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Tax-efficient investing survives to live another day (despite Ottawa)

Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.

A few years ago some Australian scientists found a male Lavarack's turtle, which was thought to have been extinct. And although I could be mistaken, I'm sure I saw a dodo bird in my backyard last summer (although it could have been my neighbour's cat, which doesn't move very quickly and is probably 15 kilograms overweight).

Investors are hoping that, after last week's federal budget rendered certain investment funds extinct, there might still be life in the world of tax-efficient investing. Let me explain.

The budget

The March 21 budget put an end to something called "character conversion transactions."

These are financial arrangements where the investor is seeking to convert highly taxed interest (or "ordinary") income into capital gains, which are taxed at half the rate. In recent years, many mutual funds have adopted this strategy to provide yield-starved investors with higher after-tax returns on their fixed income investments.

The funds would accomplish this through forward agreements to buy or sell certain capital property at a specified future date.

The purchase or sale price of the capital property under a derivative forward agreement is not based on the performance of that property between the date of the agreement and the future date, but is instead fully or partly based on the performance of some underlying portfolio of investments - called a reference portfolio.

The reference portfolio typically contains investments that produce fully taxable interest income. As the future date under the forward agreement would draw near, the fund would realize capital gains, effectively converting interest into capital gains for the investor.

The budget proposes to render this type of structure extinct by treating the returns realized under the forward agreement in these cases as ordinary income rather than capital gains where the forward agreement has a duration of more than 180 days. So much for the tax benefit.

The solution

This conversion strategy has been used by investors primarily for investments held outside registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs). After all, the tax efficiency of these funds has not been required inside registered plans, which already offer tax sheltering.

If you happen to be just such a non-registered investor, you may now be looking for alternative approaches to generating higher after-tax returns.

You should focus your attention on the two key elements of your portfolio over which you have complete control: (1) your asset allocation, and (2) your asset location.

Your asset allocation is simply the mix of investment types that you hold in your portfolio. Choosing the right asset allocation will allow you to control the type and timing of your income.

For example, choosing an asset allocation that is more equity-focused will skew your returns to capital gains (or losses), whereas an allocation that is more fixed-income focused will create more interest income instead. Interest income, as I have said, is taxed at twice the marginal tax rate of capital gains.

You can control the type of income you earn through adjusting your asset mix, or by investing in a family of mutual funds that offers a corporate class structure. Some of these fund families will allocate certain types of income to certain investors based on the investor's preference for interest, capital gains, dividends or returns of capital. NexGen Financial is one such fund family that I'm aware of.

Next, focus time on your asset location. Specifically, in whose hands are you investing the money? If your spouse is in a lower tax bracket, you might invest in your spouse's hands so that your spouse pays the tax on income earned, and not you.

To do this properly, you would need to lend the funds to your spouse and charge the current prescribed rate of interest - only 1 per cent (a rate that can be locked-in indefinitely) - to avoid the income being attributed back to you.

Alternatively, you might have your holding company make the investment if there is an opportunity, given your province's corporate tax rates, to defer and ultimately save tax. Consider also whether you, your spouse, adult child, or holding company have losses to use up.

If so, putting the investments and income in those hands (beware of tax on any transfer) can allow use of the losses and save tax. Finally, invest in your tax-free savings account, RRSP or RRIF to shelter returns from tax.

© 2007 The Globe and Mail. All rights reserved.

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