Current Trends and Issues in Financial Planning

2006 Edition Roxanne Eszes, CFP Cleartech Documentation & Training [email protected]

2006 Edition CE Course

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Over 160 pages of new material

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Consolidates new developments in one place

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Covers a wide range of topics across the CFP syllabus

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Qualifies for 10 CE hours with exam

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20 question M/C exam

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circle responses on answer sheet (optional) Go online at www.cifps.ca

to submit answers obtain a score of 12 out of 20

Course Highlights

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Professional Practice Update

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FPSC Practice Standards now in force

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What happened to Fair Dealing Model?

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CSA’s Registration Reform Project

More Course Highlights

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Economic Update

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Review of Canada’s economic framework

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Recent Canadian economic developments

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External influences

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Risks to Canada’s economic outlook

More Course Highlights

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Personal Finance Update

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Recent statistics on consumer spending

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Statistics on current trends in inflation, mortgage rates, bond yields, etc.

More Course Highlights

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Income Tax Update

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Federal personal income tax parameters for 2006

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Synopsis of 2005 and 2006 Budget proposals of interest to CFPs

More Course Highlights

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Retirement Planning Update

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Creditor protection for RRSPs upon bankruptcy

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Pension funding concerns

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Capital Accumulation Plan (CAP) Guidelines now in force – opportunities for CFPs?

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New stats on retirement life expectancies – from OAS study

More Course Highlights

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Investment Planning Update

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Structured Products

• • • •

Closed-end funds ETFs Principal protected notes (PPNs) Split Share corporations

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Income trust developments

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LSIF developments

Today’s Presentation

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Income Tax Changes (Budget 2006 and others)

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Principal protected notes

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Split share corporations

Basic Personal Amount

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2005 Update increased 2005 BPA by $500 to $8,648, with proposals to increase to $10,000 by 2009

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Budget 2006 confirmed 2005 BPA after the fact, $8,639 for 2006, increase to at least $10,000 by 2009

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Similar path for spousal amount, to reach at least $8,500 by 2009

Lowest Federal Tax Rate

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16% in 2004

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Liberals cut this to 15% in 2005

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Conservatives increased it to 15.25% in 2006

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15.5% in 2007 and later years

Middle and Top Tax Brackets

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Budget 2005 proposed reductions of 1% to the 2 middle brackets (22% to 21%, 26% to 25%, plus an increase in the income threshold for the 29% bracket

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Never passed into law

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Budget 2006 was silent, so these changes are off the table

Child Disability Benefit (CDB)

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Budget 2006 increased CDB to $2,300 effective July 2006

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Reduced the phase-out rate for family net income in excess of $36,378 from 12% to just 2% (for one child)

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Effect is benefits will be available to middle and high income earners (up to family income of $150k plus)

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Corresponding changes for families with 2 or 3 children eligible for the CDB

Universal Child Care Benefit (UCCB)

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$100 per month ($1,200 per year), starting July, 2006

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For all children under 6 years old

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Taxable to lower-income spouse

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Enhancement to Canadian Child Tax Benefit of $249 for kids under 7 in low income families will be eliminated

GST Reduction

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From 7% to 6%, July 1, 2006

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No change to GST credit

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No change to GST rebates on new housing

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For house sales where offer was made before May 2, but closing is after July 1, GST of 7% must be paid, but purchaser will get 1% rebate

Donations of Capital Property

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Taxpayer deemed to dispose at FMV, resulting in capital gain

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Donations of publicly listed securities already eligible for 25% inclusion rate

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Budget 2006 makes inclusion rate 0%

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Also applies to shares acquired via employee stock option plans (ESOPs), and environmentally sensitive land

Donations, continued

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0% inclusion rate, plus charitable donations tax credit = tax planning opportunities

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Pick and choose what you donate versus what you liquidate for your own cash flow

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Donate a portion of the stock you want to liquidate, and use the resulting charitable tax credit to offset taxes on the remainder

Dividends from Large Corps

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Ordinary dividends grossed up to 125%, then 13.33% tax credit

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Enhanced scheme will see eligible dividends grossed up to 145%, then 19% tax credit

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Applies beginning 2006

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Eligible dividends are generally from public corporations, resulting from income subject to the general corporate income tax rate

Dividends, continued

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Also can apply to small business income in excess of small business limit

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IF provinces come onside, and the corporate tax rates are reduced to 19% as proposed, this will result in full integration of personal and corporate tax systems

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Tax comparable to income trusts

Dividends, Tax Planning

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The gross up to 145% will affect income-tested clawbacks, like OAS, because net income includes grossed-up dividend amount

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Small business owners will no longer need to “bonus down” to the small business limit

Tax Grab Bag

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Canada Employment Credit (2006)

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15.25% of $250 in 2006 = $38.13

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15.5% of $1,000 in 2007 = $155.00

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Self-employed people would have to incorporate and become employees to receive this

Tax Grab Bag

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Tools Tax Deduction (after May 2, 2006)

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tools required by employer, over $1,000 but under $1,500 – max. $500 deduction in any one year

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Textbook Tax Credit (2006)

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15.25% of eligible amount

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$65/month full time study, $20/month part time study

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= max credit of $9.91/month or $118.95/year transferable, like education and tuition amounts

Tax Grab Bag

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Scholarship income (2006)

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Full amount tax free (used to be only first $3,000)

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Mineral exploration expenses tax credit

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15% of expenses passed on through flow through shares (agreements after May 2, 2006 but before March 31, 2007)

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Pension credit (2006)

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pension income amount increased from $1,000 to $2,000 = new credit of $152.50 for 2006

Tax Grab Bag

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Children’s Fitness Tax Credit (2007)

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15.50% on up to $500 of eligible expenses = tax savings of $77.50

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Public Transit Passes (July 1, 2006)

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15.25% on cost of monthly or annual transit passes

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Adoption Expenses Tax Credit (2005)

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15% on up to $10,000 (2005), indexed

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only in year adoption is finalized

Tax Measures for Disabled

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Expanded eligibility for DTC, and thus for the disability supports deduction

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Expanded eligible expenses for disability supports deduction, or the medical expenses tax credit

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Clarified eligible medical expenses (no more hot tubs)

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Caregivers can claim METC on $10,000 of expenses for dependent relatives (used to be $5,000)

Business Income Tax Changes

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General Corporate Tax Rate

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Full-rate taxable income currently taxed at 31% less 10% provincial abatement = 21%

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Reduce this to:

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20.5% on Jan. 1, 2008

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20% on Jan. 1, 2009

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19% on Jan. 1, 2010

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Eliminate corporate surtax of 4% of federal tax for all corporations, effective Jan. 1, 2008

Business Income Tax Changes

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Small Business Limit

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Deduction reduces tax rate on first $300,000 of active business income to 12%

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Limit to increase from $300,000 to $400,000

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Must still be shared between associated corporations

Business Income Tax Changes

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Small Business Tax Rate

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Rate to decrease from 12% to:

• •

11.5% in 2008 11.0% in 2009

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Non-capital Losses and ITCs

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Carried back 3 years

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Carried forward 20 years (up from 10 years), to be deducted from all sources of income

Principal Protected Notes

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Combine exposure to underlying securities with a principal guarantee

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Maturity: 7 to 11 years

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Sold via offering memorandum

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Trade on exchange or secondary market facilitated by issuers

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43 issues on the TSX

PPN Guarantee Structures

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Zero coupon bonds – 60% to 70% of investors’ capital, depending on term to maturity and interest rates

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Leaves only 30% to 40% of the capital for underlying investments

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PPNs are most attractive when prevailing interest rates are low…but this means the price of zero coupon bond increases, and less is available for investment

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Use leverage, including loans and call options, to enhance returns

PPN Guarantee Structures

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Constant Proportion Portfolio Insurance

Value of PPN’s assets Principal Guarantee Notional Strip Value or Floor Maturity Time

PPNs – CPPI

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Difference between current value of portfolio and notional strip value is the “cushion”, expressed as a % of original portfolio value

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This %, along with an allocation grid, determines the allocation to underlying assets

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Requires constant supervision and quick action if things go sour

PPNs – CPPI – Allocation Grid

Cushion (% of original PPN assets) ≥ 40% ≥ 40% <50% ≥ 30% < 40% ≥ 20% < 30% ≥ 15% < 20% ≥ 10% < 15% ≥ 5% < 10% ≥ 0% < 5% < 0% Allocation to Underlying Assets 200% 150% 100% 75% 50% 25% 15% 10% 0% Allocation to Strip Bond 0% 0% 0% 25% 50% 75% 85% 90% 100%

PPNs – Underlying Investments

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Originally (1992) used well know stock market indices

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Progressed to broader indices

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Mutual funds and foreign markets in late 1990s

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During last 5 years – income trusts, hedge funds, commodities, futures, options, other derivatives

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Minimum investment of about $5,000 gives investors access to hedge funds, etc.

PPNs - Trading

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Many trade on an exchange, but could trade at less than NAV

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Others trade via secondary market, via FundSERV

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Some offer redemptions on specified dates (monthly)

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Early redemption fees or deferred sales charges may apply…as much as 7%

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Redemption fees calculated either as % of original investment or NAV

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Each PPN is unique, so ask before buying

PPNs – Performance Caps

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Gains may be capped, either annually or cumulatively

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Annual caps can be particularly disadvantageous

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Good performance is capped, bad performance isn’t

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One bad year can wipe out earlier capped years, lowering compounded annual return

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Some PPNs are callable

PPNs - Fees

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PPNs repackage mutual funds, hedge funds, etc., which have their own fees

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PPNs add another layer, could include:

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Sales charges (4 to 7%)

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Risk transfer and management fees (1%)

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Advisory fees (1.5% to 3% of investment exposure)

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Incentive fees (10% to 20% of growth)

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Swap fees (0.2%), Servicing fees (0.65%)

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Redemption fees (up to 5%)

PPNs – Risks Despite Guarantees

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Inflation Risk !!!

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Credit risk – not covered by CDIC

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Investment risk

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Liquidity and marketability risks

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Leverage can magnify losses

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Lack of disclosure

PPNs - Taxation

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Investors generally don’t receive payments until maturity

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Accrued interest

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must be reported annually interest is only “accrued” if it is certain to be paid

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Payments at maturity

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Excess of amount received over investment (less accruals) is taxed as interest income

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Disposition prior to maturity

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Difference between proceeds (less accrued amounts) and cost results in capital gain/loss

Do-it-yourself PPNs

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Invest a portion of your capital in a strip bond

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Use the balance to purchase investments of your choice

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Advantages

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Lower fees Greater transparency Greater liquidity

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Disadvantages

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Investment knowledge Not all investments are accessible (e.g. hedge fund minimum purchase limits)

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Must accrue interest income on the strip annually

Split Share Corporations

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Mutual fund corporation that issues 2 types of shares: capital and preferred

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Each type issued in equal numbers

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Each pairing (1 capital + 1 preferred) = 1 Unit

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Initial offering price of capital and preferred shares can be different

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Afterwards both shares trade on exchange

Split Share – Portfolio Investments

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First split share corps invested in a single underlying company (20 years ago)

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Now invest in common shares of more than one company, usually in the same industry

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5Banc Split Corp – 5 big Canadian banks

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Financial 15 Split II Corp – 15 banks and insurance companies (Canada and US)

Split Share – Preferred Shares

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Receive fixed cumulative dividend + Return of capital upon maturity

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Sometimes Corp has to sell underlying assets to pay these dividends – return of capital

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Do not share in capital growth of underlying assets

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Have first claim on assets upon maturity

Split Share – Capital Shares

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Exposure to the capital appreciation of underlying investments

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May benefit from an increase in dividends paid by underlying investments

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Dividends earned in excess of preferred shareholders entitlement are paid to capital shareholders to avoid tax within the Corp.

Split Share Corps - Leverage

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Built-in, low-cost leverage

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Preferred shareholders get access to twice the dividends they would have received by investing in underlying shares directly

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Capital shareholders get exposure to twice the capital growth of underlying shares

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No interest charges or margin calls

Split Shares – Option Writing Income

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Many split share corporations try to boost returns by selling covered call options on underlying stock

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Premiums accrue to capital shareholders

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If options are exercised, the corporation will forego future capital appreciation

Split Shares – Redemptions upon Termination

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Corporation terminates after 5 or 10 years

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Sells underlying investments

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Distributes proceeds (net of expenses)

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preferred shareholders get first claim, return of original investment

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balance goes to capital shareholders

Split Shares - Retractions

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Most corporations provide for periodic retractions/redemptions

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Must maintain an equal number of preferred and capital shares outstanding

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Retraction of preferreds is conditional on corp. being able to buy capital shares in secondary market, and vice versa

Split Shares - Fees

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Front-end sales charges (3% to 6%), may differ for preferred and capital shares

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Retraction fees (0% to 5% of NAV)

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Administration fee paid to manager

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Base management fee paid to manager

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Performance fee paid to manager

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Service fee paid to dealer

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Initial offering expenses, ongoing operating and administration expenses

Split Shares – Risk Factors

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Leverage – magnifies losses as well as gains

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Interest Rates – if interest rates rise, value of preferred shares will decrease

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Market and Economic Risks – affect performance of underlying shares

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No voting rights

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Lack of diversification

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Call options – may be no market for them, may result in foregoing capital appreciation

Split Shares - Taxation

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Ordinary dividends – subject to gross up and tax credit scheme

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Return of capital – not taxable, but reduces investor’s ACB

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Capital gains/losses prior to maturity

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If corp. sells underlying investments prior to maturity, capital gain will be allocated to capital shareholders. If no cash is distributed, this will increase investor’s ACB

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Losses cannot be distributed

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Capital gains/losses at maturity – normal rules apply