Canadian Investing in the UK? Caution on Dividends and Taxes

If you are an expat Canadian working or living in the UK but still subject to Canadian taxes because of ties to Canada and you are in a lower tax bracket, such as up to $72k in taxable income, then it might be wise not to invest in UK investments that pay dividend income ... unless you don't mind paying extra taxes. Here how and why this happens.

The first thing to note is that in the UK 10% tax (termed a tax credit) is automatically deducted from dividends paid out, no matter what tax bracket you are in, or whether you are a UK taxpayer or a foreign tax payer. The amount cannot be reclaimed or recovered, whether you are a native in the nil rate band, or you hold the investment in a tax-exempt account like an ISA or a PEP, or you are a foreigner considered to be a tax resident of another country under terms of a Double Taxation Convention like the Canada-UK treaty I wrote about yesterday.

The second factor at play for a Canadian is the fact that dividends are taxable at a much lower rate for the lower tax brackets than is the case in the UK. I have made a comparative chart of 2008 rates (modified in the February Canadian federal budget) for an Ontario taxpayer.

(Thanks to TaxTips.ca for the basic info on Canada. The UK rates, as updated following the March 2008 budget are from the HMRC page on Rates and Allowances.) Note the areas highlighted in green under the dividends column where the Canadian rates are lower than those of the UK.

Thus if you intend to obtain income from dividends on ordinary or preferred shares and you are not a higher rate taxpayer, then there is a tax penalty from investing through the UK stock exchange. For the highest rate expat Canadian taxpayer, with more than $75k in taxable income, there is no significant tax penalty since the maximum UK withholding tax on dividends is only 15% according to the Canada-UK Convention, Here is a table I have compiled of the various types of income and how they are handled in the treaty.


Of course, there is also no tax advantage since you must report your worldwide income and you must therefore pay Canadian tax on UK investments if the Canadian calculation works out to more than the 10% already paid at source in the UK. There will always be a minor penalty since 10% of whatever tax is owing is paid immediately instead of following the completion of the tax year, which means the money cannot be used for the extra length of time.

When to Move Back to Canada from the UK?

A reader asks a question:
"I'm currently a non-resident of Canada living in the UK, but I am thinking of moving back to Canada later this year. I just have a question with regards to when I would be considered UK resident for tax purposes by the Canadian Revenue Agency? Would they use the 183-day rule? And would that apply from the beginning of the UK Tax Year (April 6th) or the Canadian Tax Year (Jan 1st)?

The reason why I ask is that I have my own company in the UK and wish to take a large dividend payment out after April 6th of this year, so that it will count in next years UK tax year. I also don't want to be considered a Canadian Resident for the next tax year since they will tax this dividend payment as world-wide income if I am."

Take this for what it's worth since I am not a certified tax expert but here goes:
1) each country applies applies its own rules independently without considering the other unless there is a conflict when a person is considered resident in both countries simultaneously, in which case the terms of the Canada-UK Double Taxation Treaty with 2003 Amendments come into play to resolve the conflict;
2) Canada judges residency based on when you establish ties, not the length of time in the country in a tax year, so visiting Canada for one week and buying a house might trigger that date of entry as the date determining residence even if you spent the rest of the year in the UK - a house and a spouse/dependents in the country are key ties, as explained in the Canada Revenue Agency bulletin on Determination of an Individual's Residence Status IT-221-R3;
3) the UK judges residency based on being in the UK 183 days or more in a tax year; note that the UK is about to change the rule, as soon as the latest budget is passed, so that the date of departure (or arrival for incomers) will now count as a day in the UK; as of now day of arrival or departure do not count in the 183 days
4) you cannot be resident nowhere at any time with respect to tax, you will always be resident at least in one country, sometime two at the same time - the double taxation treaty you will notice also has an objective to prevent the avoidance of taxation and it allows the CRA and HMRC to enquire about you from each other;

Bottom Line: Your CRA/Canadian tax liability would only arise for amounts received after you established residence, so you only have to make sure you receive the dividend before the date of arrival in Canada when you establish those ties (it's the date of arrival not the date of buying the house or whatever); you would then be taxed in the UK and report that income on the UK return not the Canadian one (actually I'm not 100% sure that you might not have to report it on the Canadian return and then claim an exemption; a tax accountant would have to say how exactly to report it). It would be easiest to leave the UK before 183 days have passed from April 6 onwards to avoid the double taxation rules and the tie-breaker provisions that might end up with you being considered resident of the wrong country at the time of the dividend payment.

I presume that you would also have checked out the relative tax rates and figured out that it is better to receive the dividend in the UK and not Canada. Dividends are taxed more in the UK for higher rate taxpayers (taxable income >£36,000 in for 2008/2009). Canadian tax rates on dividends are lower for all except the narrow income range from $72-76k. Speak to an accountant to confirm your position.

Investing an Inheritance: How to do a "File and Forget for Forty Years"

Most of us save for retirement in tax-deferred accounts like RRSPs and LIRAs. But what happens when you suddenly receive a large lump sum and you do not have RRSP contribution room, in other words you must invest in a taxable account?

Here's a situation I've come across recently that got me thinking and researching. (Initially, I thought it was simple but it has taken me some time to figure it out to get the practical details right.)

Situation:

• $50,000 inheritance, specified in the will to be "for retirement"; a very wise thing the person who died has done, creating a very strong moral, if not legal impediment to spending the money since half the battle of saving is actually doing it; I would note in passing that the person receiving the inheritance does not have to include the amount in income and pay tax since that would already have been done in the process of settling the estate; I would also note that it is not a testamentary trust, which could absolutely ensure that the money not be touched till retirement.
  
• 40 years till retirement; the person is in his twenties so the planning horizon is at least that long; due to the above-noted restriction on the lump sum, it is highly likely that the actual time horizon will correspond to the planned horizon - in other words, people frequently suddenly decide that their "retirement nest egg" needs to be cracked open for an omelette craving today, thus blowing the value of a long term approach to smittereens.
  
• No RRSP room: the inheritance must go into a taxable account, which means that income taxes for various types of investment returns (interest, dividends and capital gains) can play a crucial role in net returns, especially over the long term; though the person could or should intend to move the investments progressively into an RRSP as his career advanced and contribution room became available, in this case, his apparent career orientation into government or educational jobs suggests that one of those golden defined benefit plans will use up most or all of tax-deferred pension room, so it is better to plan as if it will not happen
• Maximize net after-tax wealth: obviously ... but he is not interested in high-risk investments that may suffer absolute final losses, as opposed to waiting through market ups and downs, and subject to the following constraint,
  
• Zero maintenance and attention portfolio: the person would ideally like to have to do nothing at all for forty years! No buying and selling, no rebalancing, nothing, if at all possible; unfortunately, it is still required to file a tax return every year, so tax reporting simplicity is a consideration. As a consequence, things should be as simple as possible - few holdings at one broker.

General Principles: these should always apply to investing

• low costs - paying higher fees for others to manage your investments is a sure way to end up with less; 0.1% less per year can add up to many thousands difference after 40 years - 4.1% return compounded will see $50k reach $240k while 4.2% yields $249k; high MERs = low net returns; this eliminates from consideration all equity mutual funds except index trackers
  
• diversification - the "not all eggs in one basket" and "some go up while others go down" factors entail being invested in many assets with as low as possible correlation with each other; this ensures that there is a net gain, not a loss, over the long term
• tax-effectiveness - deferring and reducing taxes means a greater net in the future; tax rates in Canada are lowest on dividends, higher on capital gains and highest on interest as this previous post on tax rates shows. There is a significant advantage to dividends for all taxable income up to the mid-$70k range, which is where our person is most likely to end up based on his career path. However, the portfolio diversification principle must be respected - meaning that it is not acceptable to ignore the fixed income component of a well-structured portfolio merely to avoid taxes. Fortunately, there is a way - substitute preferred shares returning dividends for bonds returning interest income.
  

The Proposed Solution: this is necessarily a combined solution of portfolio and broker/financial service provider due to the practical constraints outlined below; theory may tell us to do things a certain way but it is not quite possible in practice.

There are three good alternative solutions, the best ranked first.

1. Portfolio of Four ETFs at Questrade

Portfolio Composition:

• 35% / $17,500 XIC - iShares Canadian Composite Capped Index Fund, MER 0.25% (the alternative is XIU, the TSX 60 fund, which has a lower MER of 0.17% and distributes much less income as interest, but it only includes the 60 largest companies as opposed to the 270+ companies in the Canadian market, which means less diversification as the 60 only account for three-quarters of total market value of the TSX and presents less opportunity to benefit from small company growth, from income funds and from real estate); negatives of XIC are the MER and the fact that some of the annual distributions are higher-taxed interest; XIC exemplifies the simplicity and advantage of a fund that enables one to own a piece of a large number of assets/companies through one purchase; in the proposed portfolio XIC is the Canadian equity asset class
• 15% / $7,500 VTI - Vanguard Total Stock Market ETF, MER 0.07%; this is a broad market index, representing some 95% of the total US market according to Vanguard; it is exposed to USD vs CAD currency swings, which can be good or bad, depending on the direction; to some degree, there is also a diversification advantage (see discussion in a Burgundy Asset Management paper and research by Mark Kritzman - when the Canadian market falls, often the Canadian dollar follows, meaning that a VTI owner will end up with more Canadian dollars (as long as the US market doesn't fall by the same percentage); alternatives might be IYY and IWV, two index ETFs that track the broad US market but they have higher MER of 0.20%
  
• 20% / $10,000 VEU - Vanguard FTSE All-World ex-US ETF, MER 0.25%; provides very broad exposure to some 1300 companies in 47 countries around the world outside the USA
• 30% / $15,000 CPD - Claymore S&P TSX CDN Preferred Shares ETF, MER 0.45%; this is the fixed income portion of the portfolio, in which preferred shares are substituted for the bond funds typically held in registered tax-deferred portfolios; preferrred shares produce dividends so the person in a middle tax bracket will lose only about 8% to tax vs 30% - preferred shares pay less than bonds (James Hymas says about 0.89% for corporate bonds) in an article Corporate Bonds - or Preferred Shares? in the May 2006 Canadian MoneySaver) but compound the tax difference over 40 years and the difference is enormous e.g. 6% gross on $15,000 bonds would net reinvested and compounded after annual tax at above example rates $77,767 in bonds and 5.1% on dividends would net $93,892; note that bond funds always include lower yielding government bonds so this comparison understates the after tax advantage of preferred share dividends; the alternatives to CPD are three closed end funds DPS.UN - Diversified Preferred Shares Trust, PFR.UN - Advantaged Preferred Share Trust and PFD.PR.A - Charterhouse Preferred Share Index Corporation according to Portfolio Construction in the July/August 2007 Canadian MoneySaver issue but a cursory look suggests they suffer from making large distributions of return of capital, which is just giving his own money back to an investor, as well as trading often at well-below NAV.

Why the portfolio allocation proportions and holdings?

This is perhaps the most uncertain area. While the whole world is represented, Canada has a much larger proportion of total equity - equal to the sum of the USA and the rest-of-the-world - than in my own portfolio. The logic is simply that the person is likely to live and retire in Canada and use Canadian dollars. The foreign holdings introduce a significant enough exposure to diversification benefits from the equities themselves and from currency swings, but not too much. I've wrestled with this in the past e.g. this post on IFA Canada's model portfolio and this post on my own portfolio but cannot find the "perfect answer".

What does the above portfolio achieve?

• diversification through diffuse ownership of a large number of companies
• diversification through investment in most areas of the world
• diversification through equity and fixed income asset classes that move in different ways at different times (but which all move upwards over the long term)
• higher net returns through low fees of the ETFs
• higher net returns through use of a discount broker, which will charge nothing for account administration or management and only charges for trading
  
• higher net returns through lower taxes
• zero maintenance through index tracking - the fund managers regularly restructure the holdings to reflect market evolution requiring nothing of the investor
  
• zero market knowledge and investigation required - you get the market average automatically year after year, sometimes that is down but mostly it is up and certainly over the long term it is up
• zero maintenance through automatic dividend/distribution reinvestment by Questrade
  
• minimal administration through the small number of funds requires less work to do annual tax returns for distributions and down the road when they are eventually sold
  

What does it not achieve and what are the risks?

• rebalancing to keep the portfolio proportions the same will not happen without selling and buying by the investor; rebalancing every four years or so, or when one holding gets more than 5% (e.g. XIC goes up to 41% or down to 29%)out of whack, is the optimal strategy (see this post for discussion); over many years, the equity investment growth should far outstrip the fixed income CPD, which will increase the overall riskiness of the portfolio; normally, that's a cause for concern and the reason for rebalancing; in this case it is quite possibly a good thing, a worthwhile natural evolution. Why? As this person gets older and if, as expected, he begins to build up a defined benefit pension plan paying a fixed inflation-adjusted income at retirement, that in effect has increased the fixed income portion of his total personal wealth.
  
• shifting the portfolio into an RRSP for tax deferment and tax-protected growth as and when that becomes possible can only happen with monitoring and action by the investor; contributing the funds in-kind is possible but that will trigger a deemed disposition and the necessity to calculate and declare capital gains along the way, more work for the investor; the first thing that should go into the RRSP is fixed income, but the CPD should then be sold and replaced by a purchase of a bond fund like XBB the iShares Canadian Bond Index Fund since bonds will produce a higher gross and net (once protected from taxes) yield
• keeping a record of the Adjusted Cost Base of ETFs is a manual procedure as I explained in this post and it is a pain in the you-know-where; it doesn't really need to be done till the ETF is sold and the gain is to be reported on a tax return so maybe it can be put off and done in one massive catch-up session after 40 years but I'd want to not be further than five years behind simply because corporate fortunes rise and fall, companies come and go and records disappear or become hard to find (I had a lot of trouble some years back trying to figure out mutual fund ACBs to do final returns going back a mere 20 years)
• potential instability of the solution is an inescapable risk, especially over forty years, since the practical evolves greatly e.g. forty years ago, index funds did not exist and there was no capital gains tax in Canada; change will happen, it's just not possible today to know where, when and to what degree; one thing to remember is that big does not equal absolutely safe, stable or permanent - the current financial turmoil is affecting most the world's biggest banks, some will fall and over the long term, most will fall (just check the stock listings of the TSX, oops it used to be the TSE, 40 years ago and see how many names you recognize); Questrade is a relatively new, smaller player and going with them entails a degree of risk that it will be necessary to shift the portfolio to another institution if they run into business problems ... or maybe their superior product will see them grow into the dominant broker of tomorrow; is CIBC a good place to be, they seem to keep stumbling? Regardless, it will always be necessary for the investor to keep a general eye on developments for this maximum passivity portfolio.
  

Broker: All ETFs produce cash distributions, either monthly, quarterly, semi-annually or yearly, and there is no option, like there is with mutual funds, to have the ETF manager reinvest the cash automatically. So the investor can do it at his own time and expense or a broker can offer the service. But the objective is to have everything run on autopilot. The choice of Questrade boils down to one thing - Questrade is the ONLY Canadian discount broker I found that could reinvest the cash distributions for all the above ETFs so that the cash would not sit around in the account earning little or nothing. CPD was a particular no-can-do for everyone but Questrade and we see above above, it is a key element of the plan.

2. Portfolio of DFA Mutual Funds described on IFA Canada from Advisor De Thomas Financial.

This approach consists of handing over the $50k to De Thomas Financial for them to invest in the DFA mutual funds described in detail on the IFA Canada website. They follow passive indexing principles to the nth degree, they say convincingly enough (i.e. they back up their assertions with believable data) even more than the various index ETFs. The breakdown of asset classes is more numerous, enabling reductions in volatility and higher returns. Though De Thomas charges a 1% annual fee on top of the 0.25-0.70% embedded in DFA funds, their approach makes up for that 1.25 to 1.7% vs 0.07 to 0.45% ETF fee spread by lower tracking costs, by stock lending revenue and by tax deductibility of the fees (on taxable accounts only). Michael Hill of IFA Canada & De Thomas explained all this in my Q&A blog post of Oct.23. The end result is that the investor should attain a higher net return. The fact that the holdings are mutual funds eliminates the special ACB record-keeping hassle of ETFs, as well as the reinvestment of distributions problem. The rebalancing issue goes away too since De Thomas does it. Finally, part of the De Thomas service is general financial advice (I notice that Mr. Hill is a Certified Financial Planner, one of the better designations) and that may come in handy.

My biggest concern is that all of the portfolios have only bond funds and none with preferred shares and so taxes will be considerably higher. Another is that the "Easy Chair" portfolio for accounts smaller than $100,000 (the minimum required to do the full asset allocation using all the funds) has some limitations but those are not described.

3. Portfolio of TD Canada Trust e-Series Mutual Funds

This portfolio mimics the ETFs in the first portfolio with the difference that they are mutual funds available only through having an account at TD Canada Trust. The funds are:

• TDB900 - TD Canadian Index Fund, MER 0.31%, tracks the TSX Composite Index (it doesn't appear to be a capped fund like XIC, which limits any stock to no more than 10% of the fund; this shoudn't cause any difference or problem as long as there is no tech bubble II where Nortel gets up to 30% of the total value of the TSX!)
• TDB902 - TD US Index Fund, MER 0.33%, tracks the S&P 500, which is only three quarters or so of the total US market and really only tracks large companies, a disadvantage since small company stock returns historically have outperformed large company returns
• TDB911 - TD International Index Fund, MER 0.48%, tracks the Morgan Stanley Capital International Europe, Australasia and Far East Index("MSCI EAFE Index"), which is probably quite a bit less diversified ( we cannot tell because TD's fund information on the above website is too incomplete) than VEU
• TDB909 - TD Canadian Bond Index, MER 0.48%, tracks the Scotia Capital Universe Bond Index ("Universe Bond Index"); because it's a bond fund in a taxable account this is much less desirable than CPD
  

The TD funds do offer the advantages of mutual funds over ETFs already noted above but the higher MERs and a bit less ideal diversification characteristics promise lower long run returns. The biggest negative is the absence of a preferred shares fund. Of course, it would be possible to take the $15,000 for fixed income, go to Questrade and have an account only for that holding there. But why start to complicate life with accounts here and there if there is a better overall solution with Questrade?

iShares Distribution Reinvestment vs DRIP

A follow-on to yesterday's post about Exchange Traded Funds (ETFs) is another perhaps confusing characteristic regarding distributions and reinvestments. As the blue highlighted area of this table shows for the Canadian iShares ETFs, in 2006 there were both cash distributions and reinvested distributions paid on a number of the ETFs. The cash distributions are actually paid out to the owners of each ETF at the end of each quarter just like dividends of any other company stock (with shareholders of record date for eligibility etc). An iShares press release gives the amounts for the 2007 March end quarter. For buy and hold investors like me, I don't need the cash/dividend to pay everyday expenses and I would rather that all the money be reinvested with the least cost and effort. Unlike many companies which have Dividend Reinvestment Programs (DRIP) that allow any dividends paid out to be automatically used to buy extra shares without brokerage fees, iShares cannot do so itself with its cash distributions as it explains on this FAQ page, though it says that brokers might provide the service (and it seems that Canadian ShareOwner Investment Inc is one that will but mine - BMO Investorline - will not ... hint, hint).

Stingy Investor has a very handy page listing all the Canadian companies with DRIPs (and related things like Stock Purchase Plans) for those who are interested.

Free Money at Renasant Financial?

A friend noted that today March 20th the shares of Renasant Financial Partners Ltd (TSX: REN) were trading around the $2 mark and wondered if it would be possible to get the $3 per share special distribution the company will be making on March 30th per this press release. Not a bad deal if it were so. But the press release states that the $3 would go to shareholders of record on March 22nd. Therein lies the rub and the explanation why it isn't possible to buy a share for $2 to get the $3 cash. It is simply that the shares are trading "ex-dividend" as of March 20th, that is, any shares bought on March 20th will NOT receive the distribution, which is a return of capital and not a dividend. The reason the payment is not included is that shares in Canada, as in the US, have three business days to settle and to appear on the company's records. Two days - March 20 to March 22 - doesn't make it. The Investopedia has a good explanation of how this works.

As a result, from March 19th to the 20th, the price of REN dropped by almost $3 ($2.92 to be exact). The chart from Yahoo shows this in operation, though it is a bit puzzling why the trades early in the day were around the $4 mark. Maybe some investors got confused about the ex-dividend status, or did they just think the remaining business minus the $3 payment was still worth only a buck less?

It's another illustration of the old adage "if it seems too good to be true, it probably is."

Canada's High-Taxes vs the UK

When I decided to come over to Scotland, I investigated the tax consequences, expecting to find myself paying more tax over here in the UK. I was surprised to find the opposite, in fact, quite the opposite. For my fellow Canadians out there, here's the shocking news - the excess rate of taxation is considerable and across the board in all types of income and investment taxes.

Refer to the chart for all the numbers. I've used Ontario as my benchmark province.
The UK advantages start with the personal exemption of about $11,500 vs only $8839 in Canada. Take your marginal tax rate and compute the savings on the difference.

On income and interest, treated as the same in Canada but taxed at a slightly lower rate on interest in the UK, the Canadian rate is higher in every single tax bracket and the difference is the worst for middle income earners. For example, in the blue highlighted line for taxable income in the $60k range the Canadian marginal rate is 33% vs 22% in the UK. Ka-ching, another difference that could reach into the four figures.

On dividends, the UK has a zero effective rate due to an offsetting dividend tax credit until a person has more than about $76,000 taxable income.

On capital gains, the rate is actually higher in the UK throughout the tax brackets but everyone is given an annual exemption of about $20,150 in net gains. That should suffice to ensure a tax-free existence for most investors of modest means.

Not shown in the chart are the comparable retirement savings vehicles, the RRSP in Canada and the Individual Savings Account (ISA) in the UK. An ISA offers the same tax-free accumulation/compounding as the RRSP. An ISA does not allow a tax deduction as does the RRSP. Instead, any withdrawals are tax-free as opposed to the RRSP where withdrawals are taxed at the rate for marginal income. The RRSP advantage of saving taxes by withdrawing after retirement when one's tax rate would be less is not there for the ISA ... but the UK tax rates are lower in the first place and more uniform up to high levels. In addition, the ISA doesn't create artificial incentives to keep interest bearing securities inside the RRSP and dividend or growth investments outside. For anyone who has struggled with portfolio balancing across both RRSP /LIRAs and regular accounts while minimizing taxes, this ISA feature would be a big boon. Perhaps the biggest plus of the ISA is that the £7,000 annual allocation that is not reduced by contributions to a regular pension plan and thus allows a much high tax-free savings rate if desired.


Though such differences are and were not the motivation for my move to the UK, nor would I advocate moving to another country just to save taxes, it does lead one to ask those people who make our taxes why they are so high.

Taxes on Interest vs Dividends vs Capital Gains

A friend asked about how dividend taxation works and the difference in tax rates between the different types of investment revenue - interest vs dividends vs capital gains. He tried unsuccessfully to figure out the answer browsing through the Canada Revenue Agency's comprehensive but daunting website. Since he, being a smart guy, did not succeed, I figure this is worth a post for someone else's benefit.

I must acknowledge the excellent free Taxtips website, already linked under the Resources sidebar of this blog, for providing the calculators and information that produced the following results, though of course, if I've made any errors of interpretation that's not their fault.

The tax calculation of Canadian dividends goes through a grossing up process of the actual dividends we receive by cheque. Currently, this means adding 45% on top of the actual dividend, and the new higher amount is included in our taxable income. Yikes, you may say, that will raise my taxes! But through a clever tax credit calculation on the amount, the CRA gives it back and we all end up better off. Better even than interest or capital gains. (I'm referring to the most common type of dividends, those paid by companies listed on stock exchanges such as the TSX. See this Taxtips page for the nitty gritty of what is in this category termed "eligible" dividends.)

Use the Taxtips calculator to do your own numbers for your own province. I used Ontario for me and my friend. For almost every tax bracket, dividends have the lowest marginal tax rate, better even than capital gains, which may surprise some. The dividends tax advantage against capital gains diminishes progressively as you go up in tax bracket, being about 1% in the $72k-118k brackets for 2006. In the very top bracket, over $118k, the tax rate is higher on dividends. However, both dividends and capital gains have a significantly lesser tax rate - half or less - than interest or ordinary income (like salary) at all taxable income levels. (See this Taxtips chart, which shows both 2006 and 2007 brackets and marginal rates for Ontario.) That's why we are constantly told to put our bonds, GICs, CSBs and the like into our tax-sheltered RRSP.

Hmm, those banks stocks and utilities look better and better.