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Escape the December Tax Bite
Tax-smart strategies

Last week I talked about the mutual funds' December tax bite and I profiled a few funds that may produce some unwanted surprises. This week, the focus is turned to strategies that investors can use to avoid these taxable payouts. The earliest of distributions will be payable on December 15 but most aren't planning to pay out until December 21, 2000. That gives investors enough time to crunch some numbers, do some planning, and take action.

When to avoid distributions

Investors whose paper or unrealized gain on a fund is less than the expected distribution would save themselves a few tax dollars by trying to avoid the distribution. If you're in a gain position it's pretty straightforward. Let's look at an example.

Gary invested $10,000 in the Global Strategy Canadian Companies fund on December 31, 1999 - acquiring about 793 units. Unfortunately, Gary is sitting on a paltry year-to-date gain of about 1 per cent (about $100). The worst part: this fund is expected to pay a distribution of $1.41 per unit - that's about $1,118 or more than 11 per cent of his original investment. In this case, it's a no-brainer. Assuming Gary still wants to hold this fund, he can sell it before the December 21 record date - triggering his $100 capital gain - then buy back after the December 22 distribution. This strategy would produce a tax savings of about $200 this year - deferring that eventual tax bill to later years when he eventually sells at a likely lower tax rate. (Don't forget to factor the 3-day settlement into your plans. To have a mutual fund trade settle on December 21, for instance, the trade must be implemented by December 18.)

Those in a loss position might be tempted to implement this same strategy but caution must be exercised for those investors. The Canada Customs and Revenue Agency (CCRA) doesn't take kindly to the tax-loss selling that often takes place this time of year. In fact, they view such transactions as very superficial since many are selling for tax reasons, not because they really want to get rid of their investment. So strong are their feelings that they created tax laws to cover just this scenario.

Superficial Losses

Superficial losses result when a holding is sold at a loss, then bought back shortly thereafter. This transaction is viewed as "superficial" and, as such, the loss triggered on the sale can't be used in the current year. Sure, it's a good idea to sell before a distribution is paid but you must proceed carefully to make sure you're not prohibited from using the capital loss this year. If a superficial loss is triggered, the loss cannot be used in the year realized. Instead the loss is added to the holding's adjusted cost base (ACB) to reduce any future gain or increase a loss. How is this avoided?

It is often said that you must sell and wait 30 days before buying back in to avoid a superficial loss. However, there's more to it than that. There actually is a 61-day period, of which to be aware - 30 days on either side of the date of sale which triggers the loss. During that 61-day period, neither you nor any person affiliated with you (i.e. your spouse or a corporation controlled by you or your spouse) can purchase the security-to-be-sold, or an option to buy this security. Let's look at another example.

On the heels of its stellar year of performance, Sandy invested $20,000 into the AGF Aggressive Growth fund (a US mid-cap stock fund) on December 31, 1999, acquiring about 472 units. Sandy is down by more than 14 per cent - roughly $2,858. We saw last week that the expected distribution on this fund is $8.95 per unit - $4,788 for Sandy. How can she avoid the distribution without triggering a superficial loss? Can she avoid the superficial loss and stay exposed to US mid-cap growth stocks? As in Gary's situation above, I'm assuming that Sandy wants to keep this fund because she has confidence in its long-term potential. There are two strategies that Sandy can use to keep exposure to this area.

Tax-savings strategies

The first involves using tax-deferred accounts like RRSP and RRIF plans. Sandy can sell the fund at a $2,858 loss and put it in cash. In a separate transaction, Sandy can direct an equivalent amount of money in her RRSP to buy the same fund immediately. That allows her to use the capital loss that year while effectively keeping the position in her portfolio. Had Sandy tried to transfer her AGF Aggressive Growth directly to her RRSP, the $2,858 capital loss would have been denied and its benefit lost altogether. However, this strategy involves two separate and distinct transactions that are perfectly legal and avoid the superficial loss trap.

If you don't have a RRSP or if that first strategy just isn't possible, there is another alternative. Sandy can sell her fund at a loss before December 21, but instead of putting the proceeds in cash, she can invest it in a similar fund. If she is tied in by a deferred sales charge schedule, Sandy can sell her AGF Aggressive Growth and buy the AGF Special US Class - a small-to-mid cap US stock fund managed by Cameron Scrivens and Steve Rogers. (Universal US Emerging Growth is a similar fund also, but it's expected to pay a distribution of about 6 per cent.) While they're not identical funds, they offer similar exposure and the AGF Special US Class fund is not expected to distribute any income for 2000. Since Sandy still wants to hold the AGF Aggressive Growth fund, she can buy back in on January 22, 2001. Either of the two strategies allows her to trigger the loss, use it for the 2000 tax year, maintain exposure to US mid-cap stocks, and resume ownership of her desired fund.

While triggering a superficial loss doesn't result in permanently losing use of the capital loss, having its use in the year incurred can provide added flexibility. If you have capital gains from other sources this year, having the use of the loss may have a significant benefit. Even if you have no gains this year, being able to trigger and credit the capital loss this year will enable you carry the net capital loss for the year back three years or forward indefinitely to offset capital gains of other years, if any. (In order to carry capital losses backward or forward, the net amount of gains minus losses must be negative for the current year. If a negative figure - i.e. net capital loss - results, that net amount is available for use in other years.) Capital gains prior to February 28, 2000 were taxed at a 75 per cent inclusion rate, making the loss carry-back more valuable than using it in 2000 or in subsequent years.

The distribution figures mentioned here and in last week's articles are only estimates. Market movements and portfolio activity between now and year-end can result in a significant difference between the estimated and actual payout. Income tax is inevitable, but any steps you can take to minimize and/or defer them equals money in your pocket. The distribution estimates and the strategies detailed above should help you in your planning. Before taking any action, consult with a professional advisor who knows a thing or two about income tax - specifically the superficial loss rules, the definition of identical property, and the fine details capital gains/losses.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...