Tax-efficient investing

Tax-efficient investing doesn't mean tax-free investing. It means that once an asset allocation is determined, it should be set up in a tax-efficient manner, while at the same time being mindful to not let the tax tail wag the dog. An asset's tax efficiency is affected by both its expected return and the tax rate on such return. Remember that taxes are one aspect of investing that you can control. While there is no "one rule fits all" concept, the strategies presented here are mostly intended to provide guidance to investors in the accumulation phase (saving for retirement).

Generally investors should take full advantage of registered (tax-sheltered) accounts before investing in non-registered accounts as this is the most tax efficient strategy.

If you cannot fully tax shelter all of your investments, you need to be aware that Canadian tax laws treat interest income, qualified dividend income, and capital gains differently, they are taxed at different rates. For that reason, the goal of this article is to guide you on how you might reduce (or minimize) the taxes you pay by strategic placement of investments among various investment accounts. A word of caution, Canadian tax laws are sufficiently different from American tax laws that advice written for Americans is inapplicable or even wrong when Canadian investing is considered.

Prioritizing investments
Prioritizing investments is sometimes a challenge for investors who are able to place their investments in several different kinds of accounts. Investing in a prioritized order can maximize the tax efficiency of a portfolio (pay the minimum amount of taxes). It can also maximize matching funds from employers and government grants.

Marginal tax rates
The actual tax rates applicable to each income source vary by province or territory and with income level (see Tax rate calculators), but are generally in accordance with the following progression:


 * {| class="wikitable"

!Type !Examples Tax-efficient asset allocation places the highest taxable sources of income into non-taxable accounts whenever possible.
 * +Marginal Tax Rates
 * Highest
 * Interest income, RRSP withdrawals, dividends or distributions from non-Canadian sources
 * Intermediate
 * Capital gains, Canadian eligible dividends in high tax brackets
 * Lowest
 * Canadian eligible dividends in low tax brackets
 * Deferred
 * Return of capital that reduces the adjusted cost base (ACB) (eventually payable at capital gains rates)
 * }
 * Deferred
 * Return of capital that reduces the adjusted cost base (ACB) (eventually payable at capital gains rates)
 * }
 * }
 * }

The dividend tax credit
Common shares and preferred share dividends from most Canadian corporations are eligible for a dividend tax credit, which significantly reduces the tax rate in non-registered accounts, particularly in the lowest tax bracket. For this reason, such shares are preferably held in non-registered accounts. After 2005, most dividends from public corporations are eligible, and thus known as eligible dividends, for the enhanced dividend tax credit, which dividends from Canadian controlled private corporations, known as non-eligible dividends, are subject to the regular dividend tax credit. You should also note that there are two parts to the dividend tax credit, the federal dividend tax credit (Line 425 on your federal tax return and a provincial or territorial tax credit.

Tax loss harvesting
If you sell a property or security on which you have a capital loss calculated using an adjusted cost base to determine your cost, you are allowed to deduct that loss from your capital gains, provided that you or a related entity does not buy and continue to hold the property or security for the 30 days preceding or 30 days following the sale. However, you can use those losses to reduce your taxes due by selling one security and immediately rebuying a similar but not identical security.

For example, suppose you hold an exchange-traded fund (ETF) such as the iShares S&P/TSX 60 Index ETF, which tracks 60 of the largest stocks in the TSX and trades on the Toronto Stock Exchange under the symbol XIU. Further suppose that you had suffered a large paper loss on that holding. You could sell your XIU position and immediately repurchase a similar dollar amount of XIC, which tracks a different stock index (the S&P®/TSX® Capped Composite Index) yet offers similar (but not identical) performance. You would have then captured the loss and could use it in the current tax year, while still maintaining a similar position so that you could benefit from future gains.

It should be specifically noted that, if a security is sold at a loss from a non-registered account and repurchased within 30 days in an Registered Retirement Savings Plan (RRSP), the tax credit from the loss will be disallowed and the loss deemed to be zero.

Charitable donations
It is possible to actually zero the taxes due on a security on which one has a significant capital gain by donating a portion of the shares to charity. A calculator that estimates the portion to be donated can be found here.

Bond taxation
Conventional bonds that trade at a premium above their face value ("premium bonds") should not be held in a non-registered account because of unfavourable taxation. In addition, strip bonds and Real Return Bonds (RRBs) will require payment of taxes on returns accrued but not paid as they are treated as prescribed debt obligations as described in paragraph 7000 of the Income Tax Act.

Prescribed debt obligations
Unless held in a registered account, the tax treatment and record keeping requirements of strip bonds and Real Return Bonds is complex.

The Canada Customs and Revenue Agency has indicated that purchasers of strip bonds will be treated as having purchased a “prescribed debt obligation” within the meaning of the Regulations. Accordingly, a purchaser will be required to include in income in each year a notional amount of interest, notwithstanding that no interest will be paid or received in the year.

Accrued Inﬂation Compensation for a series of Real Retun Bonds must be included in a your income in the manner described under "Canadian Federal Income Tax Considerations", notwithstanding that payment in respect thereof will not be made until Maturity for such series.

Registered accounts
It is usually recommended that fully taxed securities (i.e., those that pay interest) be placed inside these accounts. In particular, securities in which interest is deemed but not received such as compounding Guaranteed Investment Certificates, strip bonds, and RRBs should be held in these accounts, rather than in a non-registered account.

RRSPs, RRIFs, LIRAs, RDSPs, and LIFs
These accounts all share the characteristic that any withdrawals are taxed as ordinary income.

RESPs
Registered Education Savings Plans (RESP) withdrawals are partially taxed in the hands of the student, who may pay little or no tax by using the basic personal exemption and the tuition credits. The original capital contributed to the plan was from after-tax savings, so its withdrawal is tax free, provided the beneficiary has started post-secondary education.

TFSAs
Tax-Free Savings Accounts (TFSA) differ from other registered investments in that no tax is due on withdrawn funds. They are compared with RRSPs here.

As discussed in the following section, foreign tax deducted at source (such as from most non-Canadian investments) is not recoverable in a TFSA. Although the dividend tax credit on Canadian securities is also lost, this loss is generally moot (except for those with very low incomes who have a negative income tax rate on dividends) since no tax is payable on TFSA holdings in any case.

Foreign withholding taxes
Some foreign countries apply a withholding tax to payments, such as dividends or interest, paid to non-residents. The amount of tax withheld, if any, is specified by the foreign country’s tax laws. However, Canada has tax treaties in place with numerous countries that may supersede those foreign tax laws. For example, US tax legislation generally requires a 30% withholding on US-sourced dividends paid to “non-resident aliens”, but the Canada-US tax treaty reduces that withholding to 15% for Canadian residents.

Foreign tax paid may be recoverable through a foreign tax credit claimed against the normal Canadian tax payable, but only to a limit of 15%. If the withholding tax were 30%, only half of that can be claimed as a foreign tax credit, with the excess being deductible on line 232 of the tax return.

If the foreign income would not ordinarily be taxable in Canada, such as foreign dividends earned within a registered plan, the tax is not recoverable and is forever lost. Again, tax treaties may in some cases supercede this general rule. Under the Canada-US tax treaty, dividends and interest paid into an RRSP or RRIF from a US source are exempt from US withholding. In order to qualify for these US tax exemptions or reductions, Form W-8BEN (pdf) must be filled out and filed with your brokerage. Note that the exemption does not extend to RESPs or TFSAs, thus high-yielding US stocks or US-based ETFs are better held elsewhere than in an RESP or TFSA. Also note that using a Canadian based mutual fund to invest in US stocks would result in US tax being withheld, even in an RRSP or RRIF - in such a case the foreign tax would not be recoverable for a registered account, but would be for a taxable account. For a Canadian mutual fund, the capital gains inclusion rate applies on distributions from foreign stocks. For US-based ETFs, capital gain distributions are taxed as income.

There is some debate about whether to hold US-based ETFs versus Canadian-based ETFs that invest in the US. In both instances, the withholding tax can be claimed against income in a taxable account. A U.S. based ETF would also be exempt from withholding tax in a registered account, but not a Canadian-domiciled ETF investing in the US.

When investing outside North America, the following considerations apply:
 * a Canadian domiciled mutual fund will have paid withholding taxes to foreign governments, on the income it has received from foreign securities. The mutual fund will distribute the net amount; if the unitholders have the fund in a non-registered account, they will receive a tax slip including the foreign tax paid by the fund, which in most cases is fully recoverable from the CRA;
 * a non-Canadian mutual fund (e.g., U.S. based ETF) investing in EAFE securities will have also paid withholding taxes to foreign governments, on the income it received from foreign securities. Such a mutual fund / ETF will not issue information to a Canadian resident about foreign tax credits. In addition, there will be another level of tax withheld by the fund / ETF's country of residence (e.g., USA); as mentioned in the above paragraph, this latter tax is not applicable if the US based fund is held in a retirement account (but does apply to a TFSA), and this second level of tax may be recoverable from the CRA for a non-registered account.

The consequence of these issues is that US-based ETFs that hold non-US stocks have an additional irrecoverable tax burden that raises the effective management expense ratio (MER), and may negate any nominal MER advantage. Morevover, Canadian-based ETFs that are wraps of US based ETFs will also have this irrecoverable foreign tax burden. Are you confused? The external links below should help. Also, Justin Bender has calculated the "total cost" of several Canadian-domiciled ETFs investing in international stocks, showing the effect of the two layers of withholding taxes.

Another consideration about foreign withholding taxes deals with holding foreign securities in an incorporated Canadian controlled private corporation (CCPC). Although the withholding tax is theoretically recoverable from the regular tax payable by the corporation, the intricacies of CCPC taxation lead, in most cases, to about three-quarters of the foreign tax credit being lost, thus any high-paying foreign securities that attract foreign withholding taxes are better held outside the corporation.

US estate tax exposure
Canadian residents (who are not US citizens) may be subject to US estate tax if they die owning certain US assets, such as shares of US corporations, US real estate and US business assets. Under the Canada-US Tax Treaty (the Treaty), Canadian residents will now have a US estate tax liability only if their worldwide assets are valued at more than $5.43 million (as of January 2015).

Canadian investors may be able to mitigate their exposure by holding Canadian domiciled index funds and exchange-traded funds (ETFs) for their US equity exposure.

Tax-efficient asset allocation
(Taken from "Shakespeare's Primer" with permission of the author.)

Tax-efficient asset allocation of Canadian assets should be in accordance with the following table:


 * {| class="wikitable"

! Asset Class ! Non-Registered account ! Registered account
 * +Tax-Efficient Asset Allocation
 * Canadian Common shares or ETFs ||Usually best||OK
 * Canadian Preferred shares ||Yes ||No
 * Tax-Deferred Canadian REITs/Trusts ||OK||If necessary (e.g. for RRIF)
 * Income Trusts with Low Tax Deferral ||If necessary ||Yes
 * Canadian Stripped Bond ||No ||Yes
 * Canadian nominal Bond ||If necessary ||Yes
 * Canadian Real Return Bonds ||No ||Yes
 * US/Foreign Equity (high-dividend, low-growth) ||If necessary ||Yes
 * US/Foreign Equity (low-dividend, high-growth) ||Usually best ||OK
 * US/Foreign Normal Bond ||If necessary ||Yes
 * US/Foreign Stripped Bond ||No ||Yes
 * US TIPS Bond ||No ||Yes
 * }
 * Canadian Real Return Bonds ||No ||Yes
 * US/Foreign Equity (high-dividend, low-growth) ||If necessary ||Yes
 * US/Foreign Equity (low-dividend, high-growth) ||Usually best ||OK
 * US/Foreign Normal Bond ||If necessary ||Yes
 * US/Foreign Stripped Bond ||No ||Yes
 * US TIPS Bond ||No ||Yes
 * }
 * US/Foreign Stripped Bond ||No ||Yes
 * US TIPS Bond ||No ||Yes
 * }
 * US TIPS Bond ||No ||Yes
 * }

Building a tax-efficient portfolio
Once a portfolio design is decided upon, perhaps with the help of an investment policy statement (IPS), the investor will be tasked with placing the components in a tax-efficient manner. Some examples will be used to show the process.

The general approach is that the registered accounts are filled first in reducing order of tax rate, with what's left going to the non-registered account.

Example 1. The four-component portfolio
The first example will be based on a four-component portfolio. The investor decides on an asset allocation, based on broad indexes or ETFs, of 40% bonds, 20% Canadian equities, 20% US equities, and 20% international equities. His investment room is 50% non-registered and 50% registered (in an RRSP). (He also has an emergency fund in a TFSA which he does not consider as part of his investment portfolio.)

After reviewing various options, he chooses Canadian-based ETFs for the bonds, Canadian equities, and international equities. He decides to use a US-based ETF for US equities, since Canadian choices are either more expensive or currency-hedged (which adds cost). Although currency conversion charges can add to the costs of US-based ETFs, those charges can be minimized by Norbert's gambit.

Since bonds are taxed at the highest marginal rate, all of the bond component is assigned to the RRSP. This leaves 10% of the portfolio as RRSP room. Since Canadian equities have a dividend tax credit and international equities have foreign tax withheld that can be credited against Canadian tax, the most efficient way to assign the remaining RRSP room is to fill it with 10% US equities, which are not taxed in an RRSP. His final portfolio allocation is as follows:


 * 40% broad bond index - all in RRSP
 * 20% US equities - split between RRSP (10%) and non-registered account (10%)
 * 20% international equities - all in non-registered account
 * 20% Canadian equities - all in non-registered account

Example 2. Adding real estate investment trusts
In the second example, a four-component portfolio is modified by adding exposure to Canadian REITs, either for greater income or for portfolio diversification. The desired asset allocation is 40% Bonds, 20% US equities, 20% foreign equities, 15% Canadian equities (all of the previous based on broad indexes), and 5% REITs. The REITs offer a blend of tax-advantaged income (due primarily to Return of Capital, which reduces the ACB and defers tax) and fully-taxable income.

If the investor is still accumulating his portfolio and does not need the REIT income, he may wish to place them in his RRSP to avoid current tax, forgoing the tax advantage of the Return of Capital. In this case, again with 50% in an RRSP, his asset allocation would be as follows:


 * 40% broad bond index - all in RRSP
 * 5% REITs - all in RRSP
 * 20% US equities - split between RRSP (5%) and non-registered account (15%)
 * 20% international equities - all in non-registered account
 * 15% Canadian equities - all in non-registered account

However, if the investor is now in withdrawal mode, and wishes to use the REIT income for living expenses, he may instead prefer to have the REITs in his non-registered account, replacing the RRSP content as before with US equities. On the other hand, once the RRSP has been converted to an RRIF and mandatory minimum withdrawals are required, placing REITs within the RRIF will produce cash flow to meet the minimum withdrawals.

Since investments cannot be switched from a non-registered account to a registered account without incurring a tax liability on embedded capital gains, it is important that the investor plan ahead in deciding his portfolio allocation, including the possibility of incurring future taxes.

Example 3. Preferred shares and high yield bonds
In the third example, preferred shares and high-yield bonds are added to the four-component portfolio. This investor, who is retired, has limited RRSP room and has decided to use preferred shares in his non-registered account to boost income in a tax-advantaged way via the dividend tax credit. His final asset allocation is 40% in a broad bond index, 10% in a high yield bond fund, 10% in Canadian preferred shares, 10% in broad Canadian equities, 15% in broad US equities, and 15% in in international equities. His RRSP room is again 50%.

His most tax-efficient asset allocation would be as follows, placing the high-yield bonds (which have the highest tax rate) in the RRSP first:


 * 10% high yield bonds - all in RRSP
 * 40% broad bond Index - all in RRSP
 * 10% preferred shares - all in non-registered account
 * 15% US equities - all in non-registered account
 * 15% international equities - all in non-registered account
 * 10% Canadian equities - all in non-registered account

Example 4. Limited RRSP room
In this example, we will assume the investor wishes to have a 50:50 bond:equity mix, based on the FPX balanced four-component portfolio, but has even more limited RRSP room (25% of the portfolio). In this case, he will use a GIC ladder for part of the non-registered bond allocation. This avoids the tax disadvantages of premium bonds. Preferred shares will again be used for the remaining part of the "fixed income" allocation. The RRSP room is first filled to its entirety with a bond fund or ETF. Everything else must go in the non-registered account:


 * 25% broad bond index - all in RRSP
 * 15% 5-year GIC ladder - all in non-registered account
 * 10% preferred sharesNote 1 - all in non-registered account
 * 10% US equities - all in non-registered account
 * 15% international equities - all in non-registered account
 * 25% Canadian equities - all in non-registered account

Tax-adjusted asset allocation
An argument can be made for applying an adjustment factor depending on the tax status of the account where each asset is located. Basically, this takes into consideration that part of the money in each account, or growth thereof, eventually must be paid to Canada Revenue Agency.

Here are some adjustment factor guidelines for various types of accounts:
 * TFSA 1.00 (no adjustment)
 * RESP 1.00 (no adjustment -- in most cases)
 * RRSP / RRIF and similar
 * 0.75 if small to medium
 * 0.60 if large to gargantuan
 * Non-registered personal
 * 0.80 if buy and hold for decades
 * 0.90 otherwise
 * Non-registered corporate (CCPC)
 * 0.70 if buy and hold for decades
 * 0.85 otherwise

For a US perspective on this topic, see Tax-Adjusted Asset Allocation.

Asset location and tax-efficient investing

 * Canadian Couch Potato, Put Your Assets in Their Place, a general explanation of the asset location concept and of tax-efficient investing, March 5, 2010.
 * Canadian Couch Potato, Managing Multiple Family Accounts, August 13, 2014.
 * Tax-efficient investing, part 1 | Advisor.ca, April 18, 2012.
 * Tax-efficient Investing: Part 2 | Advisor.ca, April 18, 2012.

Foreign withholding taxes

 * Canadian Couch Potato, Foreign Withholding Tax Explained, September 17, 2012.
 * Canadian Couch Potato, Foreign Withholding Tax: Which Fund Goes Where?, September 20, 2012.
 * Canadian Couch Potato, The True Cost of Foreign Withholding Taxes, February 20, 2014.
 * Canadian Couch Potato, The Wrong Way to Think About Withholding Taxes, a follow-up on The True Cost of Foreign Withholding Taxes above, January 30, 2015.
 * PWL Capital, Foreign Withholding Taxes, February, 2014.