If you invest in US-listed equity ETFs or mutual funds that hold US or international stocks through your Canadian controlled private corporation (CCPC), foreign withholding taxes will be levied on the dividends, and you will generally be able to recover only 26% of the taxes withheld. This tax drag arises while calculating the Refundable portion of Part I tax on a corporate tax return. In order to illustrate this concept better, we’ll compare this amount on the corporate tax return for two distinct investors:
Refundable portion of Part I tax:
The Refundable portion of Part I tax allows a CCPC to recover a portion of the taxes paid on investment income when the corporation pays a taxable dividend to its shareholders. It is referred to on page 6 of the corporate tax return as amount F, and is equal to the lesser of amounts C, D, or E. On Melvin’s corporate tax return below, amount F is equal to $10,667 (for simplicity, I’ve omitted the section of the corporate tax return that explains how amount E is calculated).
Now let’s see what happens to Gord’s Refundable portion of Part I tax when we assume half of the $40,000 of investment income came from US dividends.
As we can see in the example above, amounts C, D and E have all changed. Amount F is now equal to $8,445 (the lesser of amounts C, D, or E).
Although we may be able to claim a foreign tax credit of $3,000 to offset the foreign withholding taxes levied, we will also have a reduction of the Refundable portion of Part I tax of $2,222 ($8,445 - $10,667 = -$2,222). In other words, we will lose about 74% of the $3,000 of foreign withholding taxes levied ($2,222 / $3,000 ≈ 74%), recovering only 26%.
Although this information should not cause you to make changes to your overall asset allocation, you may want to reconsider your asset location. For example, if you or your spouse own personal non-registered accounts as well as corporate accounts, consider allocating your US and international equity ETFs and mutual funds to those accounts instead of to your CCPC.
Special thanks to George Hronis, CFP, for his comments and insights.
Most stock market forecasters have terrible track records (although they continue to make their predictions, with little to no accountability). However, one metric has been shown to offer some degree of predictive ability; the Shiller CAPE ratio.
The Shiller “cyclically adjusted price-to-earnings” ratio takes the current price of the stock market and divides it by the average stock market earnings over the past 10 years (adjusted for inflation). By averaging the earnings over 10 years, the effects of large earnings fluctuations in any given year are mitigated. A high relative value indicates an overpriced stock market, while a low figure indicates a bargain.
Vanguard recently produced a paper titled, Forecasting stock returns: What signals matter, and what do they say now? They found that valuation measures, such as the Shiller CAPE ratio, have shown some modest historical ability to forecast long-run returns. So what are these valuation metrics saying today?
Luckily for us, Raymond Kerzerho, Director of Research at PWL Capital, has come to the rescue. He has constructed Shiller CAPE ratios for some well-known stock market indices:
The Earnings Yield (E/P)
In order to estimate the real expected long-run return of the stock market, you will need to take the inverse of the Shiller CAPE ratio; this will give you the amount of real earnings you should expect for each dollar you invest. I also prefer to adjust this figure downwards by about 1% to account for earnings dilution (i.e. some of the earnings will go to owners and shareholders that do not yet exist).
Future Expected Portfolio Returns
If we assume inflation of 2% going forward, and nominal bond returns of 2.25%, what would be a reasonable return expectation for various Couch Potato asset allocations going forward?
Although these future returns could be better or worse than expected, this framework can be used to construct appropriate asset allocations that would be expected to meet the investor’s individual financial goals (stay tuned for my next post on this topic). As always, investors should never increase the risk of their portfolio beyond their ability, willingness and need to take risk.