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Jun 02, 2020

Capitalizing on Market Losses

The end of a long bull market may have you concerned whether your financial goals will still be met. Focusing on your long-term financial strategy, we’ve highlighted some benefits of the current market correction that we encourage you take advantage of.

With over 12 years of experience, Robert specializes in wealth preservation, risk management, business wealth integration and retirement planning. He leads the wealth advisory team, ensuring a consistent approach to advice and strategies for all our clients.

As we experience the end of a long bull market, it is easy to be concerned that your financial goals may no longer be met as expected. However, there are many benefits to market corrections (silver linings, if you will) that we encourage you to take advantage of.


Lower Prescribed Rate

An opportunity that has emerged is the use of a lowered prescribed rate for Canadian borrowers and investors. With the market downturn, many investors fled to traditionally safe investments, such as Canadian government Treasury Bills (T-bills). As demand for three-month T-bills went up, the investment yield plummeted. The timing of this event matters because the average yield of three-month T-bills determines the prescribed rate, which we saw move from 2% to 1% for the third calendar quarter.


The benefit of a low prescribed rate is reduced interest burden for loans made in a non-arms length situation. Further, once a loan is created the low rate is ‘locked-in’; the interest rate that must be charged for the term of the loan will not change in the future as new prescribed rates are set.


Suppose you are in a high income bracket and your non-registered investments are generating a large amount of tax. Let’s say your spouse is in a low income bracket and you loan $500,000 to your spouse to invest. If no interest is charged, income earned by the investment will be attributed back to you, not your spouse. If interest of at least the prescribed rate is charged, and paid, all income resulting from the investment will be taxed in your spouse’s hands, not yours. The low rate results in $5,000 of interest income in your hands rather than all income from the investment.


Use of a prescribed rate comes into play in a variety of scenarios from loans to children, spousal loans, taking money out of your corporation via loans to shareholders and can even be useful in family trust planning.

In all planning scenarios, the lower the prescribed rate the better for parties involved.


Superficial Loss

Disciplined investors may find benefit in a market decline when their positions begin to show a loss. Although the goal of investing is not to lose money, an investor may wish to ‘harvest’ some capital losses from a corporate investment account or a non-registered investment account in order to offset future expected (losses may be carried forward indefinitely) or recent capital gains (generated within the past three years).


Suppose an investor held 3000 shares of XYZ.co with a cost base of $100/share within his non-registered trading account. XYZ.co is now trading at $60/share. Let’s say the investor had a realized capital gain of $250,000 from the previous tax year. The investor could use this strategy to sell all 3000 shares, for a capital loss of $120,000, with the goal of partially offsetting last year’s capital gains. If this investment account were held within a corporation, it may be advisable to check for a balance in the capital dividend account and pay a tax-free capital dividend before realizing the loss on the security.


Triggering capital losses can be tricky. It is not as simple as just selling an investment to record a capital loss and immediately repurchasing that same security to again establish your position. A series of rules in the Income Tax Act, known as superficial loss rules, are designed to discourage this sort of action. If an investor were to buy the same or identical property during a period of 30 days before and 30 days after the realization of a capital loss, the deduction of that loss would not be allowed. However, generally, the amount of the loss may be added to the adjusted cost base of the newly repurchased security.


To further our example, suppose that same investor really liked XYZ.co and didn’t want to miss out on the market rally. If he were to purchase another 300 shares after the realization of the loss within a 30 day period, he wouldn’t be able to use that loss to offset the previously incurred capital gain. However, being an astute investor, he knows success comes from time in the market so he makes a purchase of a competitor to XYZ.co with very similar fundamentals and growth prospects, ABC.co. The substitute investment will not hamper his ability to use the capital loss and will allow him to participate in the market rally.


Small Business Deduction

Decreased market values can present specific opportunities within a corporate investment account as well. The 2018 Federal Budget introduced a decrease of the small business deduction (SBD) available to Canadian controlled private corporations (CCPCs). Generally CCPCs, via the SBD, are eligible for a reduced tax rate of 11% (2020, 9% Federal, 2% AB) on the first $500,000 of income. Without the deduction, income is generally taxed at 25% (2020, 15% Federal, 10% AB). However, since the 2018 budget, companies (and associated companies) generating aggregate investment income (income from an investment portfolio for example) over $50,000/year will experience a reduction in the income to which the SBD applies. The active income this generous tax rate applies to will be reduced to $0 once the aggregate investment income is greater than $150,000/year.


For certain business owners with both holding companies and active companies, the potential loss of the SBD on the first $500,000 of active income can be painful. One solution to prevent SBD loss is to invest in a manner that generates lower amounts of income; another solution is to remove capital from the holdco so that aggregate investment income drops below the required thresholds. Both of these solutions require the sale of an asset. Given the highs of the market over the past years, many companies chose to forgo the active business SBD, rather than rebalance or sell positions within the holdco and realize tax. With the current market pull back, we now have an opportunity to move assets and shuffle capital to a more advantageous location. By limiting the amount of passive investment income generated within a group of associated companies, a business owner has the ability to take full advantage of the generous effective tax rate through the SBD. Special care should be taken to analyze the impact on a business' capital dividend account when selling at a loss.


Purifying the Business

A similar strategy involves moving capital out of a corporation in an effort to ‘purify’ a company before a sale. In order for qualified small business corporation owners to take advantage of their lifetime capital gain exemption, certain criteria must be met. First, 50% of the value of assets must be used principally in an active business by the corporation or related corporation through the 24 months before share sale. Second, at the time of sale, at least 90% of the value of the assets must be used in the active business. When portfolio assets have decreased in value and when business owners may themselves be experiencing lower income for the year, this can create a window of opportunity to remove assets from the company and begin the purification process for future share disposition.


Estate Freezes

Just as a publicly-traded company within your portfolio may be valued based on the potential for future earnings, a private company owned by a small business owner is also valued on earnings. For parents hoping to pass a corporation over to their children, an estate freeze during times of decreased valuations can help to both limit tax for the parents and increase growth potential for the next generation.


Generally, an estate freeze involves trading common shares for fixed value preferred shares. Mom and dad give up their common shares, which rise and fall in value with the company, for new preferred shares that keep a fixed value. The preferred shares allow for an income stream to mom and dad, while the tax from disposition may be deferred until a later date or even death. Meanwhile, the next generation is issued new common shares to which all future value growth of the company accrues.


By taking advantage of decreased corporate valuations, mom and dad can lock in a lower value for the disposition of their shares which translates to a lower tax bill. When the general business climate returns to normal and earnings look good again, the increases in valuations back to normal levels will accrue to the new shares held by the children.

Taking advantage of decreased values can be useful even for those who have already executed an estate freeze.

A re-freeze may be possible to lock in an even lower valuation for mom and dad and lower their deferred tax liability.


We have really only skimmed the surface of these strategies and it’s important to have a full discussion with a qualified accountant and/or legal professional before any implementation. In addition to the strategies listed above, there are further opportunities that take advantage of decreased market conditions. Our client teams have strong relationships with accountants and lawyers that can help assess these strategies for you. Part of our client service is offering access to a qualified in-house wealth advisory team that provides a deep and comprehensive review of your financial plan. If you haven't reviewed your financial plan recently, we can help ensure you're on the right track. Fill out the form below and we will be in touch shortly.