In This Issue
RRSP Season Approaching Good Bank Idea Bad Bank Idea Revisiting a Christmas Carol
Dear Member,
With the RRSP season fast approaching, the
promoters of Canada's labour-sponsored venture capital
funds are sitting on pins and needles, waiting to see
what's going to happen to their business.
The move by the federal and provincial governments
to drastically slash the tax breaks associated with these
funds has created a totally new marketing environment.
The maximum tax credit has been cut almost in half, from
$2,000 to $1,050 (New Brunswick became the last
province to follow the federal lead in their recent budget).
The reduction was achieved by dropping the federal and
provincial credits to 15% from 20% (Newfoundland and
Alberta offer no provincial credit), and by cutting the
maximum annual purchase for tax credit purposes to
$3,500 from $5,000.
Clearly, this is going to have an effect on business.
Just how large an effect, no one is quite sure. Further
adding to the uncertainty is the fact that the largest of the
national labour-sponsored funds, Working Ventures, is
sitting on the sidelines this year, relegated there by an
excess of cash that must be invested quickly to mitigate
government-imposed financial penalties. The absence of
Working Ventures is a two-edged sword -- it opens the
door to smaller funds seeking to build their asset base, but
it removes the largest marketing budget from the field.
Small funds with limited resources benefitted from the rub-
off effect of Working Ventures' promotions.
Despite the uncertainty, new funds continue to appear.
One which I suggest is worth a special look, and which
my wife and I will be adding to our personal portfolios this
year, is the recently-launched Business, Engineering,
Science & Technology Discoveries Fund, known for
short as the B.E.S.T. Discoveries Fund.
I like this one for several reasons, all relating in one
way or another to my view that in the light of the reduced
tax credits and the longer holding period (eight years),
these funds must increasingly be judged on the basis of
their potential returns. There are several characteristics of
this fund that suggest it could do well. They include:
> The investment mandate. The fund will focus on
niche businesses and companies that have some kind of
edge in engineering, technology or science. This is a
target area that offers the possibility of above-average
returns.
> The screening criteria. No fledgling start-ups for this
portfolio. To be considered for inclusion, a company must
already have annual sales in the $2 - $10 million range,
and the potential to increase to $50 million in sales within
three years.
> Liquidity. Most venture capital deals are illiquid
(there's no public market for the shares)
and may remain so for several years. B.E.S.T. Discoveries
won't consider a deal unless the company has the
capability to go public within 12-18 months.
> Management. The investment decisions will be in the
hands of Trinity Capital. This is a relatively small but highly
respected Toronto-based venture capital company with
an excellent record of identifying good emerging
companies in the scientific field. One of their recent
winners was Certicom, an Ontario-based firm that has
developed an encryption system for on-line financial
transactions that's regarded as one of the best of the
world. Trinity bought into Certicom as a private placement
in August, 1995 at $2.15 and managed the subsequent
IPO, which came out at $3. The shares closed on Friday
at $30.
The final point that tips the scales in favour of B.E.S.T.
Discoveries is the fact that Trinity Capital will have some
of its own cash in every venture that goes into the
portfolio. Since Trinity is a private company, that means
the partners will be putting themselves on the hook -- if
you lose money, so will they. There's no better way to
focus a portfolio manager's mind! Trinity will also have a
representative on the board of directors of every company
brought into the portfolio.
Although I like the concept of this fund a lot, it is brand
new and therefore untested. So I don't recommend
putting your entire $3,500 allotment into it. Use it as one of
two or three, to provide some diversification. The minimum
initial investment is $1,000. The main distributer is Midland
Walwyn, but any broker should be able to acquire units for
you. The fund is only available in Ontario.
For residents of other provinces, I recommend the
Canadian Medical Discoveries Fund, which is offered
everywhere except Saskatchewan. However, it only
qualifies for provincial credits in P.E.I., New Brunswick,
Nova Scotia and Ontario. B.C. residents should consider
the Working Opportunity Fund, the only one that gets a
provincial credit there. It has performed quite well to date.
Special caution: There is no exception to the new
eight-year holding period for labour-sponsored funds. In
the past, age and/or retirement enabled you to redeem
your units early without having to repay your tax credits.
This is no longer the case for units purchased after the
last federal budget came down. Once you buy in, you're
stuck with your purchase.
This means that older people who will soon be needing
retirement cash flow must give careful thought as to
whether they should tie up their money here. Remember
that if you're over 61, the holding period will extend
beyond age 69, when you have to wind up your RRSP
under the new rules. That means any labour-sponsored
fund units will likely end up in a RRIF. But the amount of
cash flow they will generate will probably be minimal,
which could be a serious problem if they form a large
percentage of your RRIF assets. So think it through
before you act.
GOOD BANK IDEA
Every so often the banks come up with a product that
offers a genuine good deal to their clients. The new
RRSP Catch-up Loan being offered by the Bank of Nova
Scotia falls into that category. It's not for everyone, but if
you're one of the hundreds of thousands of people who
have carry-forward RRSP credits from past years, it may
be for you.
Ever since the 1991 tax year, we've been allowed to
accumulate unused RRSP contribution room. There is no
limit on the amount of your RRSP reserve and, as of the
last federal budget, no time limit on when it can be used.
To find out if you have any unused contribution room, just
check the 1995 notice of assessment you received from
Revenue Canada.
Until now, it's been difficult for most people to make
use of that RRSP room. It may amount to tens of
thousands of dollars, and finding that kind of spare
change isn't easy. This new Scotiabank loan makes it
possible, however, and if you have a lot contribution room
available I strongly recommend you look at it.
I don't normally advocate going into debt to invest, but
this is an exception. The RRSP Catch-Up Loan allows
you to borrow up to $50,000 at rates as low as prime, and
take up to 10 years to repay. This is a terrific deal,
particularly for someone in a high tax bracket.
Here's a little math to show you what I mean. Let's say
you've accumulated $50,000 in RRSP credits (very
possible for higher income earners), and that your marginal
tax rate is 50%. We'll use 5% as the interest rate on the
loan and assume you invest the money in a mutual fund in
your self-directed plan that returns an average of 8% a
year. Let's assume the loan is repaid over ten years in
equal monthly instalments. Here are the results:
Immediate tax savings = $25,000
Value of mutual fund investment after 10 years =
$108,000
Interest charges (10 years) = $13,640
Monthly payment required = $530.33
If you decide to pursue this idea, here are some things
to keep in mind:
> This strategy works best if the total amount of the
extra RRSP contribution will benefit from the highest
marginal tax rate. If you contribute so much that you drop
into a lower tax bracket, you'll lose some efficiency. One
way to get around this is to take out the loan in early
1997. Apply the total needed to reduce your 1996 tax to
the bracket threshold and save the rest for your 1997 tax
return.
> Watch out for the alternative minimum tax (AMT). If
you make an especially large contribution, you could be
hit by it. Here again, spreading the contribution over two
taxation years may make the difference.
> Use your immediate tax savings to pay down the
principal, this reducing total interest charges.
> The Scotiabank rate is guaranteed for the term of the
loan. You can choose a term of from one to five years
(amortization is over ten years). With rates this low, take
the longest available term.
> Interest charges for RRSP loans are not tax
deductible.
A BAD BANK IDEA
I recently received a special promotion from the friendly
people at Visa inviting me to order free personalized
cheques to use against my Visa account. "They work like
regular cheques", the flyer states.
Some "free" offer! Accepting it can cost you a bundle.
In fact, these cheques are treated in the same way as
cash advances on your card. That means they start
attracting interest immediately -- no grace period if you pay
off the balance on your next due date. And you'll pay at
Visa's high rate (my card currently charges 17.5%).
This certainly isn't an effective way to use a Visa card.
If you're cash short, apply for a personal line of credit at
your financial institution. It will be a lot cheaper.
REVISITING A CHRISTMAS CAROL
With Christmas just a day away, I'd like to close with
an appeal to your good will, and your desire to cut down
your 1996 tax bill.
You'll recall that one of the early scenes in A Christmas
Carol involves the visit of two local businessmen to the
establishment of Scrooge and Marley, where they attempt
to inveigle Mr.Scrooge into contributing to the Victorian
equivalent of the United Way. I'm sure you also recall
Scrooge's response: "I help to support the prisons and the
workhouses, and those who are badly off must go there."
Of course, none of us think we're anything like old
Scrooge. But often at this time of year we get so caught
up in our own family festivities that we lose sight of the
fact that many people are less fortunate.
I was reminded of that when I opened our family
budget file on the weekend and found myself facing a
stack of charitable appeals that I'd tucked away for future
action. It's easy enough to do. We're so bombarded with
mail and telephone solicitations from non-profit foundations
and charitable organizations that we tend to shunt them
aside from sheer exasperation. But there are a lot of
organizations out there that do very good work. Pick the
ones you think are most worthy of support, and spend an
hour or so in the quiet period between Christmas and New
Year's catching up on your donations.
Here's a quick summary of the tax rules relating to
charitable donations that may encourage you to give a
little more. Who knows, if they'd been in existence in
Scrooge's time, he might not have been so grouchy when
the fund-raisers came calling.
> If you want to claim a donation this year, it must be
sent in by Dec. 31.
> You get a federal tax credit of 17% on the first $200
worth of donations. After that, the
basic federal credit rises to 29%. However, with surtaxes
taken into account, the maximum federal tax credit ends
up being 31.3%.
> Donations are treated as tax credits on your federal
return, which in theory makes them of equal value to
every one. In fact, that's not the case. Higher income
people benefit more because of additional savings that
accrue along the way: federal surtaxes, provincial taxes
which are based on federal taxable income, and provincial
surtaxes. So your actual savings will depend on your
income level and your provincial tax rates. In most
provinces, a top bracket tax payer will recover more than
half the value of charitable donations over $200 when all
the calculations are done.
> You do not have to claim your charitable donations
during the calendar year. They can be carried forward up
to five years (or you can go back five years if you have
past receipts you haven't claimed). There are very few
situations in which carrying forward makes sense. In some
cases, the tax value of the donation could actually drop in
the future, for example in Ontario where provincial tax
rates are gradually coming down. As a general rule, you
should only carry forward your donations if you haven't
exceeded $200 (in which case you should wait until your
total is high enough to take advantage of the 29% credit),
or you expect to be in a much higher tax bracket within a
year or two.
> The limit for charitable donations has been increased
to 50% of net income (it used to be 20%). This could be
especially useful for people donating collections to charity
(art, fine wine, etc.)
Special tip: If you have a credit card that accumulates
bonus points, make your charitable donations that way. I
use my Aeroplan Visa card, so my contributions are
helping to earn our family more free flights.
That's it for this week. Look for the next letter on Dec.
30.
A Merry Christmas to all,
Gordon Pape