Performance figures for each account are calculated using time weighted rate of returns on a daily basis. The Composite returns are calculated based on the asset-weighted monthly composite constituents based on beginning of month asset mix and include the reinvestment of all earnings as of the payment date. Composite returns are as follows:

When the Reward is not Worth the Risk: Part One

By David Sung, CFP, CLU

IN THIS ISSUE: Over the course of the next TWO issues of our newsletter, we will explore two different aggressive tax savings strategies and we will also present you with two conservative alternatives – – we hope these newsletters help you clarify how much risk you’re willing to take (or not) in order to build your wealth.

The above proverb, adopted from Aesop’s fables, suggests that we can over-think situations in a fashion detrimental to our well-being. If anything, our solution may bring a cost greater than the benefit we might receive. Finding the loophole in any bureaucracy may be a fun exercise, but does it really result in a benefit? When it comes to money and taxes, the answer is ambiguous at best, and oftentimes the answer is “NO”.

When it comes to investments, estate planning and tax planning, you may not want to take the road less travelled – there are plenty of reasons to steer clear of overly convoluted tax and estate planning measures. If there’s a surprise tax bill at the end of that road or an unfriendly looking auditor waiting to rummage through our financial matters, that less-travelled road of “creative” loopholes can become a path to disaster. Just as one of my favourite comedians Jerry Seinfeld once remarked, “Sometimes the road less travelled is less travelled for a reason.”

When it comes to Canadian tax law and the Canada Revenue Agency (CRA), one such example that taxpayers may recall, is the many Film Tax Shelters sold in the late 1990’s. Most of the Film Tax Shelters had an “advance tax ruling”. An advance tax ruling essentially meant that CRA was aware of the shelter and was not opposed to the tax outcome. Now, many Film Tax Shelter investors are experiencing tax reassessments from CRA. The Film Tax Shelter companies have a good legal argument to fight the reassessments on behalf of their investors, but this legal challenge is coming at a cost. Was the reward of tax savings worth the risk?

Each year around this time, my colleagues and I attend a conference in Ottawa that focuses on financial and tax planning. Having just returned from this year’s conference, tax planning is on my mind and the question inevitably arises: when does creative tax planning become too creative and unnecessarily aggressive?

We cringe to think that any aggressive tax minimization strategies would bring our clients’ personal financial situations under scrutiny with the CRA. In both this and next month’s issues of Nicola Tactics, my colleague Brent Thomson and I will review two “tax savings” strategies that have recently been suggested to our clients by other advisors.

In November of 2004 and in January of 2005 a local publication called “Just for BC Doctors” featured two articles, one on the topic of “converting highly taxed salary income to capital gains” and another on using “shared ownership” life insurance to remove retained earnings out of a corporation. In short, a taxpayer trying the strategy from the first article (converting salary income to capital gains income) is hoping to have income that would have been taxed at 44% taxed at 22%.

A taxpayer trying the strategy from the second article (shared ownership life insurance) is attempting to save as much as 31% tax on moving assets (retained earnings) from a company to personal hands.

We would like to examine these two approaches in particular (keep in mind that all figures are analyzed using income tax rates currently prevailing in Canada) and explore the alternatives for the benefit of all our clients, because we simply believe that they are not worth pursuing when there are safer and more rewarding options available.

This month’s issue will tackle the “salary income to capital gains” strategy, so let’s dig in and see if risk is really worth the reward or if, in fact, there is an alternative strategy with no risk, but with a similar financial outcome.

The “Salary to Capital Gains Strategy”

In the November of 2004 publication of “Just for BC Doctors”, the featured article titled “Keeping More of Your Money” outlined a strategy whereby incorporated professionals can extract money from their corporation in the form of a capital gain. The author suggests that the incorporated professional employ the following steps:

Did you catch all that? Simple, right? Perhaps not so simple, but then again, that’s why the business owner employs the services of a tax advisor and legal advisor. Ah, what is the cost you ask? There is a fi nancial cost to employ this strategy and the additional accounting and legal costs would need to be factored in for a meaningful comparison.

What are the risks? The strategy outlined by the author of the article is clearly quite convoluted – while there is nothing inherently wrong with a convoluted structure (we encourage creative thinking when it comes to financial matters), we are concerned by the fact that CRA auditors are apparently not in favour of this strategy.

David Christian, a lawyer with the law firm Thorsteinssons (Canada’s largest law fi rm practicing exclusively in the area of tax) had some cautionary words when approached with this strategy. He states that, “technically, there is no reason this cannot be done. The problem is the General Anti-Avoidance Rule (GAAR). I understand that the GAAR committee has taken on a number of cases involving use of this strategy to avoid the kiddie tax and at least one case is working its way through the courts. To date, the audit experience of those who have had the (above) plan reviewed has been mixed.”

Is there an alternative to taking either a highly taxed “salaried” income or employing a possible “high risk” capital gains strategy? What about simply drawing total income in the form of dividends? Most business owners and professionals incorporate because there are a number of tax advantages. The combined federal and BC provincial tax rate for a Canadian Controlled Private Corporation (CCPC) on the fi rst $300,000 of earnings is 17.62%, while the highest personal marginal tax rate is 43.7% (Source: Wolrige Mahon).

Every client’s situation is unique, but as a result of the low corporate tax rate, we often advise our incorporated clients to draw all dividends from their corporations instead of “salaried” income. There are a number of advantages in drawing all dividends such as the elimination of CPP premiums which can add up over time. The reasons to consider an “all dividend strategy” are numerous and significant. In fact, this topic has been the subject of many of our previous newsletters.

Our newsletter from the fall of 2004, “The Tax Man Part II,” reviewed the advantages of extracting money from your corporation in the form of dividends rather than income. This is a process that has become commonplace due to its rewards (greater after-tax wealth accumulation), but most importantly, it is a process that is without risk. It does NOT seem ambiguous to CRA and certainly is NOT seen as tax avoidance. This practice is becoming more common and we are pleased that many of our clients are reaping the benefits.

As you can see, the tax savings of employing the “capital gains” strategy versus taking regular salary income is substantial – it is about 20%. Versus dividends, the savings decreases to 8.1%.

Keep in mind that annual transaction costs (not to mention initial set-up costs) will reduce the tax savings one will get from the capital gains strategy; however, on much larger incomes, these transaction costs become a much smaller percentage.

After hearing the views of a well-respected tax lawyer, factoring in the costs of such a strategy, and knowing fullwell that the CRA might be waiting for you at the end of the line — if you have a “middle ground” option, such as dividends, is taking the risk really worth the reward?

Through years of helping our clients build their wealth, we have recognized that taking unnecessary risks can be detrimental to one’s financial well being. When it comes to risk versus reward, sometimes avoiding risk is the reward in itself. Too often, we take it as a given that we always benefit from doing everything we can to lower taxes.

As Aesop noted in the now famous proverb, “Sometimes we can be too clever for our own good.” Our ‘solution’, however, may end up with a cost greater than any benefit we can receive.

In our next issue of Tactics we will continue our examination of risk versus reward by assessing the cost effectiveness of a “Shared Ownership Life Insurance Agreement” versus an “Insured Annuity”.