Tax-Efficient Investing

Introduction

Although investment strategy should not be determined primarily by tax efficiency, once an asset allocation is determined, it should be set up in a tax-efficient manner. 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.

Non-Registered Investments

The Dividend Tax Credit

Common share 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.

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 hold the property or security for the 30 days preceding or 30 days following the sale (see Superficial loss). 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 the iShares CDN LargeCap 60 Index Fund, which tracks 60 of the largest stocks in the TSX (the S&P®/TSX® 60 Index) 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 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.

Registered Investments

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 GICs, stripped bonds, and Real Return Bonds 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 US investments) is not recoverable in a TFSA.

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. 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 supersede 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. Note that this exemption does not extend to RESPs or TFSAs, thus high-yielding US stocks or US-based ETFs are better held elsewhere than in RESPs or TFSAs. 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.

Another consideration about foreign withholding taxes deals with holding foreign securities in an incorporated small business (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.

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:

Tax-Efficient Asset Allocation

Asset Class	Non-Registered	Registered
Canadian Stocks or ETFs	Usually best	OK
Canadian Preferred Sharesa	Yes	No
Tax-Deferred Canadian REITs/Trustsb	OK	If necessary (e.g. for RRIF)
Income Trusts with Low Tax Deferralb	If necessary	Yes
Canadian Stripped Bond	No	Yes
Canadian Normal Bond	If necessaryc	Yes
Canadian Real Return Bond	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

a. Preferred shares produce dividend income and should be held outside an RRSP so as to benefit from the dividend tax credit.
b. Most REITs or trusts include a "return of capital" component that is tax-deferred outside an RRSP. If the trust produces entirely income, it should be held inside an RRSP. The tax status can be determined from the trust's web site.
c. Premium bonds should not be included in non-registered accounts. See Conventional Bonds - Taxation in Non-Registered Accounts.

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

Additional Information

Tax Rate Calculators