In a previous post, I discussed how to assess your risk tolerance and then use that to choose the asset allocation for your portfolio. At a high level, we choose an allocation of equity (stocks) to maximize investment risk/return and use fixed income (bonds) to stabilize volatility and reduce our behavioral risk.
On a more granular scale, we use different types of holdings (asset classes) to diversify and minimize investment risk. As our portfolio grows or our risk tolerance changes, we may need to rebalance our assets to keep those risks where we want them.
It is how much income you have in your hands after-tax that really matters. So, matching investment types and accounts to optimize for tax-efficiency may be important. Particularly for high-income professionals facing heavy tax burdens. That is called
The agenda for this post:
- How investments produce income.
- How that income is taxed.
- Why it is taxed that way.
Our current tax system may appear as though it emerged randomly from some primordial soup and evolved by chance. However, it was originally intentionally (?intelligently) designed. Politics can buffet that, and politicians nibble at the edges to appease the prevailing political winds of the day. However, major deviations from the underlying design are much more difficult to implement.
Investing & Types of Investment Income
All investments are essentially loaning our money to a company or government.
How those entities pay us back for the use of the money that we lend them can vary. It could be by giving us a stake in the company (equity) where we share in the growth of its value. They could dispense a portion of the company earnings to us as dividends. In the case of debt, interest is collected on the loan made.
The potential for risk & reward for investment returns are closely related.
Capital Gains: when investing in equity, the potential for reward is infinite, and for loss is absolute.
When you invest money through buying equity in a company, you can make a profit if the value of that share is higher when you sell it. That change in value is called a capital gain. When you sell to actually get the money in hand, it is called a realized capital gain.
There is no predetermined limit on how much a company could be worth other than its ability to grow and make profits. Of course, there is also the potential for bankruptcy and the net value of a company dropping to zero or below. At the extremes, there could be a large capital gain or a complete loss of capital. Lumped together, large groups of stocks (like an index) average out to perform somewhere in between. Individual companies are more prone to extremes.
The more established and stable a company is, the lower that risk of bankruptcy is. However, the potential for further growth is usually less also. While the relationship is not perfect, risk and reward go hand-in-hand.
Dividends: Stable income-producing companies may reward you with dividends.
Stable income-producing companies may reward you with dividends. Dividends are paid out of a company’s profits. They are also entwined with risk and reward.
The proportion of a company’s value that is paid out as a dividend is the dividend yield. The proportion of the company’s profits consumed by dividend distribution is called the dividend
The more that company spends its profit margin to pay back shareholders, the less it has to re-invest, pay down debt, or build cash reserves. That could limit equity growth (capital gains). If the payout ratio is high, then the dividend is also more vulnerable to being reduced if profits shrink.
While receiving dividend income is appealing to many people, there is no free lunch when you think about dividends as part of the total return of an investment. The total return of an investment includes both the
Loan Sharking: The reward with debt-investing is more defined and the risk usually lower than equity.
At best, making a successful loan investment will recoup the original amount plus the agreed-upon interest. A defined maximum return.
If a company goes bankrupt, then its assets are sold and its debtors paid first. That does not mean that there is no risk. There may not be sufficient assets to cover the debts. In that case, the bondholders would lose some of the money that they lent. They might only receive partial debt repayment.
Alternatively, they may accept relaxed repayment terms in the hope of a chance for recovery and more of the debt eventually being repaid. This is colloquially called taking a hair-cut. It can vary in price from that of a visit to the local barber to a stay at a celebrity hair salon.
Unlike hair-styling – price, risk, and reward are very tightly related in debt markets. Higher-risk debt commands a higher interest rate. So, individuals or less stable companies pay more interest compared to stable companies or governments.
Governments not only have assets, but also the power to tax. For collateral, they have all of the assets and human capital of their population that they can take (without rebellion) to pay their debts. So, government bonds have the lowest interest rates and risk. They are the most effective type of bond for stabilizing a portfolio.
Risk & Taxation of Investment Income
Taxation can be used to encourage or discourage behaviors. Encouraging behaviors that help grow our economy makes sense. Governments generate revenue from the economy to pay for programs. They also like to take credit when the economy is doing well. Therefore, it is politically and practically motivating for governments to promote healthy economic growth. We can see this applied to investment income taxation.
Our taxation system encourages investors and entrepreneurs to take on risk.
That is how we encourage people to innovate and produce things. If successful, they build the value of their company (equity) and its income (dispensed as dividends). Increasing production and service provision, or the efficiency of that through innovation is how our economy grows. Credit provision (lending money) can help support innovation and production. However, the risk/reward exposure is lower, as discussed above.
The taxation of investment income types relates to the associated investment risk.
Capital appreciation via equity generally carries the most risk. Hence, it is taxed the most favorably to incentivize people to take the risks required to innovate and grow our economy. Interest is generally the lowest risk and taxed the least favorably. Of course, it is not a perfect relationship.
There are debt investments that pay higher interest rates, but they also carry higher risk. Junk bonds or private mortgage loans would be prime examples. You may take the risk and succeed. Sadly, your after-tax take won’t be as good compared to the same equity return despite that (except in a tax-sheltered account).
This is why I take my investment risks with equity rather than debt. Equity rather than junk bonds. That way, my risk is better compensated in after-tax dollars due to the taxation by design.
Dividends and Tax Integration
Dividends from Canadian companies also receive favorable tax treatment as eligible dividends. While it does make sense that the Canadian government would try to reward those who invest in Canadian companies, that is not the main reason for the “favourable” treatment. This is actually about tax integration.
Tax integration is the concept that the money someone earns directly should have the same total income tax burden as a dollar earned through a company. “A dollar is a dollar”. It is a key principle of the Canadian taxation system.
In practical terms, that means a dollar taxed in corporate hands is not then fully taxed a second time in personal hands. It makes little sense for the government to punish investment in Canadian companies by taxing the income twice. Eligible dividends are personal-tax-saving for the investor. However, that is really because the companies dispensing them have already paid part of the total tax burden for them.
How does tax integration of eligible dividends work in practice?
Canadian publicly traded companies (like you’d buy on the stock exchange or hold in a fund) issue eligible dividends. These large companies have paid tax at the higher General Corporate Rate. That rate varies by the province that the company calls home, but averages about 27%.
To compensate for that when we file our personal income tax return, the dividend is “grossed up”. That means it is increased to simulate what the income was before the company paid tax. That grossed-up dividend is then taxed at the corresponding personal marginal rate. This could bump you up tax brackets more than regular income. A credit is then applied that reduces our tax by the amount that the company paid on that income. The mathematical acrobatics are shown below.
Is there really an eligible dividend advantage?
Tax integration does not work out perfectly in reality. Shockingly, it overall favors the government in almost all provinces. Those who like to spout that investors have an unfair advantage will point to the “dividend advantage” in the table below. However, those with a more sophisticated understanding of how profits are made and paid out know that it is the combined tax rate that matters. The far-right column.
Receiving a dividend from a Canadian stock or Canadian-equity ETF is more tax advantageous in some provinces than others as shown above. However, while investing in publicly traded companies, what province a company is domiciled in is not usually an important consideration.
While we can’t do anything about the taxation of the company, we should consider this lower personal tax rate when planning where to put our eligible dividend payers.
Foreign company dividends may get penalized.
There is no incentive for our government to encourage investment outside of Canada. So, foreign dividends are taxed as regular income. It is also important to stop people from tax-dodging through investing in other countries without claiming any income. Hence, most countries charge a foreign withholding tax (FWT) at the time of issue on dividends paid to foreigners.
Fortunately, there are tax treaties between Canada and many developed countries. Some or all of the FWT may be refunded at the time of Canadian income tax filing depending on the tax treatment of the account type. It is usually fully recovered in an RRSP or personal taxable account. The FWT is lost in a TFSA or RESP. When investing through a private corporation, the FWT may be partially recoverable.
Inflation & The Taxation of Capital Gains
As mentioned above, one reason that capital gains have lower taxation is to encourage investors to take the risks required to grow the economy. The other rationale revolves around the timing of the pay-out. You cannot spend equity until it is turned into cash.
The value of cash is not constant. That loonie in your pocket today will buy more than that same dollar will ten years from now. The same applies to the loonies you have tied up in equity. This is sometimes referred to as the time-value of money and the culprit is inflation. This raises two issues around capital gains taxation.
Why capital gains tax is deferred.
With dividends or interest, you have immediate access to the money paid out. So, it makes sense that it is taxed immediately. Conversely, you only get access to your equity when you realize the capital gain. Hence, it follows for the tax to be deferred until that time.
The capital gains inclusion rate
If that is a long time, then much of your apparent capital gain is actually just inflation. It doesn’t buy you more. You should not have to pay tax on inflation. To compensate for this, and to incentivize risking capital to grow value-add businesses, we have the capital gains inclusion rate. This is currently set at 50%, but has ranged from 50%-75% in recent memory.
An inclusion rate of 50% means that half of the capital gain is “included” as income and taxed. The other half is excluded and tax-free. The break-even point on this depends both on the gain and inflation.
A simple example to illustrate the capital gains inclusion rate and inflation.
You buy a $100 of stock in Loonie Doctor Inc. Actually, that is probably all of the company equity at present 🙂 In ten years, you sell it for $150. A realized capital gain of $50. During that intervening decade, inflation has eroded the value of $50 so that it really only buys $25 worth of goods in today’s dollars. With an inclusion rate of 50%, you pay tax on the $25 dollars of improved buying-power and are not taxed on the $25 that the inflation-monster ate.
If you had sold for $150 one year after buying your Loonie Doctor stock, then inflation would have been minimal. Say $5. In that case, the 50% inclusion rate means that you got a big tax-break for taking the risk of investing via some whacky dude on the internet [not advisable]. You paid tax on just $25 for $45 worth of increased buying-power.
So, the 50% inclusion rate would be fair if half of your gain is from inflation. A bonus if your rate of return outstrips inflation during the holding period. Or you can pay tax on inflation if you have a very slowly growing investment (slower than inflation).
The tax treatment of different types of investment income is summarized below.
Why does the intention of investment income taxation matter to optimizing asset location?
One of the risks when planning your portfolio is that tax laws will change in the future. We saw that recently with the new active-passive income limits for professional corporations. We can mitigate that by using multiple investment account types to spread out our legislative risk. However, if the rules change in the future, what is optimal asset location now may become sub-optimal later.
For example, the small business deduction was meant to promote the ability of small businesses to have more money to invest in their businesses and grow them. The government also needs small businesses to survive. Some flexibility to smooth cash flow is needed for that. However, large passive investment of retained earnings become less closely linked to those goals. So, it was not overly surprising that they changed the rules to limit how much passively invested income these companies can hold before forcing them to either spend it (and pay tax) or pay more tax. The affected group is also small and doesn’t garner much public sympathy – an easy target. Those who had used an RRSP and TFSA in addition to their CCPC have been less impacted. The combination is usually better long-term anyway and now even more so (try my CCPC vs RRSP vs TFSA simulator and see for yourself).
Understanding the intent behind the tax laws helps us consider the level of risk or the direction of future changes. Of course, governments are somewhat unpredictable in exactly how they will procure more money (other than the fact they have already spent it – which is predictable). They also usually create unintended consequences when dabbling with the grand design.
Like Jurrasic Park, the underlying principles don’t change and “nature finds a way” to bring things back to balance eventually. We should use a geological time scale when we invest anyway. The scary thing is that after reading this article, you may have a better understanding of the grand design behind taxation than our policymakers do. There are now 6 Jurrasic Park movies.