Finance: Tax Recovery… the Overlooked Investment Return

by Michael Birbari

During the bull markets of the ’80s and ’90s, making money in the stock market was relatively easy. If you held on to a good stock or mutual fund for three to five years, a double-digit return was possible. However, the tech bubble, the recent three year bear market, 9/11, corporate scandals, the Iraq War and unpredictable world events have ushered in a more cautious era for the stock market, where lower average returns are likely. Investors must be prepared to recondition their thinking and adjust their investing habits for today’s more moderate investment environment. For the foreseeable future, investors will have to squeeze returns from income paying securities, quality stocks and creative tax shelter strategies.

When capital is invested, investors can expect one of the following four possible outcomes:

1. Income–cash returns (interest or dividends);

2. Appreciation–the asset increases in value;

3. Loss–the asset declines in value;

4. Tax Consideration–increase or decrease in taxes owed.

Most investors would be happy to earn an eight percent return (per year for five years) for a pretax return of 40 percent. Certainly, such returns are possible given sufficient time, managed risk, and by owning quality securities. However, imagine getting a 46 percent return now, rather than later, through the acquisition of an asset that provides a tax savings as opposed to interest dividends or capital gain.

Let’s examine the facts. There are only a few qualifying investments that provide returns through tax savings. These are RRSP’s, Labour Sponsored Funds and Flow Through Shares. The unique feature of Flow Through shares is that there is an opportunity to earn additional returns in the form of either income or appreciation.

Over the past five years we have counseled our high tax bracket clients on creative tax reduction strategies with the use of Flow Through Shares. By investing in FTS funds, a combination of Canadian Development & Exploration (CDE & CEE) and federal investment tax credits work together to produce deductions of 100 percent of capital invested. These deductions arrive via the Statement of Partnership and Expenses (T5013). For individuals earning over $65,000 and over $100,000 of taxable income, the tax refunds are between 42 percent and 46.4 percent, up front. Imagine that. A 46.4 percent tax-free refund (once filing the T5013 on your return). By comparison, as mentioned above, one would have to wait five years to get such returns even from the typical mutual fund, top quartile fund.

In addition to the tax refunds, the shares of CMP and Canada Dominion, two of the top managed Flow Through Share funds have appreciated in value over the past three years. While past performance doesn’t assure future results, the results to date have been exceptional and can be attributed to good fundamentals in the natural resource sector as well as the exceptional portfolio management skills of the CMP and Canada Dominion investment teams. These sound fundamentals exist today.

Ideally, a FTS investment should be considered in context with a diversified portfolio of income trust, corporate bonds, blue chip equity investments and mutual funds.

As far as how much, most investors should consider investing no more than 10-20 percent of their taxable income into FTS. It would be prudent to have no more than 10-15 percent of a total portfolio invested in these securities in order to manage the risk inherent in smaller resource stocks and the cyclical nature of the commodities markets.

In this cautious marketplace we need to be innovative and utilize the creative application of the investments available. In a Flow Through Share partnership, the General Partners will usually arrange to roll the assets of the portfolio (on a tax-deferred basis) into an open-ended liquid resource mutual fund allowing the investor to do one of two things. First, the ability to rollover the FTS units to purchase new units every two years, thereby receiving another round of 100 percent tax deductions using the same capital (see table below).

And second, to immediately liquidate the portfolio for its market value after two years. This process is considered a deemed position and results in the capital gain inclusion rules, which requires a taxpayer to include 50 percent of the sale proceeds into regular income. This reduces the maximum tax rate on the liquidated FTS assets to 23.2 percent for an investor in the 46.4 percent marginal tax bracket.

The net effect is that an investor not only defers taxable income with a FTS but also benefits from a reduction in marginal tax rates from 46.4 percent to 23 percent, which is due to the conversion of ordinary income into capital gain income.

Don’t let the DOW or TSE be the only barometer of investment success. After a long bear market, the recent positive turnaround in the stock and bond markets (since March 2003) has been a welcomed event. With the outlook for a modest improvement in the underlying economy in North America and Europe expected in the next 12-18 months, investors should have more gains ahead for their portfolios. However, as outlined above a carefully planned tax reduction program can pay off handsomely by adding additional returns to recovering equity portfolios.

Michael Birbari is Director and Senior Investment advisor at Dundee Securities Corporation, providing service to the dental community.