Returns from alternative investments often come in the form of tax-advantaged income, such as capital gains and eligible dividends. But sometimes those advantages don’t materialize.
For instance, exempt market issuers won’t know their products’ taxation until they appear on people’s T-slips, says Kyle Jacober, co-founder and principal at Raintree Financial Solutions in Edmonton.
“We’re never going to be certain [how] CRA is going to treat taxation,” he says. He gives the example of Walton International, a land-banking group. “You’d think [land sale income] would be treated like a capital gain, but CRA has deemed it to be interest income because Walton is in the business of buying, speculating on and selling land.”
To avoid surprises, exempt-market (EM) issuers obtain tax guidance from one of the Big 8 accounting firms, and “we’re usually fairly comfortable with the anticipated outcome,” he says. Still, if you’re concerned, avoid the investment. Another wrinkle:
since liquidity is often limited for alternative and exempt-market offerings, make sure you know when clients will receive cash payments. “You don’t want to be in a position where you’re being taxed on income but you’re not getting cash flow to pay it,” says John Campbell, tax group leader at Hilborn in Toronto.
So researching an investment is especially important. Here are tax tips for five common alternative investments.
1. Limited partnerships
Jacober says LPs are popular vehicles in the exempt market space. They can flow through certain deductions to investors, including losses, capital cost allowance (CCA) and soft costs.
LPs give examples of how those deductions will work in their marketing materials; you can also ask the dealership’s advisors. Knowing this information helps with tax planning. “Let’s say I invest in an LP that has to declare deductions by end of year,” says Jacober. “I know I’ll have employment income this year and I’ll have an idea what deduction I might get against it.”
Some LPs include American exposure—often via real estate—which may trigger a U.S. tax obligation. “In some instances, people are finding out about this after making the investment,” says Campbell. “And even if you don’t have to pay U.S. tax you still have the ongoing cost associated with filing a U.S. return and obtaining a U.S. account number.”
You’ll also be subject to more scrutiny from CRA.
Jacober says some of these LPs have employed the U.S. check-the-box rule, which lets entities choose how they’ll be taxed: as a corporation, LP or disregarded entity. If they pick corporation, that bypasses the need for clients to have ITINs and therefore the need to file U.S. returns.
Beth Webel, a tax partner with PwC in Hamilton, Ont., says that regime makes it critical to confirm the tax status of the entity. This can be done by checking offering memoranda and the articles of incorporation, and speaking with the entity’s tax advisors.
“You might see a company with LLC at the end of its name, but it could actually be treated as a partnership” for tax purposes, she says.
2. Commodities
Most investors get commodities exposure through ETFs or futures contracts. In certain cases, this can mean annual capital gains.
“Investing in a derivatives-based gold or silver ETF might mean contract rolling and subsequent capital gains realization, in contrast to buy-and-hold physical gold and silver ETFs,” says Ioulia Tretiakova, director of quantitative strategies at PUR Investing in Toronto.
Character conversion transactions used to mitigate such taxable events by converting income to capital gains, but that changed with the 2013 budget. So tell clients they might have higher tax hits going forward.
As for futures, “The hassles of a margin account aside, a tax advantage could come from the fact that an investor could report the gains and losses from trading in a capital account if certain conditions are met,” says Tretiakova. “Generally it hinges on whether CRA views futures trading as a business activity. If it looks like an investor is trading futures professionally, reporting in a capital account could be disallowed.”
Melody Chiu, senior manager of tax services at PwC in Toronto, says CRA tends to view futures trading as speculative, and therefore taxes associated gains on income account. But if there is a capital property to which the derivative relates, then that view may change.
“For example, you have a forward currency contract and hold shares of a U.S. company, and you’re doing so to ensure you’re not affected by fluctuations in the Canada-U.S. exchange rates.”
Any gains as a result of the forward may be taxed on capital account if sufficiently linked to the capital property (in this case, shares) held. “The CRA has their own view on how close this link should be,” Chiu adds.
3. Real estate
There are three main ways to invest in real estate:
- Direct ownership (not RRSP eligible)
- Joint venture with a pool of known investors
- REIT or public fund (can be in RRSP)
For all three, depreciation on buildings and land creates a deduction. That means “capital can be distributed each year because you’re earning income that you can shelter with CCA,” says Campbell. It’s also possible to deduct expenses such as utilities and mortgage interest.
Those deductions defer tax, rather than saving it permanently. The adjusted cost base lowers each time you deduct expenses and if you sell the property for a gain, “a lot of those deductions get recaptured and taxed at the end,”
says Campbell.
And people who don’t earn profit can still have a significant tax bill “if they’ve depreciated the building over 20 years to take out an income without tax each year.”
To manage that problem, emphasize any deductions “will be payable when you sell the property,” says Campbell.
And help clients strategically time expenses and CCA, which doesn’t have to be claimed each year. For instance, if it’s a down market clients may want to hold off claiming CCA if they plan to sell the property soon because the true gains may not absorb the tax hit. In a joint venture, each owner can independently decide to claim CCA. And with REITs, the CCA is claimed by the income trust.
But there are also cost base concerns with REITs.
“Part of each distribution each year is usually return of capital, which is tax free. But the cost base of your investment is declining by the same amount each year,” he says. If you own the same REIT at 5% yield for 10 years and sell at the same price you paid for it, “you may still be subject to capital gains tax because your cost base has been significantly eroded.”
Worse, if you own that REIT until the cost base erodes to zero, any subsequent ROC will be considered a capital gain.
If your client has fully eroded REITs, donate them, says Campbell. Say that client was planning to donate $1,000 cash. She’d get a tax credit of about $460. But “if you have a REIT with a cost base of almost $0 and you donate it, you get the same $460 benefit but you don’t pay capital gains tax, which avoids [another] $230.”
4. Investment corporations
If a Canadian Controlled Private Corporation (including an investment corporation) makes more than $500,000, it’s subject to higher-rate corporate tax on income above that threshold, allowing the CCPC to distribute an eligible dividend.
That’s particularly advantageous in Alberta, where eligible dividends are taxed at 17%—the lowest possible tax rate.
5. Flow-through shares
The 2013 budget affirmed flow-through shares would survive another year.
These shares are typically issued by junior resource companies, which flow through their exploration tax deductions to shareholders so they can use them on personal or corporate tax returns. That’s because many of these companies aren’t yet profitable and can’t use the tax credits.
Thanks to this treatment, an investor can usually deduct the entire cost of her flow-through shares from her net income, bringing the shares’ adjusted cost base to zero. The entire value of the investment will be taxed as a capital gain when sold.
Problem is, “the owner must be able to fully utilize the tax advantages,” says Campbell. Otherwise, “she could be subject to alternative minimum tax if her income isn’t substantial or her income declines while she owns the investment.”
Federal AMT requires everyone to pay a flat rate of tax on gross income. It’s equal to adjusted taxable income, minus a $40,000 exemption, multiplied by 15%. The greater of regular tax and the AMT is payable for the year.
For maximum benefit, Campbell suggests buying these shares so they’re taxed at the client’s highest marginal rate. For instance, the highest Ontario tax threshold starts at $132,406 (2012). If your client makes $170,000, she should cap purchases at $37,594.
Any AMT greater than regular tax can be carried forward seven years and used as a credit against future regular taxes, “but if your client’s income never goes above the minimum tax threshold, you keep creating tax advantages they’ll never get to use,” he adds. “And a lot of times in order to break even on the investment, you need the tax relief.”
To guard clients from having to pay AMT:
- limit RRSP deductions and save the deduction for a future year;
- have business owners draw employment income instead of dividends;
- restructure portfolios to earn more income at full rates (e.g., through interest); and
- limit elective deductions.
Melissa Shin is managing editor of Advisor Group.