usinessman pole vaulting over a huge tax problem

“I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes.” — Charlie Munger (former vice-chairman, Berkshire Hathaway)

While the prospect of cutting-edge and potentially contentious tax shelters can be tempting, anyone who has spent much time in our industry will have seen the pitfalls of overzealous tax minimization and how it can lead to “really dumb mistakes.” This, however, does not diminish the benefits of thoughtful implementation of well-established methods of generating tax alpha to enhance portfolio outcomes.

Below are five time-tested strategies that can improve portfolio outcomes by enhancing tax efficiency in non-registered accounts. For simplicity, all examples will use a hypothetical client residing in Ontario who pays taxes at the highest marginal tax rates for 2024 (26.76% on capital gains, 39.34% on Canadian eligible dividends, 47.74% on non-eligible Canadian dividends, and 53.53% on other income). All other circumstances that might have tax implications have been excluded.

  1. Overweight Canadian equities

Canadian eligible dividends are generally taxed at a lower rate than foreign income due to the dividend tax credit. By overweighting Canadian equities in their strategic asset allocation, clients can benefit from reduced tax rates on dividends, preserving more of their returns. Generally speaking, our hypothetical client will pay 13.8¢ less in tax for every dollar they earn that is a Canadian eligible dividend rather than a foreign dividend, making this adjustment a meaningful source of tax alpha.

  1. Focus on low-dividend stocks

A second way to potentially enhance the tax efficiency of your client’s equity allocation is to focus on investing in stocks that pay little to no dividends. These low- to no-dividend stocks earn more of their return as capital gains than as dividend income. Our hypothetical client can expect to pay 12.6¢ less in tax for every dollar they earn as capital gains than as Canadian eligible dividends, and 26.8¢ less in tax compared with foreign dividends. Moreover, these capital gains may be deferred to future years, further reducing the taxes payable this year, which provides two additional potential benefits.

First, because less tax is paid in the current year, more capital can remain invested to generate future returns. Second, the deferred capital gains provide additional opportunities to generate tax alpha. For example, the client could wait to realize the gains in a year in which they will be in a lower tax bracket or in which they may have capital losses from another source, which they can use to offset the taxes payable on those gains.

  1. Replace high-quality fixed income and GICs with discount bonds

The interest income paid by fixed-income investments such as bonds and GICs is generally taxed as “other income,” for which our hypothetical client can attract taxes at a rate of 53.53%. Discount bonds offer an opportunity to generate tax alpha because they are purchased below par, so in addition to paying interest they also provide clients with capital gains, which in Canada are taxed at half the rate of interest income. So, our hypothetical client will pay 26.8¢ less in tax per dollar earned from fixed income that is characterized as capital gains rather than as interest income.

  1. Replace credit with a capital-efficient allocation to preferred shares

Shifting some credit exposure to a smaller allocation of preferred shares can also provide tax alpha. Preferred shares can generally offer a capital-efficient way to get exposure to credit risk, with one dollar allocated to preferred shares potentially providing the same amount of beta to credit risk as multiple dollars allocated to a credit fund. More important for the purpose of this article, Canadian preferred shares typically pay Canadian eligible dividends rather than interest income. Our hypothetical client will therefore pay 14.2¢ less in tax for each dollar they earn as Canadian eligible dividends rather than as interest income. In addition, because the preferred shares generally provide a more capital-efficient exposure to credit, they can free up capital to invest in strategies that are more tax-efficient, leading us to our final tax-alpha strategy.

  1. Allocate capital to tax-efficient alternative strategies

The capital freed up by accessing credit exposure in a more capital-efficient manner can be redirected toward tax-efficient alternative strategies. These strategies, which can serve as replacement for fixed-income investments, typically come with lower tax implications. For example, market-neutral equity strategies have been recognized by industry practitioners and academics for their remarkable tax efficiency.

There are three key reasons why these strategies are tax- efficient. First, because they use equities as the underlying building blocks, they tend to generate capital gains, which are the most tax-efficient form of income in Canada. Second, short positions provide opportunities to realize capital losses in market environments in which equity returns are high (and losses are generally less available to long-only strategies), providing tax efficiency at a time when it can be most valuable to a portfolio. And third, they reduce the likelihood of getting “tax locked.” Because markets tend to rise over time, long-only portfolios can eventually reach a situation in which the majority of holdings are in a “gain” position, making it impossible to reallocate capital to other opportunities or rebalance without triggering capital gains.

Market-neutral equity strategies can mitigate this tendency because they can continue realizing losses on their short positions as markets rise. The tax efficiency of market-neutral equity strategies is so notable that Joseph Liberman, Clemens Sialm, Nathan Sosner and Lixin Wang won the Graham & Dodd Award for Excellence in 2020 from the CFA Institute for their research into the tax efficiency gained by separating active returns from market beta.

There is a significant difference between the reckless tax evasion that Charlie Munger warns about and the strategic, defensible pursuit of tax alpha within a portfolio. The five strategies outlined above are well established, time-tested approaches to enhancing portfolio outcomes through tax efficiency. By overweighting Canadian equities, focusing on low- to no-dividend stocks, replacing core bonds with discount bonds, and replacing part of your clients’ credit allocation with a combination of preferred shares and tax-efficient alternative strategies, it is possible to meaningfully reduce tax drag on a portfolio and maximize after-tax returns.

Robert Wilson is the head of the Portfolio Construction Consultation Service with Picton Mahoney Asset Management.