How to save on taxes

There was a time when November began the tax shelter season. Dozens of them would appear, all heavily promoted, all promising huge savings for high-bracket investors.

A small percentage actually did work out, delivering both tax savings and, later, profits. Some well-managed real estate deals did okay (although many others didn’t). The mutual fund limited partnerships were generally fine – some still send regular income cheques. Some flow-through share offerings paid off.

But, on the whole, the track record of the shelters was poor. In most cases, investors got the write-offs but ended up losing money when the investment itself did poorly.

There are still a few flow-through deals around, but they are simply too unpredictable, even with an experienced management team. Most of the money goes into exploration or start-up ventures. When they do well, they can score big gains. But too often the investment gets written down to zero or close to it.

There are also some movie deals around, but most are available through offering memorandum only (which means a minimum investment of $150,000 in some provinces, including Ontario), and they’re obviously very risky/P>

Few tax shelters
Apart from that, the tax shelter cupboard is bare. The reason is two-fold:

    1. During his time as Finance Minister, Paul Martin waged a vigorous battle against tax shelters of all types. He closed loopholes, attacked off-shore havens, and even made professional advisors liable if they give clients overly aggressive advice.
    2. Tax rates are falling quickly in this country. The lower the top marginal rate, the less incentive there is for taking risks to avoid paying taxes.

Next year, not one Canadian province or territory will have a top marginal tax rate of 50 per cent or higher. The top capital gains rate has also been slashed. A year ago it was between 35 per cent and 40 per cent in most provinces. Next year, no one will have a capital gains rate that exceeds 24.61 per cent and in Alberta it will be down to 20 per cent – assuming no more cuts to come.

Yes, the marginal rates for regular income are still high when compared to the U.S. But a top-bracket taxpayer in Ontario, for example, might seriously question the wisdom of taking a big risk on a flow-through share deal when the saving amounts to 47.86 per cent this year and 46.41 per cent in 2001.

Even if the flow-through fund does pay off in the future, your money will be tied up for anywhere from 18-36 months. And if there is a profit, there will be some tax to pay on the capital gains.

Start with basics
That’s why I’m advising people to forget about the old-style tax shelters, the ones that put your money at significant risk. If you want some tax relief, focus on the new breed of shelter. The write-offs aren’t as good, but your money will be a lot safer.

Here are some suggestions, starting with the most basic.

  • Maximize your RRSP contribution.  Too often we overlook the obvious. Be sure you do this before you even look at anything else.
  • Pay down the mortgage. The house gives rise to a tax-free capital gain. The mortgage interest is not tax deductible. Paying down the mortgage builds your tax-sheltered equity and frees up more after-tax income.

Labour funds attractive

  • Invest in labour-sponsored venture capital funds. Now we’re into somewhat more risk, but I consider it to be acceptable risk. The managers of most of these funds have shown they know what they are doing, the tax write-offs are attractive and the returns are improving.

For these labour sponsored funds, the amount of your tax break will depend on where you live. Everyone qualifies for the federal credit which is 15 per cent of the amount invested up to $5,000 a year (so a maximum credit of $750 annually). This is deducted directly from your total tax payable, just like the dividend tax credit.

Some provinces also offer their own credits and these vary. Ontario, for example, matches the federal credit. Saskatchewan offers a higher credit (20 per cent) if you invest in a locally-based fund, the Golden Opportunities Fund. BritishColumbia has higher limits for its Working Opportunity Fund. Some provinces, like Alberta, have no special incentives.

Of course, if you put the units into an RRSP you get that tax deduction as well.

As a bonus, investors in labour-sponsored funds receive additional foreign content room in registered plans. The formula is $3 of extra foreign content for every $1 invested, however you max not exceed 45 per cent foreign content in this way (rising to 50 per cent in 2001).

Returns have been good recently. The average fund in this category gained 33.1 per cent over the year to September 30. The average annual three-year compound rate of return was 12.1 per cent.

The main disadvantage is the long holding period. Your money is tied up for eight years. If you take it out sooner you have to repay the tax credits.

Tax deferred investments

  • Invest in royalty income trusts. You won’t get a tax deduction when you invest. But, depending on which you choose, part or all of the income may be tax-deferred. And any tax that is payable at the end has been greatly reduced as a result of Paul Martin’s two budgets this year.

The reason is the reduction to 50 per cent of the amount of capital gain that is taxed. For each dollar you receive of tax-deferred income from a royalty trust, your cost base is adjusted accordingly. So if you pay $10 a unit and receive $1 in tax-deferred distributions, your adjusted cost base (ACB) is $9. The ACB is the figure that is used to calculate your capital gain when you sell.

 As an example, suppose you invested in Pengrowth Energy Fund. Let’s assume you paid $15 a unit and have received $9 in tax-deferred distributions (a percentage of Pengrowth’s payments are taxable so do not count against your ACB).  You decide to sell in early 2001 for $20. Your ACB is $6 ($15 – $9), so your capital gain is $14. You live in Ontario and are in the top bracket.

Had all this happened in January 2000, you would have been looking at a tax of $5.02 per unit. In January, 2001 you will be assessed only $3.25 a unit. That’s a drop of more than 35 per cent.

Look at it another way. You will have received $9 in tax-deferred distributions and $14 in capital gains (we’ll ignore the taxable portion of the distributions), for a total of $23. Your effective tax rate on that money will be only 14.1 per cent. This may not be a tax shelter in the sense we’ve come to understand the term, but it’s a pretty effective substitute.

Risk? Sure there is risk in royalty trusts. Look what happened to them a couple of years ago when oil prices tumbled. But the risk is a lot more predictable, and manageable, then that involved with flow-through shares. Plus you can sell at any time.

Compared to the old-style tax shelters, that’s a good-looking combination even without the immediate write-offs.

This article was abridged from The MoneyLetter, published by Hume Publishing. For subscription information call 1-800-733-4863.