Tax Advantaged Investing

Most of us hold a significant part of our savings outside of an RSP. The recently introduced Tax-Free Savings Account has allowed us to build tax-free capital gains, dividends and interest, but it is limited to $5000.00 per year. Other savings outside of our RSP can create quite a sizable tax bill. If we are using a high-yield savings account, GICs or bonds, we will pay tax on 100% of the interest income each year. After taxes and inflation, you may be going backwards.

For example, if you have a $100,000.00 interest-bearing instrument outside of your RSP earning 4%, you need to add all that interest income, $4000.00, on top of all other sources of income. You are likely somewhere between a 23% to 46% tax bracket marginally, which means between $920 and $1840 is payable to CRA. Subtract the long-term rate of inflation of 3% of your gross return of 4%, and you are like the frog in the kettle after taxes and inflation; you don’t see the loss of purchasing power, but it is happening.

A new form of investment called “Capital Structure or Corporate Class” gives you the flexibility to switch and rebalance non-registered investments among a leading group of funds without triggering immediate tax consequences.  When you eventually withdraw assets from the structure, they will be subject to a capital gains tax, which is currently taxed at 50% as opposed to 100% for interest. You therefore have the advantage of tax-deferred compounding, effectively reinvesting distributions you would otherwise have paid tax on.

Capital structure has several options to minimize distributions that aren't available with traditional “trust” style mutual funds or segregated funds.  Unlike interest or RSP withdrawals which are taxed at your highest marginal tax rate, Capital Structures are taxed at a lower capital gains rate, half the rate of interest or RIF income.

Keeping a Lid on Distributions
Capital structures allow you to keep a lid on distributions.  Capital structures seek to reduce or eliminate distributions to shareholders that can be subject to tax by minimizing the distribution. This is an accounting (not a portfolio management) function. Several techniques are used, all according to generally accepted accounting principles (GAAP).

Offsetting capital gains with capital losses among classes
When one class realizes a capital gain in a particular year, this gain can be offset with a capital loss realized by another class.  The remaining net realized gains must be distributed to investors in the particular classes.

Carrying losses forward
Most mutual funds are a trust and cannot carry forward losses. However, Capital Class is a corporation. When a corporation realizes a loss in a given year, it will use this loss to offset gains in following years, because a corporation can carry forward losses.

Unlike traditional mutual funds, which are trusts, capital structure lets you move from one fund to another without triggering immediate tax consequences.  Secondly, Capital Class seeks to reduce distributions by using the above-mentioned mechanisms.

Next Best Alternative to the RSP

Capital class is a good structure for those who have used up all their RSP and TFSA contribution room but would like a tax-efficient savings opportunity outside of their RSP.

Capital class is a good alternative for older investors as a way to minimize tax and high marginal tax rates that will result in claw-back of some social benefits like old-age security.

Capital class is also an alternative for corporate investors including small business owners who may have challenges funding their personal pension plans, but would like to continue to have flexibility by holding capital class in an investment holding company.  They can achieve an aspect of creditor proofing those savings and avoiding capital taxes in some jurisdictions.

Deductible Fees
Money managed outside your RSP/RIF can deduct management fees from your earned income, another easy way to significantly reduce your taxes.

In summary, capital class used in a non-registered environment is a tax-efficient way to accumulate capital. In addition, unrealized capital gains are not taxed until redemption.  Then, only 50% of the gains are taxable. Capital Class can be switched tax-free to a withdrawal plan that allows you to make 6% tax withdrawals for the first 15 years.  If you’re sitting on interest-bearing investments, downsizing your home or have received some form of sudden wealth, consider the benefits of capital class. Given the ability to convert interest income to capital gains, the astute “trusted advisor” can in fact help their client produce good tax-efficient results over the long term.