Why capital gains tax changes would be bad, but dividend tax changes would be worse

Credit: financialpost.com

The federal government’s budget will be released in a short few days (March 22) and there is no shortage of speculation on what it will contain. One of the most talked-about potential changes is to the inclusion rate on capital gains — or the portion an investor includes as taxable income on his/her tax annual tax filing.

The inclusion rate in Canada is currently 50 per cent but there are many worried that Ottawa will hike it to as high as 75 per cent. If true, this would not be without serious consequences as suddenly investors will lose an incentive for taking risk and as a result some of this money may be reallocated elsewhere.

Although there has not been any speculation about altering the tax treatment of dividends, any changes there would be equally concerning, especially in this low interest rate environment.

For example, imagine a retiree in Alberta living off the income generated from a $2 million portfolio invested 60 per cent in dividend stocks yielding of 3.5 per cent and 40 per cent in bonds yielding 2.0 per cent.

Currently, there is a tax credit on eligible dividends to account for the fact that they come out of after-tax corporate earnings. As a result, investors pay a lower rate on dividends than on regular income.

Under the current tax regime for 2017, we estimate that our retiree would pay approximately 4 per cent in tax leaving them with an annual after-tax income of approximately $55,800. If the dividends were taxed entirely as income along with the bond income, the tax-rate would rise to approximately 20 per cent, leaving the retiree with approximately $46,450 of after-tax income.

That said, for those still working and earning a large T4 income, capital gains currently appear to be more attractive with a slightly lower tax rate than dividend income under the current 50 per cent inclusion rate but would be slightly higher if changed to the 75 per cent inclusion rate.

These are all important considerations as changing tax rates will influence capital allocation decisions — something we hope our Federal government realizes. Suddenly lower-growth and less-risky dividend companies could have a lower tax rate to the investor than riskier and higher-growth companies such those in the small and mid-capitalization range.

While there is plenty of talk about equity markets setting new highs, in reality many investors who chased this growth generated only modest returns and would have done much worse if not for being bailed out by the dividends they received.

This is because many give into emotion and end up buying at market highs and selling at the market lows. Take those who return chased the equity market and bought at its March 2008 highs. Interestingly, the S&P TSX itself only gained an annualized 1.6 per cent over these nine years, but thankfully dividends came to the rescue boosting this return to an annualized 4.6 per cent.

Things get a lot worse for investors who bought developed equity markets outside of North America. Over the same period, we calculate that in USD terms, the MSCI EAFE index itself lost 1.8 per cent per year but with a positive 1.2 per cent annualized return after dividends.

The clear winner was the S&P 500, which returned an annualized 6.7 per cent over these nine years and a healthy 9.1 per cent when including dividends.

Finally, given that bonds posted a 4.2 per cent per year total return over this period, we calculate that the average Canadian-focused balanced portfolio with a 60/40 split generated a modest 4.4 per cent annualized return. This would have been only 3.0 per cent per year if not for the dividends received.

Besides bailing out those investors who buy and sell at the wrong time, dividends are also quite beneficial to those retirees who depend on tax-efficient income in this low interest rate and low return environment.

So let’s all hope there are minimal changes to the upcoming budget.

Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.

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