Thursday, 22 October 2009

Government Ban on RRSP - TFSA Swaps Revisited: One Red Herring and the Real Problem

Sometimes I'm a bit thick and it takes a while for the real reality to distinguish itself from the illusory reality.

The Illusory Reality: Yesterday I noted the scenario mentioned by two other bloggers - see here and here - for supposedly moving funds tax-free from an RRSP to a TFSA. The illusion is that the investor moved funds but what has actually happened is that the investor made a profit on an investment in the TFSA account and made a loss in the RRSP account. To see this, it is only necessary to remember that the exact equivalent result could be achieved by simply buying and selling on the market instead of doing a swap. In fact, a swap is just that - instead of the investor buying or selling on the open market, his accounts buy and sell to each other.

Another tack is to think of it in the investor's shoes - after the stock price rises in the TFSA, you are $XXX better off in total wealth. Would you really want the stock to decline after your RRSP buys it so that the TFSA can buy it back? After the round trip of swaps and the stock decline, the investor has less money in total than after the TFSA made a profit. The TFSA is the same but the RRSP is worse off. In any case, there is no guarantee that the stock will happily fluctuate up and down within the range needed to come out ahead on a net basis. That's why day trading is a highly risky proposition.

This non-problem is a manifestation of the sunk cost fallacy. At each step of the process, the investor is faced with a clean slate and a new decision about how to invest. The past, however recent, is irrelevant. I certainly hope the Department of Finance policy is not meant to stop this kind of investor operation because the government would then be taxing the profits of normal risky stock purchases and sales.

The Real Reality: The real problem is revealed in the discussion on the Financial Webring TFSA thread. It is the fact that the tax rules allow an investor to choose which price within a security's trading range on the day of the swap to have applied to calculate the value of the swap. The difference between the high and low price is what generates the tax-naughty riskless profit for the investor who has eliminated the market risk through judicious use of options. A more volatile stock, or a volatile day to perform the swap, is better because it produces a higher high-low spread and that increases the risk-free profit. Options also use less capital than straight stock, which boosts the returns.

That being the case, the Government would seem to be engaging in throwing out the swap "baby" with the dirty hi-lo price "bathwater". Instead of banning swaps (which doesn't make sense anyway since direct stock trades can effect the same outcome) or changing the rule that any price during the trading day when the swap takes place may be used to value the transfer amount, either declare that two-way swaps of the same security will automatically be valued at the same price within the same day, or perhaps within 30 days in a manner akin to the superficial loss rule. There's even a catchy name to give it - the superficial swap rule.

1 comment:

Canadian Capitalist said...

I think the FWF post makes sense. But I'm not entirely convinced that all brokerages allow this. I seem to recall RBC DI using the previous day's closing price as FMV when doing in-kind transfers though come to think of it, I may have done these transfers outside of market hours. Still, it seems to me that a blanket ban is too broad. If swaps are a problem, simply define precisely how to estimate FMV of swaps or in-kind transfers.

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