribution limits were $5,000 per year for 2009 through 2012, and $5,500 for 2013 and 2014, for total contribution room of $31,000 over those years. The TFSA will allow you to grow investments tax-free and withdraw the funds later tax-free as well.

4. Transfer assets to a child.

Giving a child assets before year-end can reduce the value of your estate, saving income tax and probate fees upon your death. If you give them your losing investments, you’ll be able to claim the capital losses that are triggered when making the gift, which can save tax. In addition, if your child is an adult, she could sell the assets and contribute to her TFSA or registered retirement savings plan (RRSP) to accelerate her own savings, or pay down debt.

5. Donate securities to charity.

Are you thinking of donating money this year? You’ll save more tax by donating some of the winners in your portfolio. Any accrued capital gain on a security that is donated to charity will be eliminated. Not only is the taxable capital gain set to zero, but you’ll still be entitled to a donation tax credit to boot.

6. Transfer capital losses to your spouse.

If you have unrealized capital losses but no capital gains this year or in the past three years, consider transferring those losses to your spouse if they have capital gains that can offset the losses.

7. Rebalance your portfolio for tax efficiency.

If the performance of your portfolio has caused certain asset classes to become over- or underweighted, think about rebalancing your portfolio. Don’t forget that capital gains and eligible Canadian dividends receive more favourable tax treatment than interest or foreign income. I’m not suggesting that you take on more risk than appropriate, but if you’re reinvesting proceeds, think about the tax that will be generated by your portfolio.

Article: Globe & Mail

Your RRSP and your will: How to keep more money in the family

Image-Tax mattersI think that every male on the planet secretly wants to be a superhero. I’m not talking about one with superhuman powers. That would be unrealistic. But a superhero with such intelligence, resourcefulness and creativity that he could save the world with nothing more than a pair of tweezers and some duct tape – which is entirely doable.

You might recall the 1980s television show MacGyver, the secret agent who had such creativity that he always managed to turn what he had into what he needed – and save the world in the process.

That type of creativity can go a long way when it comes to tax planning too. We have to think outside the box sometimes. Here’s an example of one idea that involves your registered retirement savings plan (RRSP) and your will.

The story
Jack and Diane were married many years ago. Jack passed away this year. At the time of his death, Jack owned some investments that had dropped in value. In fact, he had paid $500,000 for the investments, and they were worth just $350,000 at the time of his death this year, so he had an unrealized capital loss of $150,000. Jack also had an RRSP worth $400,000 when he passed away. In addition, Jack didn’t have much income this year, prior to his death. He passed away early in the year and hadn’t earned much income to that point.

Like many Canadians, Jack had named his spouse as the beneficiary of his RRSP and he left his other assets to Diane as well. And why wouldn’t he? This is common advice because leaving assets to your spouse is a good way to defer the ultimate tax bill. But Jack could have improved on his plan. Consider the results experienced by Jack and Diane.

The results
When Jack left his RRSP assets to Diane, those assets transferred to an RRSP for her free of tax. Similarly, the other assets he left Diane were deemed to have been sold at his adjusted cost base (ACB). Diane stepped into the shoes of Jack from a tax perspective. That is, she inherited Jack’s ACB on the assets she received.

At the end of the day, Dianne inherited $750,000 of investments from Jack, but $400,000 is inside an RRSP, and any withdrawal of those assets will be taxable in Diane’s hands. Diane also owns the $350,000 non-registered investments with an adjusted cost base of $500,000. Diane will have to somehow generate capital gains in the future in order to use up the $150,000 in capital losses she inherited (capital losses can generally be applied only against capital gains). Is there something different that Jack could have done to leave Diane better off financially? Sure.

The idea
If Jack had planned ahead better, he could have left Diane the same $750,000 in assets, but with $325,000 in an RRSP, and $425,000 outside the RRSP with an ACB of $425,000. This would have left Diane better off since there would have been less money trapped in the RRSP subject to high taxes upon withdrawal, and she wouldn’t have to worry about using up the capital losses since they’d be fully used up already.

How can this be done? It’s not hard. Jack could have named his estate, not Diane, as the beneficiary of his RRSP. You see, if Jack’s estate had been named as beneficiary of his RRSP it would have been possible to trigger some income in Jack’s hands in the year of his death by causing some of his RRSP to be taxable to him. We could have then offset that income with the capital losses from his non-registered investments. The fact is, our tax law will allow you to apply your capital losses against any type of income in your year of death, not just against capital gains (with some exceptions).

Jack’s executor could have elected to transfer just a portion, say $325,000, of his RRSP to an RRSP for Diane on a tax-free basis. The balance of the RRSP, or $75,000, could have been left in the estate to face tax in Jack’s hands in his year of death. Jack’s executor could have then elected to transfer the non-registered investments to Diane at fair market value rather than cost, triggering the $150,000 in capital losses, resulting in $75,000 (one half of the losses) being available to offset the taxable portion of the RRSP. As an aside: In the case of a registered retirement income fund, the executor cannot elect to transfer less than 100 per cent of the plan to the surviving spouse.

Article:  The Globe & Mail

How a key tax shelter will be affected by a divorce

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Earlier this year, British resident Jane Mulcahy attempted to sue her divorce lawyers. Why? Because they didn’t explain to her that finalizing her divorce proceedings would result in her marriage coming to an end. She argued that they should have taken into account her belief in the sanctity of marriage and should have recommended a judicial separation instead. The court rejected her claims.

If you happen to be going through a divorce, there are a couple of important things to keep in mind. First, finalizing your divorce will mean that your marriage will officially end. Second, divorce can complicate your income tax situation – particularly as it relates to your family home. Let me explain.

The rules

Our tax law provides a principal residence exemption (PRE) which can shelter all or part of a capital gain on the sale of your home. The catch is that each family unit (you, your spouse and any unmarried children under 18) will be allowed to designate just one property as your principal residence for each calendar year.

Suppose, for example, you own both a city home and cottage. For simplicity, let’s assume you purchased both properties in the year 2000. If you were to sell, say, the cottage this year, you could designate the cottage as your principal residence for the years 2000 to 2014 if you wanted. This means you would be sheltering the cottage for all of the years it has been owned, so that 100 per cent of any capital gain would be sheltered from tax. This also means that those 14 years are spoken for and you won’t be able to designate the city home as your principal residence any of those same years.

If, instead, you were to designate the cottage for, say, seven of the 14 years, then part of the capital gain on the cottage would be sheltered. This would allow you to use the other seven years for the city home and shelter part of its capital gain as well. But, you can’t fully shelter both properties from tax because you can only designate one property as your principal residence for each calendar year. (By the way, the rules are a little more complex than this, since our law does allow you to own two properties that overlap by one year, and still fully shelter each property from tax.)

When you divorce, each former spouse will be entitled to his or her own PRE, but not for the years in which you were married. Let me explain by way of a story.

The story

John and Jan divorced in 2010. During their marriage the couple owned a cottage (purchased in 2000) and a city home (purchased in 1994). As part of their divorce, they sold the cottage, and Jan kept the city home. They sold the cottage tax-free by using the PRE available to them. That is, they designated the cottage as their principal residence for the years 2000 through 2010, and paid no tax.

Now, four years later, Jan wants to sell the city home that she owns. She’ll be able to designate the home as her principal residence for the years 1994 through 1999 (because she and John did not use up those years when designating the cottage sold earlier), and for the years 2011 through 2014 (because she is entitled to her own PRE after their divorce), for a total of 10 years. But the home has been owned for a total of 20 years. The result? Years after her divorce, a good portion of Jan’s capital gain on the home will be taxable. She may not have expected that.

What if John and Jan had not sold the cottage when they divorced? Rather, what if they had each kept one of the properties? In that case, the first person to sell their property might “win the race” to claim those years while they were married and designate their own property as a principal residence for those married years. This suggests that any good separation or divorce agreement should clarify how the PRE will be claimed upon a subsequent sale of a particular property.

As a side note, you’ll each be entitled to your own PRE after you’re living apart only where you have a written separation agreement or a court order in place. Similarly, if you each own a property on the day you get married, you may want a marriage contract that details who will be entitled to the PRE for years prior to a divorce.

Article:  Globe & Mail

A marriage breakdown comes with tax consequences

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I’ve heard of divorce battles going on for quite a while. The story of Frances and Philip Ragusa, however, takes the cake. Their battle lasted for 34 years, starting in 1977, until Frances was 75, and Philip 77. Frances was making a claim for child support of $14,394, which Philip hadn’t paid. The amount, with interest, grew to be about $100,000.

If you’re going through a marriage breakdown, the best advice is to wrap things up sooner, rather than later. And take the time to understand the tax implications of splitting up. Here are the top tax issues to consider when you part ways:

The meaning of being ‘married’

For tax purposes, the definition of “married” matters a lot. Even common-law partners can be considered married if they’ve been living together in a conjugal relationship for at least 12 months, or they have a child. When does marriage end? In a legal marriage, you’ll usually separate for a time and then your relationship ends officially when you obtain a divorce. For tax purposes, your status as “married” is considered to have ended on the day you started living separately, provided you’ve been living separately and apart for 90 days or longer.

Dividing up assets

When you separate, you may be required to divide up assets. Generally, you’ll be able to transfer assets between the two of you without a tax hit. Capital property (most assets) can transfer at adjusted cost base (ACB) so that the recipient spouse inherits the current ACB of the property, and there’s no tax to pay on the transfer. Registered Retirement Savings Plan (RRSP) assets can transfer directly to the other spouse’s RRSP without a tax hit. It’s the same with assets in a Tax-Free Savings Account (TFSA). In the case of a TFSA, the transferor doesn’t receive a reinstatement of contribution room.

Sharing pension assets

Canada Pension Plan credits earned by both spouses during marriage can be combined and split without any immediate tax. Other pension plan assets can often be split without tax, but speak to a lawyer in your province, since family law and pension law are provincial matters.

Tax on support payments

Spousal-support payments are generally deductible to the payer, and taxable to the recipient. Lump-sum payments that reflect arrears support for prior years are generally taxed when received, but the recipient can request to be taxed as though they were received in those prior years if this works out better and if the amount that applies to previous years is $3,000 or more (not including interest). Child-support payments are generally tax-free to the recipient and not deductible by the payer (an exception applies with some pre-May, 1997, support orders or agreements).

Deductibility of legal fees

Legal fees are generally deductible if they relate to collecting late support payments, establishing a right to support, increasing your support, or to make child support payments tax-free. If you’re the payer of support, legal fees are generally not deductible. Nor are fees related to child custody or visitation issues. If your deductible legal fees happen to exceed your income in a year, a non-capital loss is created which can then be carried forward, or back, to other tax years.

Personal tax credits and deductions

Each spouse may be entitled to the eligible dependant amount. Only one spouse can claim the amount for a particular dependant, so if you have more than one child, it often makes sense to each to claim the credit in respect of different children, otherwise you’ll need to agree on who will claim the credit.

As for child-care expenses, you can claim expenses incurred by you for the period your child resided with you. Finally, in the case of tuition, textbook and education credits, a student can transfer these credits to either parent, but not a portion to both, which will require agreement between you and your spouse.

Universal Child Care Benefit

If one parent has custody of children, then the UCCB will be paid to that parent. With shared custody, you can apply to split the payment equally between the two of you. The UCCB is taxable, and if you’re single at the end of the year, you have the option of reporting the income yourself, or in the hands of your dependant.

Article: Globe & Mail

Tax-smart investing: Eight offsets to income for better returns

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My kids love to read.

“Dad, what’s the most creative work of fiction you’ve ever read?” my son, Win, asked.

“Son,” I replied, “I’d have to say your uncle’s tax return would be at the top of the list.”

Unfortunately, Uncle Charles is no longer with us, but he did suggest in his last days that tax planning would have been a good idea. So, let’s go with that advice.

I’ve been talking about the four pillars of tax-smart investing: (1) control the timing of income, (2) control the type of income, (3) control the location of income, and (4) control the offsets to income.

Today, I want to finish off by focusing on pillar number four: Offsets to income.


What I’m talking about is creating deductions or credits to offset income earned, or tax that might otherwise be owing, on your investment portfolio. The most common types of offsets include capital losses, charitable donation tax credits, interest deductions, foreign tax credits, losses from limited partnerships, business expenses in some cases, and other deductions, such as flow-through share deductions.


Try the following ideas to reduce your tax using offsets:

1. Argue that it’s a business
If you’re actively trading in securities, you may be able to argue that your profit should be taxed as business income rather than capital gains. Now, only half of your capital gains are taxable, so don’t be quick to make this argument. Having said this, if you do report your profits as business income, you’ll be entitled to deduct many types of expenses against your income, including many things you may be paying for anyway, such as a portion of mortgage interest, property taxes, and similar expenses. See my article dated April 22, 2010, for more.

2. Donate securities to charity
Since 2006 it has been possible to eliminate the tax on capital gains on specific securities by donating those securities to charity. Normally, the capital gains inclusion rate is 50 per cent (meaning that one-half of your gains are taxable), but the inclusion rate is set to zero if the securities are donated to charity. In addition to zero tax on the capital gains, you’ll be entitled to a donation tax credit for the value of the securities donated.

3. Harvest capital losses wisely
As we near year-end, many Canadians will choose to sell some of the losers in their portfolio to realize the capital losses, which can then be offset against capital gains that might have been realized this year, or in the three prior years (2013, 2012 or 2011). This can make good sense if you have capital gains this year or in the past to offset, or if you simply don’t like the investment any more.

4. Track your cost properly
If you’re investing in mutual funds, be sure to add the amount of any taxable distributions each year to your adjusted cost base (ACB) of the investment. If you fail to do this you’ll end up paying tax twice on the same growth in value.

5. Claim foreign tax credits

Don’t forget to claim a foreign tax credit for foreign taxes paid on income you’re reporting on your Canadian tax return. You may also want to avoid dividend-paying foreign shares in your Tax-Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP) or other registered account since you won’t be able to claim a foreign tax credit for foreign taxes withheld on income inside those plans.

6. Avoid the superficial loss rules
If you sell an investment at a loss and you, or someone affiliated with you (your spouse or a corporation you control, for example), acquires or reacquires that same security in the period that is 30 days prior to your sale, or 30 days after your sale (a 61-day window), your capital loss will be denied. The loss isn’t gone forever; it will be added to your ACB of the reacquired securities, so that you’ll eventually realize the tax savings from that loss when you ultimately sell those securities.

7. Choose your funds wisely
If you invest in mutual funds that have unused capital losses, future capital gains in that fund could be partially sheltered using those losses, which can result in higher after-tax returns for you.

8. Deduct interest costs
It can make sense to borrow to invest if you do this prudently. Interest on money borrowed to earn income can generally be deducted, offsetting some of your investment income, and providing tax savings.

Article: Globe & Mail


Tax-smart investing, Part 3: Find the right location for your income

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I’ve been talking recently about the four pillars of tax-smart investing: (1) control the timing of income, (2) control the type of income, (3) control the location of income, and (4) control the offsets to income. Today, I want to chat about the third pillar: The location of income.

When I told my wife Carolyn about the topic this week, she said “the location of income should be very simple: in my bank account.” Then I told her that the location of income has less to do with where the money ends up, and more to do with who pays the tax on the income, if anyone. She wasn’t as excited by that concept.

Location matters

Location. Location. Location. Perhaps you thought this matters only in real estate. Not so. The location of your investments has a big impact on how much tax you’ll pay. Common “locations” include: Your personal hands, your spouse’s hands, the hands of your children or other family, inside a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF), inside a tax-free savings account (TFSA), or inside a corporation, family trust, or partnership.

Speaking of location, people often ask whether holding assets in another jurisdiction can save tax. As a general rule, this won’t help you because you’ll face tax on your worldwide income if you’re a resident in Canada, and our tax law and recent court decisions are tough on taxpayers who try to use offshore trusts or corporations to avoid tax.

Location ideas

Consider the following ideas to optimally locate your investments to save tax:

1. Use registered plans when earning interest

To the extent you own interest-bearing investments, hold them inside a registered plan (RRSP, RRIF or TFSA) so that the interest, which is otherwise highly taxed, is sheltered from the taxman. This is not to say that equities, which you’re holding for capital growth, should not be held in a registered plan, but not if it means you then have to hold interest-bearing investments outside the plan.

2. Consider a corporation to hold investments

By holding some or all of your non-registered investments inside a corporation you won’t face tax personally on the investment income. This could reduce a clawback of government benefits such as Old Age Security, minimize U.S. estate tax on U.S. securities, and minimize probate fees. In some provinces, in some years, the tax you’ll face on investment income inside the corporation could be less than what you’d pay personally if you’re in the highest tax bracket.

In 2014, it’s the case that capital gains and interest earned in a corporation offer no benefit over earning the amounts personally, but certain dividends earned in a corporation, rather than personally, may leave you better off in some provinces.

3. Place assets in trust

Putting assets in trust can provide you with continued control over the assets while passing the tax bill on any investment income to the beneficiaries of the trust – if you structure it properly. You do have to be concerned about the attribution rules in our tax law, but if you lend money to the trust and charge interest at the prescribed rate on the loan, or are careful about which beneficiaries are entitled to the income (adult children only, for example) you may be able to reduce the overall tax of the family.

4. Transfer assets to family

I’m talking here about splitting income by moving assets to the hands of family who will pay tax at lower rates than you. If you do this properly you’ll avoid the attribution rules in our tax law and you’ll save tax. You might also gain a measure of asset protection and reduce taxes and probate fees on death when moving assets out of your name.

5. Avoid superficial losses and average costs

If you own a security and sell it at a loss, your loss could be denied if you reacquire that security in the 61-day window that starts 30 days prior to, and ends 30 days after, your sale. By repurchasing the security in the name of a child you can avoid this superficial loss. Also, when you buy a security at different points in time, your adjusted cost base (ACB) on each purchase is averaged to arrive at a weighted average ACB per share. Any future gain or loss will be based on this average ACB.

If you want to avoid averaging your cost amounts, perhaps to keep flexibility in the ACB that will be used when selling the security, consider making subsequent purchases in the name of your corporation, a family member, or your family trust.

Article: Globe & Mail

Tax-smart investing: Control the type of income you earn

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I miss my grandfather. He shared with me so many words of wisdom over the years.

He used say “Tim, before you criticize someone, you should walk a mile in their shoes. That way, when you criticize them, you’ll be a mile away and you’ll have their shoes.” That advice has come in handy over the years.

He also used to tell me that “a penny saved in taxes is like a penny more in after-tax income earned.” He would be proud that I’m not paying more in tax on my investments that I should.

Last week, I introduced the four pillars of tax-smart investing. These are to: (1) control the timing of income, (2) control the type of income, (3) control the location of income, and (4) control the offsets to income. Today, I want to talk about the second pillar: Controlling the type of income you earn on your portfolio. Here are six ideas to consider:

1. Understand your marginal tax rate

Your marginal tax rate is the amount of tax you’ll pay on one additional dollar of income. That rate will vary, depending on the type of income. Interest income is the most highly taxed. Then there are capital gains and eligible dividends. When it comes to these, capital gains are generally taxed at more favourable rates if you have a higher level of income (typically over about $80,000; but it varies by province), and eligible dividends are generally taxed at lower rates when your income is lower. If you structure your portfolio to earn capital gains or dividends, you’ll face less tax overall than if you earn interest. Keep in mind, the level of risk you take on will also be different and should be factored into your decision about the type of investments to hold. For a good summary of marginal tax rates, I like to visit this facts and figures page.

2. Returns of capital are tax-efficient

Some investments are designed to return your original capital to you over time. You won’t face tax on a return of capital, and so this type of cash flow is very tax-efficient. Keep in mind that this is really a deferral of tax since you’ll pay tax later, when you ultimately sell the investment, but the money is better in your pocket for the time being than the taxman’s. If you happen to own private company shares, you can extract your “paid-up capital” (a cousin to your adjusted cost base) tax-free from your company, which can be better than dividends.

3. Manage clawbacks of OAS benefits

If you receive Old Age Security (OAS) benefits and your income in 2014 is over $71,592, then you’ll have to repay part of your benefits. You’ll repay 15 cents for every dollar of income over $71,592 this year. If you earn eligible dividends, those dividends will be grossed-up for tax purposes, so that you’ll report $1.38 of taxable dividends federally for every $1 of actual cash dividends, and this will make a potential OAS clawback problem even worse. Again, don’t let the tax tail wag the investment dog: If dividend-paying stocks are right from a risk perspective, they may be best for you. But understand the tax implications.

4. Share buybacks can be better than dividends

If a company has excess cash and chooses to buy back shares, you’ll face tax on a capital gain rather than dividends, which could be better for you than dividends if you’re in a higher tax bracket, and provided you don’t need the income.

5. Sell shares on the right side of the ex-dividend date

You have some control over whether you’ll face tax on capital gains or dividends by choosing the time of your sale. If you sell a security before the ex-dividend date you’ll realize capital gains only, which could be best if you’re in a higher tax bracket. If you sell on or after the ex-dividend date you’ll receive dividends, which could be best in a lower tax bracket.

6. Consider a back-to-back prescribed annuity

Here’s how: Consider taking some of your capital invested in interest-bearing investments and buy a prescribed annuity. A portion of each annuity payment will be taxable interest, but a portion will be a tax-free return of capital. You’ll face less tax and put more in your pocket. Then, take some of the additional cash flow from the annuity to purchase a life insurance policy (back-to-back with the annuity) that will pay out on your death, replacing all or some of the capital invested in the annuity.

Next time, I’ll continue this discussion on the pillars of tax-smart investing.

Article:  Globe & Mail

How can an investor reduce the impact of taxes on a portfolio?


Capture-Portfolio taxes

Did you know that, in China, it’s possible to buy insurance for some pretty crazy things? You can, for example, buy insurance that will pay out if your child displays “mischievous and destructive” habits, or your favourite team is defeated in the World Cup (both of which happened to me in the past few months; I could have been wealthy if I had been living in China).

I’d love to see a policy that pays out if the taxman decides to increase taxes on investment income. Although, given the likelihood of this happening, I suppose no insurer would touch it with a 10-foot pole. So, what’s an investor to do to reduce the impact of taxes on a portfolio?

Tax-smart investing
Now, I’m not suggesting that you put taxes ahead of the merits of an investment itself, but if you can take steps to minimize the tax on your portfolio, you can add significantly to your net worth over time. A study headed up a few years ago by Professor Moshe Milevsky from the Schulich School of Business showed that returns equal to 1.35 per cent annually were lost to income taxes over the 10-year period and the 340 mutual funds he examined. If you could save that 1.35 per cent annually, you could increase the value of your portfolio by almost one third over 20 years.

By the way, the responsibility for tax-efficiency should fall on the shoulders of two individuals: You (the investor), and your money manager (if you don’t manage your money yourself). Each of you needs to consider what we’re about to discuss.

At the end of the day, there are four pillars of tax-smart investing: (1) control the timing of income, (2) control the type of income, (3) control the location of income, and (4) control the offsets to income (deductions, credits and losses that may be used to reduce your taxes on investment income). Today, let’s consider the first of these.

Timing of income
All other things being equal, you’ll be better off paying a tax bill far in the future than paying it today. The value, of course, lies in your ability to use those dollars to generate returns between today and the time you have to pay the taxman. A $100 tax bill today that is deferred for 10 years will cost you just $61 in today’s dollars, if we assume a 5 per cent return annually.

Here are some ideas to consider as you look to control the timing of your income and the resulting taxes:

Defer the liquidation of investments.
You can control the timing of any taxable capital gains by simply deferring the sale of investments that have appreciated in value. Again, don’t ignore the merits of the investment here; if it’s no longer a good investment, deferring the sale may not make sense.

Keep portfolio turnover low.
Turnover is the number of times in a single year that the investments in your portfolio are sold and the proceeds reinvested. You’d be surprised at how high turnover can be in some mutual funds (well over 100 per cent). The lower the turnover, the lower the taxes annually, assuming a growing portfolio.

Watch the style of money management.
Understand the approach of your money manager. A value-oriented approach will generally result in lower taxes annually than a growth or momentum style approach. A passive approach is generally more tax-efficient than an active approach. You might still prefer a less tax-efficient approach if you believe the returns will justify it, but look for returns that are 1 to 2 per cent higher than with a more tax-efficient approach, to justify the investment.

Evaluate the timing of distributions.
If you’re invested in funds, a sale of securities inside the fund can create a distribution of taxable capital gains without providing an increase in the value of your investment. If you buy into an established fund that has a large accrued gain, beware that you may be buying into a near-term large taxable distribution.

Remember the hurdle rate.
If you choose to sell an investment, and pay some tax as a result, you’ll need to earn even more on the next investment to make up for the capital lost to income taxes. Call this the “hurdle rate.” As a guideline, look for 2 to 3 per cent higher returns on the next investment than what you could have achieved with the current investment, to compensate for the taxes lost on the sale.

Next time, I’ll continue this discussion with a focus on more pillars of tax-smart investing.

Article: Globe & Mail


The in-trust account: Three key issues to consider

Image-Sept 23I was speaking to my good friend James last weekend about his son, who decided to make a trip to Las Vegas for his 19th birthday. As it turns out, his son is pretty good at Blackjack, and came back with double his money.

“Tim, I don’t know whether to laugh and celebrate, or cry,” James told me. “I’m glad my son didn’t lose all his money, and proud of the fact that he’s so good at Blackjack, but I’m not impressed that he took the entire savings in his in-trust account that we set up for him years ago.”

I think this is cause for a look at in-trust accounts.

The definition

You’ll know an in-trust account when you see one, by the name on the account. Most often, the account will be in the name of the adult “in-trust for” the child; for example: “John Doe in-trust for Bobby Doe.” Many parents or grandparents will set up an account like this for a child because there’s a desire to split income with the child. And for the most part, this can save tax. More on this in a minute.

Setting up an in-trust account can provide a vehicle for saving for an education, or for other purposes, and if the growth in the account over the course of time faces little or no tax, that growth can be much higher than if the parents were to keep the money invested in their own names.

The issues

There are some challenges with in-trust accounts. Three key issues, in fact. First, once your child has reached the age of majority there’s no guarantee you can keep your child from taking the money in the account and running. There’s a historic case called Saunders v. Vautier, which established that a trust can generally be wound up if the beneficiaries are of sound mind, have reached age of majority and want to wind up the trust.

As a practical matter, most parents assume their kids won’t recognize their right to wind up the trust, and that a little moral suasion would likely prevent junior from blowing the money on a trip to Las Vegas even if he did recognize his rights. Ultimately, most parents would likely respect the rights of their children if the kids did choose to wind up the trust. Just be aware that this is a possibility.

Next, you won’t be able to arbitrarily allocate the assets in the in-trust account to different children. If you’ve set up separate in-trust accounts for each child, you can’t steal from one to give to the other. Even if you’ve named more than one child as beneficiaries on a particular in-trust account, you can’t simply change the percentages allocated to each child. A formally established trust, with a written trust agreement, can provide greater flexibility here, but at a greater cost.

Finally, if you place assets into an in-trust account and name your spouse as the trustee (to avoid the attribution rules in our tax law – more on that below), what happens if your marriage breaks down? Your spouse will control the account. And if your spouse were to die, who would control the account after that? Perhaps his or her second spouse, or someone else named as executor over his or her estate. This may not be your intention.

The ideas

As mentioned, an in-trust account can be used for income splitting. But you’ll need to avoid the attribution rules in our tax law, which can cause all of the interest, dividends, rents or royalties to be taxed in the hands of the person who transferred the assets to the account. You can avoid this attribution by avoiding those types of income and focusing on capital growth. Capital gains will not be attributed back and can be taxed in the hands of your children named as beneficiaries on the account. Also, income earned on Canada Child Tax Benefits, Universal Child Care Benefits and second-generation income (that is, income on income), won’t be attributed back to you.

Make sure that there’s a true transfer of the assets to the child, the transfer is irrevocable, and you’ve specifically named the beneficiaries on the account. If you’re the one who has transferred assets to the in-trust account, make sure a different adult (perhaps your spouse) is named as the trustee (that is, your spouse’s name should be on the account, in-trust for the child). If you don’t follow these guidelines, CRA could take the view that a trust doesn’t truly exist, and that you should pay all the tax on the income earned in the account.

Article: Globe & Mail