Budget 2013: Only The Paranoid Survive - Nicola Wealth

Budget 2013: Only The Paranoid Survive

BLOG 2013-03-25 2013 Budget (header)

By John Nicola, CFP, CLU, CHFC

About 15 years ago, Andy Grove (then CEO of Intel) wrote a wonderful book with the same title as this budget update.

The 2013 Federal Budget is, in fact, just the latest example of how and why governments plan on raising their income to reduce deficits while funding programs such as health care and pensions that are increasing in cost much faster than the economy.

Consider the following:

  • In the Eurozone, many countries are actively prosecuting tax evaders – as they should – while increasing both income and sales tax rates. (France has recently increased their maximum marginal income tax rate to 75% and Gerard Depardieu now wants to be a Russian.)
  • There have been protests worldwide about how “the 1%” continue to get increasing shares of both national income and wealth. (Objective data supports these observations, but this group also pays a disproportionate share of taxes in relation to their income which, in a progressive tax environment, is as it should be.)
  • The U.S. agreed to increase taxes on those families earning more than $400,000 per year starting in 2013.
  • BC’s last Liberal budget (really a right of centre party) introduced a “temporary” tax of 2.1% on incomes over $150,000 which will bring our marginal tax rate to 45.8%.

This brings us to the latest Conservative budget just announced on March 21, 2013. In comparison to Europe, Japan, and the U.S., Canada is a pillar of fiscal prudence.

Our federal deficit in 2013/2014 is expected to be just 1.3% of the overall economy (perhaps 3% when we factor in the provinces compared to 7%+ for America). Our actual deficit should be gone by 2015/2016. We would be one of the very few OECD countries to achieve that worthy goal.

However, eliminating the deficit is being done through a combination of spending restraint and tax increases, which, in some cases, are described by the government as tax loopholes.

A number of these affect our clients, but in most, if not all cases, there are effective strategies for minimizing their impact. The bottom line is that Canada is looking to high income and high net worth taxpayers to increase their share of taxes.

Here are the key changes in the 2013 Budget:

Dividend Taxes

Dividend taxes on small businesses (which would in most cases include incorporated professionals) are going to rise. Many of our clients take dividends instead of salaries as their major form of compensation.

We believe that for the vast majority of our clients whose active business income is under $500,000 per year, this will continue to be the best form of compensation.

There are many benefits to taking dividends as a form of compensation that were not changed with the budget including:

  1. There is no need to remit CPP premiums, which amount to about $4,300 per year for a self-employed professional or business owner.
  2. It is easier to income split between an owner/professional and spouse with dividends vs. salary or bonus.
  3. Paying dividends lowers net taxes in companies on passive investments.

We have a model that we will be revising for tax years after 2013 which will show how much the difference is for our clients between dividends and salaries taking into account both the increased rates, federally and provincially. Please speak to your advisor about this.

Capital Gains Exemption

The lifetime capital gains exemption will be increased in 2014 to $800,000 from $750,000 and thereafter change each year with the CPI. This is some welcome news in a budget that otherwise increased taxes on several fronts. For some of you it may make sense to crystallize this exemption before an actual sale of your business or practice.

Foreign Investment Assets

The budget addresses the issue of the ownership of more than $100,000 of “foreign income producing property” and amends the rules for the completion of the Foreign Income Verification Statement (form T1135). There are substantial penalties for noncompliance.

Many of our clients hold our (very successful) U.S. Real Estate Partnership (SPIRE US LP). Our initial interpretation (which we will verify) of the enhanced disclosure rules is that our partnership escapes these rules as it is a Canadian Partnership holding U.S. property. This will, in fact, be another reason why our structure would be preferable to holding US rental property directly.

Similarly, one must disclose the holding of foreign stocks (if for example, one holds shares in Microsoft or Berkshire Hathaway). However, if the foreign investments are held through an investment fund (such as our Global Equity Pool), the disclosure is not required.

Testamentary Trusts

The government is reviewing how testamentary trusts are taxed. At the moment these trusts (which are created as a result of a will) provide graduated tax treatment for the beneficiaries of the trust. This is in addition to any normal graduated tax treatment the beneficiary would have on their own.

The government is proposing that these trusts should pay tax at the same rates as inter vivos trusts (in B.C. that would be 45.8% on taxable income). While this is not yet law, it is the intention of Finance to move in this direction after a consultation period. There are many non-tax reasons to establish testamentary trusts, including:

  1. Protecting assets for minors and even younger adult beneficiaries.
  2. Creating a legacy that can pass between generations.
  3. Creditor protection.

A rule change such as this would certainly diminish the effectiveness of such trusts. Many of you have these in your wills and, at this time, there is no need to change until we see what the new rules might be.

10/8 Life Insurance

For many years the tax department has been frustrated at not being able to effectively close down two tax loopholes involving insurance, annuities, and leverage. This year they appear to have successfully closed down these strategies for those individuals who are using them as part of their overall tax planning.

10/8 life insurance plans are where an individual makes deposits into an exempt life insurance policy and then immediately borrows money back to invest in their business or alternative investments.

In these arrangements, the 10% loan rate is deductible and might cost 5.5% after tax, while the 8% interest inside the policy accrues tax free. Over time, there can also be significant benefits in the amount credited to the Capital Dividend Account (CDA) of a company as the death benefit grows.

From now on, these arrangements will be denied deductions on interest expense and insurance premiums, and will be limited in how much of the policy qualifies for the CDA. This is more than enough to eliminate this as an effective strategy.

For many years we have recommended an alternative approach to borrowing on life insurance that should not be impacted by these new rules, and, in fact, has been used for many decades by borrowers.

For those of you who are using or want to consider leverage with your life insurance policies please speak with your advisor about the structure that will work best for you.

Leveraged Insured Annuities

Leveraged Insured Annuities occur when an individual or corporation takes out a life insurance policy and annuity at the same time and then borrows against both contracts to reinvest in other assets. The objective is usually to:

  1. Make the interest tax deductible.
  2. Part of the premium on the life insurance would be deductible.
  3. At death, when the loan is paid off with the life insurance proceeds, there would be a large CDA credit if the owner of the policy was a private company (usually the case).

For any new transactions after March 21, the new rules propose to deny interest and insurance premium deductibility, make the life policy subject to accrual taxation, and deny any access to the CDA. This will likely end this type of arrangement going forward.

However, it does not man that combining annuities with life insurance does not create a very attractive investment outcome (especially when the life insurance is acquired many years before the annuity).

It also does not mean that IA’s cannot indirectly help finance leverage that is used in building an investment portfolio. Please speak with your advisor to learn how these new changes might affect you.

In Summary

Collectively, these changes are focused on wealthier Canadians and based on trends elsewhere in the world I would expect we’ll see more of this.

That makes good tax planning an important aspect of financial planning, and in this environment, it needs to be reviewed frequently.

This document is not intended to provide legal, accounting, tax or specific investment advice. Information contained in this document was obtained from sources believed to be reliable; however Nicola Wealth Management does not assume any responsibility for losses, whether direct, special or consequential, that arise out of the use of this information. Please speak to your advisor for personalized advice based on your unique circumstances.