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August-28-17

Asset Location Across Canada: Some Rules Are Made To Be Broken

Aren’t GPS devices the best thing ever? You punch in your desired destination and they tell you exactly where to go. Then again, every so often, they’ll go wonky on you, insisting you turn on a street that doesn’t even exist, or sending you straight into a major traffic jam.

Just so with implementing asset location, as introduced in my last post. General guidelines can be useful when trying to understand complicated topics like tax-efficient investing. In practice, however, these rules of thumb can lead you astray – especially if you follow them blindly, without regard to what’s going on right around you.  

For example, you’ll often hear that it’s wise to fill up your taxable accounts with Canadian equities first and global equities next. Sometimes, this makes sense, as the Canadian company dividends receive preferential tax treatment (and global stock dividends don’t).

But where do you live? Depending on your actual tax rate and which province or territory you call home, there may be times when this “Canada first” rule of thumb might be a thumbs-down idea for you.

Today, I’ll explain how to estimate the taxable dividends on the equity ETFs in my model portfolios. We’ll then review the taxes payable in 2016 on each of the ETFs for residents across Canada. I’ll wrap up with suggested taxable account asset locations for top-rate taxpayers in each jurisdiction.

By the way, all yields and MERs below are annual; I’ll skip repeating that every time!

Canadian Equities

The Vanguard FTSE Canada All Cap Index ETF (VCN) follows the FTSE Canada All Cap Index, which has a gross dividend yield of 2.88%. Once we deduct the fund’s MER of 0.06%, we end up with a taxable dividend yield of 2.82%. Although this may seem high relative to the other asset classes below, you’ll recall that the eligible dividends receive preferable tax treatment, resulting in lower taxes than if the dividends were treated as ordinary income.

So … remember that rule of thumb, suggesting higher-income earners should first hold Canadian equities in their taxable accounts before all other asset classes? This really only applies in jurisdictions with relatively low eligible dividend tax rates (generally below 35%). Otherwise, you may be better off first holding certain foreign equities in your taxable accounts, even though their dividends are fully taxable as income.

Source: FTSE Russell Index Fact Sheet as of July 31, 2017

U.S. Equities

The iShares Core S&P U.S. Total Market Index ETF (XUU) follows the S&P Total Market Index, which has a measly gross dividend yield of only 1.90%. After deducting the fund’s expenses of 0.07%, the taxable dividend yield drops to about 1.83%. Even though taxes are initially withheld on the foreign dividends, they are generally recoverable at tax time, when you will be fully taxed on the dividends after the fund’s expenses have been deducted.

For provinces or territories with relatively high eligible dividend tax rates (i.e. above 35%), U.S. equities may be a more tax-efficient first choice to hold in your taxable accounts, instead of the Canadian-first rule of thumb.

Source: S&P Dow Jones Index Fact Sheet as of July 31, 2017

International Equities

The iShares Core MSCI EAFE IMI Index ETF (XEF) follows the MSCI EAFE IMI Index, which boasts an impressive dividend yield of 2.96%. As XEF holds the underlying stocks directly, any foreign withholding taxes are generally recoverable at tax time. Similar to U.S. equities, investors will be fully taxed on the gross dividends after deducting the product fees of 0.22%, for a taxable dividend yield of about 2.74%.

Although many investors love their dividends, this spells trouble for taxable investors throughout Canada. As I mentioned in my last blog post, if you’re going to hold any equities in your RRSP accounts, international equities should be your first choice (and your last choice for taxable accounts). This is one rule of thumb that applies nationwide, since there is not a single province or territory where holding international equities in taxable accounts first is expected to reduce the tax bill.

Source: MSCI Index Fact Sheet as of July 31, 2017

Emerging Markets Equities

The iShares Core MSCI Emerging Markets IMI Index ETF (XEC) follows the MSCI Emerging Markets IMI Index. With a gross dividend yield of 2.32%, it falls somewhere between U.S. and international equities.

As XEC doesn’t hold the underlying stocks directly, there’s one layer of unrecoverable foreign withholding taxes, with an estimated tax drag of 0.23%.

With fees of 0.26%, it’s also the most expensive ETF in my model portfolios. After deducting the fees and foreign withholding taxes, we end up with a taxable dividend yield of about 1.83% (which happens to be identical to the U.S. equity taxable dividend yield). This low yield may make emerging market equities even more tax-efficient than Canadian equities in many jurisdictions going forward (including Ontario, Manitoba, Quebec and Nunavut).

Source: MSCI Index Fact Sheet as of July 31, 2017

Our Model Portfolio Summary

So, in summary, below is the expected taxable dividend yields on the ETFs in my model portfolios. (Remember, VCN’s dividend yield is taxed at the lower eligible dividend tax rate, while the remaining ETFs are taxed at ordinary income tax rates.)

Expected Taxable Dividend Yields of ETFs

Exchange-Traded Fund Gross Dividend Yield Unrecoverable Foreign Withholding Tax Management Expense Ratio (MER) Taxable Dividend Yield
Vanguard FTSE Canada All Cap Index ETF (VCN) 2.88% - (0.06%) 2.82%
iShares Core S&P U.S. Total Market Index ETF (XUU) 1.90% - (0.07%) 1.83%
iShares Core MSCI EAFE IMI Index ETF (XEF) 2.96% - (0.22%) 2.74%
iShares Core MSCI Emerging Markets IMI Index ETF (XEC) 2.32% (0.23%) (0.26%) 1.83%

Sources: FTSE Russell, S&P Dow Jones and MSCI Index Fact Sheets as of July 31, 2017. BlackRock Canada and Vanguard Canada.

Going Local

Now, to the good stuff. What are the optimal asset location guidelines where you live?

For that, let’s estimate which asset class has the lowest expected annual tax liability in each province or territory by calculating 2016 taxes payable on a $10,000 investment for a taxpayer in the highest marginal tax bracket.

To make the comparison a little easier on the eyes, I’ve included a second chart below that provides the optimal 2016 asset location order for taxable accounts. (I’ve only considered annual income and its tax ramifications here, since we cannot accurately predict your unique long-term, unrealized gains.)

The compelling conclusions?

  • Most of the provinces and territories with the lowest eligible dividend tax rates tend to favour Canadian equities first (except Nunavut, which has relatively low ordinary income and low eligible dividend tax rates)
  • Jurisdictions with the highest eligible dividend tax rates favour U.S. equities first.
  • Throughout Canada, international equities place dead last in terms of tax-efficiency (due to the relatively high taxable dividend yield).
  • Going forward, emerging markets may swap places with Canadian equities in Manitoba, Nunavut, Ontario and Quebec.  

2016 taxes payable on a $10,000 investment (top marginal tax bracket)

Province of Territory Vanguard FTSE Canada All Cap Index ETF (VCN) iShares Core S&P U.S. Total Market Index ETF (XUU) iShares Core MSCI EAFE IMI Index ETF (XEF) iShares Core MSCI Emerging Markets IMI Index ETF (XEC)
Alberta $88 $93 $131 $101
British Columbia $87 $92 $130 $100
New Brunswick $95 $103 $145 $112
Northwest Territories $79 $91 $128 $99
Prince Edward Island $95 $99 $140 $108
Saskatchewan $84 $93 $131 $101
Yukon $69 $93 $131 $101
Manitoba $105 $97 $138 $106
Nunavut $92 $86 $121 $93
Ontario $109 $103 $146 $112
Quebec $111 $103 $145 $112
Newfoundland and Labrador $113 $96 $136 $105
Nova Scotia $116 $104 $147 $113

Sources: 2016 Personal TaxPrep, TaxTips.ca, CDS Innovations Tax Breakdown Service, BlackRock Canada, Vanguard Canada

2016 Taxable Account Asset Location Order

Province of Territory Ordinary income (top marginal tax rate) Eligible dividends (top marginal tax rate) 1st 2nd 3rd 4th
Alberta 48.00% 31.71% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
British Columbia 47.70% 31.30% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
New Brunswick 53.30% 34.20% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Northwest Territories 47.05% 28.33% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Prince Edward Island 51.37% 34.22% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Saskatchewan 48.00% 30.33% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Yukon 48.00% 24.81% Canadian Equities U.S. Equities Emerging Markets Equities International Equities
Manitoba 50.40% 37.78% U.S. Equities Canadian Equities Emerging Markets Equities International Equities
Nunavut 44.50% 33.08% U.S. Equities Canadian Equities Emerging Markets Equities International Equities
Ontario 53.53% 39.34% U.S. Equities Canadian Equities Emerging Markets Equities International Equities
Quebec 53.31% 39.83% U.S. Equities Canadian Equities Emerging Markets Equities International Equities
Newfoundland and Labrador 49.80% 40.54% U.S. Equities Emerging Markets Equities Canadian Equities International Equities
Nova Scotia 54.00% 41.58% U.S. Equities Emerging Markets Equities Canadian Equities International Equities

Sources: 2016 Personal TaxPrep, TaxTips.ca, CDS Innovations Tax Breakdown Service, BlackRock Canada, Vanguard Canada

So, there you have it: A few jurisdiction-specific rules of thumb to guide you along your tax-wise way. But, as with that GPS that usually takes you where you want go, you may want to take a good look around at your personal circumstances before blindly following anyone’s general directions – even mine.

By: Justin Bender | 2 comments
August-22-17

Asset Location: Tax Savings Through More Organized Living

Among the most common questions I receive from blog readers is: “How do I tax-efficiently manage an ETF portfolio across various account types?” This question relates to asset location – or which asset classes should end up in which accounts. This is not to be confused with asset allocation, which is how much of your portfolio to allocate to each asset class.

If that’s still a little confusing, think of the assets in your portfolio as being like the hours in your day. You may allocate eight hours each to working, playing and resting. You’ll also locate each hour in a place most appropriate for the activity – such as a dark, quiet room when it’s time to sleep. Similarly, you may allocate 40% of your assets to fixed income and 60% to equity, but you’ll locate these holdings where you’ll get the most tax-efficient bang for the buck.

Big picture, that means you want to consider the tax efficiency of each type of holding, based on its potentially taxable annual interest or dividends, as well as its potentially taxable eventual capital growth through the years. (At least we hope your holdings grow!) You then locate each holding where both types of tax ramifications are expected to cause the least overall damage done.  

So how does that work?

First, a few ground rules. In the scenarios that follow, I’ll assume a 40% fixed income/60% equity asset allocation. Since most investors are managing a similarly balanced/rebalanced portfolio, this practical model strikes me as a happy medium between ignoring the potential tax-saving benefits of asset location, versus taking the calculations to an extreme.

If you really wanted to sharpen your pencil, some might suggest using the less-traditional, but more complex after-tax approach for calculating optimal asset locations. Since asset location is always a best-estimate effort (with THE best answer only available in hindsight), it seems to me that the law of diminishing returns begins to apply.

Let’s get started!

Scenario 1: All assets in RRSP accounts

This is the most basic situation. Obviously, if you only have one type of location in which to invest your assets, your choice of location is pretty easy. It’s like living in a one-room house. The only way to make the portfolio slightly more tax-efficient is to swap out the Canadian-listed foreign equity ETFs for their US-listed counterparts (using Norbert’s gambit to convert your loonies to dollars).

Scenario 2: Assets are split between TFSA and RRSP accounts

In this situation, you and your spouse have assets in both TFSA and RRSP accounts. As all growth and dividends that accumulate in a TFSA account are never taxed (even upon withdrawal), investments with the highest expected returns should be held here first.

That makes equities the obvious choice for the TFSA account. Unfortunately, we have no idea which equity region will outperform moving forward. As a personal preference, I choose to hold Canadian, U.S., and international/emerging markets equities evenly, to mitigate my regret if I otherwise managed to choose the worst outcome. Feel free to adjust this allocation if you would rather roll the dice.

Don’t bother holding US-listed foreign equity ETFs in your TFSA accounts – this does nothing to mitigate foreign withholding taxes.

Scenario 3: All equities fit into TFSA and taxable accounts

Once you’ve maxed out your TFSAs with equities, your taxable accounts are usually the next best location if you have more equities (since only 50% of capital gains are taxable there). You may also stumble across tax-loss selling opportunities in your taxable accounts, which could help you defer future capital gains taxes when rebalancing your portfolio.

Scenario 4: Fixed income has spilled over into the taxable account

Your portfolio is looking great and you’re on the right track. Just don’t blow it by holding tax-inefficient fixed income products in your taxable account. As I’ve written about in the past, most bond ETFs are not ideal candidates for taxable investing (due to the higher coupon payments of the underlying bonds). The BMO Discount Bond Index ETF (ZDB) attempts to mitigate this issue by investing in lower coupon bonds. As you can see in the chart below, the taxes paid on a $10,000 taxable investment were substantially less for ZDB vs. the BMO Aggregate Bond Index ETF (ZAG).

2016 taxes payable on a $10,000 investment (Ontario taxpayer in the top marginal tax bracket)

Exchange-Traded Fund Asset Class Total Taxes Paid (2016)
BMO Aggregate Bond Index ETF (ZAG) Canadian Bonds $150
BMO Discount Bond Index ETF (ZDB) Canadian Bonds $103

Sources: CDS Innovations Inc. Tax Breakdown Service, BMO ETFs

 

Scenario 5: RRSP accounts must still hold some equities

What if you can’t fit all of your equities into your TFSA and taxable accounts? Generally, if you must hold some equities in your RRSP accounts, opt for international equities. With their fully taxable and juicy dividend yield of around 3%, the taxes payable each year will take their toll. In the chart below, I’ve shown the taxes paid by an Ontario resident in the top tax bracket during the 2016 tax year for a $10,000 investment in each equity ETF. As you can see, holding international equities resulted in higher taxes payable during the year than any of the other equity regions.

This is also a good example of when it makes sense to build a 5-ETF rather than a 3-ETF portfolio. Holding a global equity ETF (such as the iShares Core MSCI All Country World ex Canada Index ETF (XAW)) would not allow you to isolate the less-tax-efficient international equities, so you could locate them within your RRSP account. Breaking up the ETF into its underlying U.S., international and emerging markets components provides more flexibility in this situation.

Depending on where you live in Canada (and your actual tax rate), prioritizing the asset location order for remaining equity asset classes could differ from the results below. Next week, we’ll take a closer look at that.

2016 taxes payable on a $10,000 investment (Ontario taxpayer in the top marginal tax bracket)

Exchange-Traded Fund Asset Class Total Taxes Paid (2016)
Vanguard FTSE Canada All Cap Index ETF (VCN) Canadian Equities $109
iShares Core S&P U.S. Total Market Index ETF (XUU) U.S. Equities $103
iShares Core MSCI EAFE IMI Index ETF (XEF) International Equities $146
iShares Core MSCI Emerging Markets IMI Index ETF (XEC) Emerging Markets Equities $112

Sources: CDS Innovations Inc. Tax Breakdown Service, BlackRock Canada, Vanguard Canada

 

By: Justin Bender | 12 comments
August-08-17

Corporate Taxation: The Magical Dividend Refund

I’ll be the first to admit, there are times when the way our tax codes play out seems more like magic than accounting – especially when integrating your personal and corporate taxes. “Look, nothing up my sleeves,” says your tax professional. Can you believe it? That’s what this series is for: Putting some of the acts into slow-mo, so you can see the sleight of hand for yourself.

Today, we’ll talk about the magical dividend refund, whose purpose is to ensure that corporate shareholders don’t end up being unfairly taxed twice on the same income. Ready to see how this nifty trick works?

In my last blog post, I showed how Canadian interest income is taxed within a corporation. In our example, an Ontario-based corporation was taxed 50.17%, or $5,017 on $10,000 of Canadian interest income. This left $4,983 of after-tax income to reinvest in the corporation’s passive portfolio or to distribute to shareholders.

Let’s say this money were distributed to you, a shareholder and Ontario taxpayer. If there were no further adjustments, you’d then incur an additional $2,258 of personal taxes on the non-eligible dividend. (Trust me on that figure, and I’ll spare you the details so we can get to the good stuff.)

If you’re keeping an eye on the action, you can see how unfair this would be. Your combined corporate and personal taxes would be $7,275, for an effective tax rate of 72.75%. That’s considerably higher than Ontario’s top personal tax rate of 53.53%.

A Part 1 corporate tax disappearing act

The government is well aware of this inconsistency, so they rightfully allow your corporation to “disappear” a portion of your otherwise unequal burden by obtaining a dividend refund when taxable dividends are paid out to shareholders. Specifically, we apply a bit of pixie dust to the federal 38.67% Part I tax payable on investment income to position your corporation to qualify for a refund on 30.67% of the aggregate investment income from Schedule 7. In our example, that’s $10,000 × 30.67% = $3,067.

The remaining 8% of the 38.67% federal Part I tax is non-refundable, as are provincial and territorial taxes like Ontario’s 11.5% tax.

Source: Corporate Taxprep – T2 Corporation Income Tax Return (2016)

 

Refundable dividend tax on hand (RDTOH)

We’re not yet done with the fancy footwork. There’s also the ever-so-catchy refundable dividend tax on hand (RDTOH) account, where the available dividend refund described above accumulates.

To obtain the full dividend refund available, the corporation must pay out a taxable dividend of sufficient size to shareholders. The corporation is refunded 38.33% of each dollar of taxable dividends it distributes to shareholders. So in our example, a business owner would need to pay out taxable dividends of at least $8,002 to reclaim the full $3,067 of refundable taxes available in the RDTOH account balance ($3,067 ÷ 38.33%). This refunded amount of taxes is the actual dividend refund.

Source: Corporate Taxprep – T2 Corporation Income Tax Return (2016)

 

The Dividend Refund

As mentioned in the discussion above, the corporation will have $8,050 available to distribute to its shareholders (once you include the dividend refund of $3,067 and the after-tax corporate income of $4,983). As this amount is higher than the required $8,002, we’ll have no issues receiving the full dividend refund.

To pay out the taxable dividends to shareholders, the business owner would include $8,050 of taxable dividends on Schedule 3 (line 450). This figure would feed through to the dividend refund section of the corporate tax return, resulting in a dividend refund of $3,067.

If you’re watching closely, you may notice that the $8,050 dividend payment should generate a dividend refund of $3,086 ($8,050 × 38.33%). But only $3,067 is actually refunded, since this is the balance available in the RDTOH account.

Source: Corporate Taxprep – Schedule 3 (2016)

 

Source: Corporate Taxprep – T2 Corporation Income Tax Return (2016)

 

Did you follow all that? Below is the summary.

Next week, we’ll look at how tax integration works (or doesn’t) with Canadian interest income. We’ll also look at whether it makes sense to retain the investment income within the corporation for reinvestment, or dividend it out to the shareholders.

General Formula Amount Calculation
Canadian interest income $10,000  
Deduct:
Part I tax – non-refundable
($800) $10,000 × 8%
Deduct:
Part I tax - refundable
($3,067) $10,000 × 30.67%
Deduct:
Provincial or territorial tax – non-refundable
($1,150) $10,000 × 11.5% (Ontario)
Equals:
After-tax corporate income
$4,983 $10,000 - $800 - $3,067 - $1,150
Add:
Dividend refund
$3,067 $10,000 × 30.67%
Equals:
Amount available to distribute as a taxable dividend
$8,050 $4,983 + $3,067

 

By: Justin Bender | 0 comments