Incorporating Tax in your Investment Planning

“Don’t let the tax tail wag the investment dog” is a popular saying in the world of investment management. And while there is wisdom in this statement, being thoughtful about what for most is their highest investment-related cost is essential. There is no cookie-cutter approach to efficiently incorporating tax considerations into your investment planning. As it is with investing generally, it is important to consider your family’s unique circumstances throughout the tax planning process. This article will outline a few key factors to keep in mind as you and your family think about how best to integrate tax considerations into your investment plan.

Job Description

Throughout the planning process, we find it helpful to think about the job description of a portfolio and its various components.

For instance, do you require income from the portfolio? If so, what is likely to be the most tax-efficient way to generate income? Through investments that distribute cash? Or perhaps by redeeming portions of investments that do not distribute? And either way, how do you balance this need against the expected risk profile of the underlying investments so that you sleep well?

Structure

And while we’re talking about job descriptions, it is important to understand your family’s structure and investment entities. We’re talking about individuals, corporations, partnerships, and trusts here. Having clarity around the roles of each entity in your family’s structure is imperative. This means having clearly defined investment, tax, and estate plans for each entity that ties back to the overall portfolio job description.

Return Character

And while we’re talking about job descriptions, it is important to understand your family’s structure and investment entities. We’re talking about individuals, corporations, partnerships, and trusts here. Having clarity around the roles of each entity in your family’s structure is imperative. This means having clearly defined investment, tax, and estate plans for each entity that ties back to the overall portfolio job description.

Offshore Investments

Some factors to consider when investing outside of Canada include, but are not limited to, foreign tax filing requirements, foreign exchange gain/loss, Canadian tax disclosure requirements, and the additional administration that may accompany these elements. So while there will always be terrific investment opportunities outside of Canada, it is essential to consult your tax advisor to ensure you understand the investment’s tax implications and their impact on your portfolio.

Tax-Loss Harvesting

Tax-loss harvesting (aka tax-loss selling) involves selling investments at a loss and offsetting those losses against realized capital gains, which can reduce an entity’s tax liability for a given year. This strategy can be either temporary or permanent. And back to the tax tail of the investment dog, the decision to sell an investment should not be solely based on tax efficiency – but rather on its merit and position with the investment plan. If a tax-loss harvesting plan is temporary, you should review the superficial loss rules [1] with your tax advisor.

Deferral Opportunities

Deferral opportunities should always be taken into consideration when incorporating tax in your investment plan. In certain circumstances, there may be the ability to defer taxes by earning and retaining investment income within a corporation. This can allow a portfolio to compound returns over time rather than paying tax immediately if the returns are distributed from the corporation to its shareholders. There are key factors that need to be considered with this approach, including current tax rates and shareholder needs, therefore a tax specialist should be consulted to ensure it works effectively within your structure. Another deferral opportunity takes us back to the concept of return character.  An investment that distributes dividends annually will generate tax on an annual basis.  In contrast, an investment that creates value over the long-term, without annual income or distributions, will generally not result in taxes owing until the asset is sold.

End of Year Fund Purchases

Investors should be thoughtful when purchasing units of a pooled fund near the end of the year. The issue that can arise is some funds pay taxes within their structures – and if a fund has had a good year, and you purchase units just before the fund pays its tax bill, you can end up paying taxes for returns you did not realize. Not nice.

Registered Accounts

Being thoughtful about optimizing the benefits of your RRSP, TFSA, RESP, etc., can improve after-tax returns. For example, it may be best to hold an investment in a registered account if it is expected to generate significant taxable income (i.e., depending on the expected magnitude and tax character of the return). The tax deferral opportunities associated with a registered account allow gains to compound over time rather than having a portion lost immediately to tax. In the case of an RRSP, the flipside of these “partnerships with the government” is that you will eventually pay taxes on all withdrawals (so it may make sense to withdraw from an RRSP in a year where your taxable income is light). Also, if losing investments are located in your RRSP, you cannot harvest those losses and apply them against gains elsewhere in your portfolio.

Connecting Your Advisors

Arguably the most important action you can take when incorporating tax considerations into your investment plan is to establish a strong line of communication between your family’s tax and financial advisors. Not only will this help develop the connective tissue necessary to optimize your tax and investment planning, but it will also help to ensure investments are made through the best entity. An open line of communication can also help prevent any unwanted surprises during tax season.

Pulling It All Together

The thoughtful integration of tax and investment planning is like completing a puzzle with a few missing pieces. The missing pieces, of course, are what the future will bring in terms of investment returns, tax policy, your future cost of living, etc.

This article has focused on the puzzle pieces you can utilize if you:

• Have clarity around the job description(s) of your portfolio and structure;
• Pay attention to the jurisdiction, expected return character, and timing of investments you are considering;
• Look for opportunities to defer gains, harvest losses, and maximize the utility of your registered accounts; and
• Connect your tax and investment advisors and make it easy for them to communicate when appropriate.

THIS RESEARCH REPORT DOES NOT INCLUDE TAX ADVICE AND THE PRINCIPALS OF PRIME QUADRANT ARE NOT TAX EXPERTS. PLEASE CONSULT A TRUSTED TAX EXPERT BEFORE MAKING ANY INVESTMENT DECISIONS.