Tax tips for Americans in Canada

Recommendation No. 1: Seek advice on reporting requirements

Most countries, including Canada, do not tax on the basis of citizenship. For example, Canadian citizens who live in Canada pay tax in Canada on the taxable income they earn. If a Canadian citizen moved abroad a few years ago, with no continued ties to Canada, it is most likely this individual would be considered “non-resident” and would have no tax reporting obligation to Canada. In other words, Canadians are taxed based on residency.

The U.S. tax system is different as it treats all U.S. citizens as U.S. residents for tax purposes, no matter where they live in the world, including Canada. Many U.S. citizens live in Canada and are resident here. A U.S. citizen has to pay tax in Canada on taxable income if they are resident for Canadian tax purposes.   Canada and the U.S. have entered into various agreements (i.e. tax treaties) to address taxation differences and to largely avoid double taxation.  

The Internal Revenue Service (IRS) in the U.S. has been trying to crack down on American taxpayers using financial accounts held outside of the U.S. to evade taxes. For example, the U.S. introduced the Foreign Account Tax Compliance Act (FATCA), signed into law on March 2010, with the objective of identifying taxpayers evading taxes. To do that required co-operation from other countries to provide information.  

The U.S. effectively told Canada that if it did not comply, then all income from U.S. investments would be subject to a 30 per cent withholding tax. This threat of withholding was for both registered and non-registered investment accounts.

Previously, Canada was not required to withhold any tax on U.S. investments held in registered accounts. For non-registered accounts, the negotiated tax treaty had withholding rates on U.S. dividends at 15 per cent and nil for US interest income.

Earlier this year, Canada and the U.S. signed an Intergovernmental Agreement (IGA) regarding FATCA, in which Canada agreed to pass laws requiring that, primarily through financial institutions, that annual reports be made to the Canada Revenue Agency on specified accounts held in Canada by U.S. persons. The agreement brings Canada, via the CRA, into a reporting agreement to satisfy FACTA.

Under the agreement, the U.S. has agreed not to apply the 30 per cent withholding tax on registered accounts, such as RRSPs, TFSAs and RESPs, and to maintain the existing withholding rates for non-registered accounts.

Effective July 1, 2014, an amendment to the Canada Income Tax Act adopting Canadian tax regulations related to FATCA.   Also beginning in July 2014, financial institutions have new requirements to report to the CRA, not the IRS. Clients of financial institutions will be required to complete additional mandatory questions for all non-registered accounts. New account-opening forms will require you to state if they are a citizens of Canada, and if they are a citizen of the U.S. Another question is, “Are you a U.S. Person (Entity) for tax purposes?” Certain legal entities must answer a new classification question relating to active or passive entity.

For the purposes of FATCA, here are some examples of who is deemed a U.S. Person (Entity):

  • U.S. citizens, include persons with dual citizenship, U.S. residency,
  • Any person who meets the IRS “Substantial Presence Test of U.S. Residency,”
  • U.S. resident aliens (Green Card holders who do not have U.S. citizenship),
  • Persons born in the U.S. or who hold a U.S. Social Security Number (SSN) or U.S. Tax Identification Number (TIN) or a U.S. Place of incorporation or registration

Financial firms have a mandatory obligation to provide this information to CRA. CRA will begin sharing relevant information pertaining to the agreement with the IRS starting in 2015.

For the majority of Canadians, this is a non-issue. For the approximately one to two million people in Canada that would be deemed a U.S. Person (Entity), it reinforces the need to have all of your tax filings up to date with both the IRS and CRA.

Sharing information electronically between CRA and the IRS will enable the IRS to obtain information on U.S. Persons (Entities) that have not fulfilled their reporting obligations.

Other indicators must also be reviewed, including U.S. address (residence, mailing, in-care-of, or interested party), U.S. telephone number, standing instructions to transfer funds to an account held by the client in the U.S., a power of attorney or signatory authority granted to a person with a U.S. address.

Many snowbirds have asked me what their requirements are under FATCA. Reviewing the “Substantial Presence Test of US Residency” on the IRS website is a good starting point. A wealth advisor should have enough knowledge about FATCA to make sure your accounts are documented correctly and that they are asking you the right questions.

I recommend every client who is not sure if they have a reporting obligation to consult with an independent tax advisor to determine if they are a U.S. person for tax purposes. It is important that the accountant you approach has knowledge in these areas to be able to provide you appropriate advice.

Effective July 1, 2014, financial institutions are required by law to report annually to CRA on accounts where a client is unwilling or unable to provide documentation for FATCA, one of more U.S. owners are specified ”U.S. Persons,” undocumented account holders for FATCA purposes, and passive entity with one or more controlling persons that are specified “U.S. Persons.” The information that must be sent to CRA includes name, address, TIN/SIN and total account value.

If you are not sure if you have a reporting obligation, we encourage you to speak with your wealth advisor who should be able to communicate with your independent tax professional, and together ensure your financial accounts are documented correctly and you are fulfilling your reporting requirement, if any.  

This article is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication.

Another good reason to have an accountant – Rules change on foreign reporting

In 1997, the Canada Revenue Agency (CRA) proposed changes on how foreign property is reported. In 1998, CRA introduced the reporting of certain foreign property by requiring all Canadian tax filers to answer, “Did you own or hold foreign property at any time in 1998 with a total cost of more than CAN $100,000?” If you answered “yes” to this question then you were required to complete a “Foreign Income Verification Statement” – CRA and accountants refer to this form as T1135. In my experience, the biggest misunderstanding people have relates to the term “foreign property” and what is included and excluded. An accountant is invaluable in providing guidance in complex areas such as these.

Since 1998, modifications have been made to the T1135 but the form was relatively easy to complete as CRA provided broad monetary ranges for disclosure (i.e., $100,000 to $300,000; $300,000 to $500,000; etc.) and broad categories (i.e., shares of foreign companies without the name of the companies or the investment firm, real estate without the specific location, bank accounts without the name). This information was all that was required, along with a general indication of where the foreign property was held.

In June 2013, CRA released a new version of T1135, to be applicable for 2013 and later taxation years. CRA then delayed its application so that it would only apply for taxation years ending after June 30, 2013. The new version of T1135 was very detailed and many tax practitioners felt it was too onerous. The new T1135 required more detailed information on each specified foreign property. The additional information would require the following for each specified foreign property: name, country code, institution, maximum cost during the year, year-end cost of the property, income or loss, and capital gain or loss.

Accountants and financial advisors were sorting out the logistical nightmare of these new requirements. Many individuals who prepare their own income tax returns are likely unaware of the new requirements or the penalties for not complying.

After listing the new requirements, CRA complicated it further by providing exclusions from the detailed reporting, including specified foreign property where the Canadian resident received a tax slip (T3 or T5). CRA provided different options with respect to how the new T1135 form could be completed (i.e. standard reporting method versus transitional reporting method).

Near the end of February 2014, CRA announced new transitional relief for Canadians who must comply with the more detailed T1135 information reporting. At this stage, the transitional relief applies only for the 2013 taxation year. This relief is only allowed for investments that you received a T3 or T5 for the income. Other investments that issue slips such as a T5013 do not meet the exclusion and must be listed in detail. This relief is intended to assist taxpayers in transitioning to potentially the more onerous reporting requirements in future years. The transitional relief will allow CRA time to respond to concerns raised by Canadian residents.

One of these reliefs relates to individuals who have foreign property held in non-registered investment accounts with Canadian securities dealers. Rather than reporting the above details of each specified property individually (i.e. each individual stock), investors are able to report the combined “market value” of all such property at the end of the 2013 taxation year.

To illustrate we will use John Smith whose only foreign property is the 30 US stocks he holds in non-registered account 999-99999 with ABC Financial. For illustration purposes only we also assumed that the T3/T5 reporting exception is not being utilized for any specified foreign property. As of December 31, 2013 Mr. Smith’s book value on his USD investment account is $150,000 USD, and the market value is $250,000 USD. The USD to CAD dollar exchange rate on December 31, 2013 is 1.0636 per the Bank of Canada website. The USD to CAD dollar average exchange rate for 2013 is 1.0299148 per the Bank of Canada website. Mr. Smith received a T5 slip totaling $9,000 USD in income on his US dollar denominated account. Mr. Smith’s investment advisor sent him a realized gain (loss) report showing a net realized gain on 2013 dispositions of $14,300 CAD on his US holdings. The first step is to determine if the “book value” of certain foreign property exceeded $100,000 CAD at any time during 2013. Mr. Smith’s case is easy as his book value clearly exceeded $100,000 CAD on December 31, 2013 – he is required to file the T1135. The 2013 relief mentioned above allows Mr. Smith to greatly simplify the reporting with respect to his US dollar brokerage account in section six of T1135. Under Description of property he can enter “ABC Financial Account # 999-9999”. Under Country code he enters CAN even though he owns stocks in the US and other countries. Under Maximum cost amount during the year he can enter “0”. Under Cost Amount at year end he enters the “market value” in Canadian dollars of the account at the end of 2013 which is $265,900 (calculation: market value $250,000 US x year end exchange 1.0636). Under Income (loss) he enters the converted amount of $9,269.23 (calculation: income $9,000 USD x average exchange 1.0299148). Under Gain (loss) on disposition he reports the $14,300 amount from the realized gain (loss) report that his advisor already sent him which is denominated in CAD dollars.

The above analysis should not lead people to do the form themselves unless they understand all the reporting requirements thoroughly. It is by no means a comprehensive explanation of the revisions. I would strongly urge any person who has foreign holdings (outside of registered accounts) to discuss their reporting obligations with their accountant and advisor. Under the CRA website (cra-arc.gc.ca) you can search for T1135 (and other foreign disclosure forms) to obtain general information and answers to commonly asked questions. The website also has a table of penalties for not filing various disclosure forms applicable to your situation. As an example, Mr. Smith could be fined $25 per day (up to a maximum of $2,500) for not filing the T1135. If CRA feels that Mr. Smith knowingly didn’t file the form the maximum fine is $500 per day (up to a maximum of $12,000). The penalties above can also apply to prior years, albeit the prior year’s forms were relatively simple to complete and the taxpayer may have innocently not filed because they were unaware of the requirement to file.

The deadline to file Form T1135 has been extended to July 31, 2014 for all taxpayers. Currently, the T1135 form cannot be electronically filed. Most tax correspondence on Vancouver Island goes to the Surrey Taxation Centre; however, the paper copy of this form must be mailed to the following address: Ottawa Technology Centre, Data Assessment and Evaluations Program, Verification and Validation, Other Programs Unit, 875 Heron Road, Ottawa ON K1A 1A2.

This article is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication.

Staying competitive on a global stage

Downward economic cycles can be frustrating for some people as they generally result in layoffs and declines in average wages. In an effort to stay competitive in a downward economic cycle, companies will sometimes choose to eliminate benefits (such as medical or dental), modify pensions in a negative way, or simply keep wages the same as the cost of living increases. However, when economic conditions improve then the upward cycle of hiring and increased salaries follows. Beyond these normal economic cycles are some considerations for future generations for how the global marketplace will impact their employment and financial opportunities.

It is clear that the emerging markets, such as China, India, Brazil, etc are outpacing developed countries in the area of growth. The labour market in the emerging countries is significantly cheaper and most manufacturing facilities have moved abroad. Developed countries have also used technologies and automation to work smarter – not harder. The opportunities for increasing employment in Canada with the other emerging global markets are challenging.

Perhaps this decade will be classified as the period of equalization between emerging and developed markets. The decade ahead will likely go down in history as a period of higher unemployment and a stagnant period of growth if we continue on the current path. We are living in a global market place that is becoming increasing competitive. The five biggest obstacles I see with the current employment situation are: 1) Organised labour demanding higher wages and benefits, 2) Attitude towards doing certain type of work, 3) Environmental attitudes, 4) Companies hoarding cash and not taking as much risk, and 5) Continued advancements in technology. 

It seems there are daily announcements regarding how unsatisfied some fully employed individuals are. A common complaint is not having a wage increase that matches the cost of living. Organised labour has become very powerful in developed countries demanding increased salaries and benefits. On the opposite spectrum we know about the poor employment standards and human rights issues in some of the emerging countries and how people are working for a fraction of what developed country workers make. As employees demand more, are they effectively pricing themselves out of the global market? What is the economic incentive for companies to continue their operations in Canada when other overseas markets will allow for lower costs to produce the same goods?

Some Canadians are choosing not to work because they do not want to do certain types of work. Attitude towards accepting certain types of work as well as salary levels should be adjusted if we want lower unemployment. In this period of equalization is it reasonable to force higher minimum wages, or for university graduates to expect six figure salaries immediately. If we want companies in Canada to hire people here, it has to make sense for them, relative to the global marketplace.

There is always a balance between economic progress and the environment. This is especially the case for a country such as Canada, where 45 per cent of the publicly traded companies on the S&P/TSX Composite Index are in the resource sector. It would not surprise me to see this percentage exceed 50 per cent in the next couple of years. There are economic consequences if we put up too many environmental road blocks for companies. As investors we also have to see how this impacts the companies we invest in. Other countries all over the world are continuing to develop their resource sector with less environment regulations. We continue to send raw resources to other countries that create pollution on route and in processing – a prime example of this is shipping coal to Asia.

Investors have to monitor the changing political landscape. Stringent employment and strong environmental standards have an impact on the companies we invest in. The great country we live in was built during a period where environmental and employment standards were significantly different then today. Most people drive a car to work, take a jet on vacation, enjoy lower energy and power costs to run their home, etc.. None of these activities can occur without an impact to the environment. Shoppers are often looking for the lowest price. The lowest price item is often manufactured in a country outside of Canada. The majority of Canadians would buy something made in a country that lacks appropriate human rights and environment standards if they could save money. In many ways Canadians are being hypocritical when they complain too strongly about projects that may impact the environment. If the product is going to be bought or consumed anyways, then one could argue that we should focus on getting the most economic benefit ourselves.

In controlling growth activities in our own county, we have better control over the standards that are put in place. If we continue to only consume goods manufactured abroad then we have limited control. We have people who can analyse project costs, reduce risks, and address the legitimate concerns people have.

One quote that I recently heard that I liked was the problem in North America today is not that we are taking too much risk, it is that we are not taking enough risk. The excitement of corporations expanding in years past with new ideas has largely been replaced by fear and preservation by many companies. Companies are hoarding cash and operating in regions that have fewer regulations, absences of organised labour, less litigation, and fewer environmental complexities.

Advancements in technology can be both a positive and a negative. The obvious negative is that jobs can be lost through automation. There is a cost to automating through machines to replace manual labour. As labour costs rise then companies have a greater long term incentive to automate. Machines do not go on strike to demand more, and do not require pensions and benefits.

Political announcements and regulations are having an increasingly important role to consider when monitoring the economy and picking investments. As the emerging markets continue to outpace our Canadian marketplace, we should expect the employment challenges to continue on the same path unless our attitudes change, and we become more competitive. Might our current levels of unemployment be closer to the new norm? As one wise person once said, “you can not have your cake and eat it too.”

Looking at the best ways to obtain international exposure

The term “global” is used to describe the entire world.   As an example, a global mutual fund could be primarily invested in Canada and/or the US, as it is part of the world.

The term “international” is used in Canada to describe investments outside of North America.  Picking international investments outside North America comes with a few additional challenges.

Many Canadians are comfortable investing in domestic or North American companies, this is known as home country bias.  We feel investors can be successful sticking close to home when selecting investments.   We also feel that opportunities are available for investors who want to venture outside of Canada.

Five years ago, the market capitalization of the US and Canada was 49.4 per cent and 2.6 per cent, respectively.  These two countries combined represented 52 per cent of the world’s market capitalization.

Today, the market capitalization of the US has dropped to 43.1 per cent and Canada has increased to 4.7 per cent.  Combined, the US and Canada has dropped to approximately 47.8 per cent of the world’s market capitalization.  This represents a decline of 4.2 per cent.

The primary reason for the above drop in the combined US and Canada is the significant increase in the emerging markets.  The current weighting between developed and emerging markets is 86.37 and 13.63 per cent, respectively.  Below we have noted the changes in the BRIC (Brazil, Russia, India, and China) countries, the four most commonly referred to emerging markets.

The BRIC markets
  Then Now
  Dec 31, Dec 31,
Country 2005 2010
Brazil 0.5% 1.99%
Russia 0.2% 0.79%
India 0.4% 1.15%
China 0.4% 2.34%

Source:  MSCI All Country World Investment Market Index

Growth versus Value

The terms “developed” and “emerging” could almost be stated another way.  Developed market countries (Top 10 By Country Weight:  US, Japan, United Kingdom, Canada, France, Australia, Germany, Switzerland, Sweden, and Spain) could be compared to value investing.

Emerging market countries (Top 10 By Country Weight:  China, Brazil, Korea, Taiwan, India, South Africa, Russia, Mexico, Malaysia, and Indonesia) could be compared to growth investing.

International Companies – if you own a large US and/or Canadian company then chances are you already have some international exposure.  Some companies may have a stock exchange listing in either the US or Canada but still generates significant revenue from non-domestic operations.  One approach to increasing foreign content is to focus on North American companies that derive revenues outside of Canada and the US.

US Equities – in allocating foreign investments to the US, investors should be looking for both diversification and sectors that have a competitive advantage over their Canadian counterparts.  This is where US equities can play a unique part of a diversified portfolio in sectors such as health care, consumer staples, and technology.   Canadians are able to purchase publicly traded securities through US exchanges.

ETFs – Exchange Traded Funds (ETFs) and Index Shares (iShares) are designed to closely track a domestic index, foreign index or specific sector.  They provide easy access to a wide variety of Global and International indexes.  When you invest in ETFs, you know exactly what you’re investing in as their components are generally disclosed every trading day.  ETFs have become a popular and simple way to add market exposure in a highly diversified, cost-effective way.   Investors buy and sell shares of ETFs on Canadian and U.S. exchanges.

ADRs – American Depository Receipts (ADRs) is one system of purchasing individual foreign securities through an American trust company or bank, which holds the security in safekeeping.  ADRs are generally quoted in U.S. dollars and trade on U.S. exchanges.

Mutual Funds – For years, mutual funds have marketed the merits of investing in areas such as Asia, Europe, Latin America, The Middle East and Africa.  Our view on all mutual funds is that you have to be very selective, ensure that the portfolio manager has a proven methodology and a good track record.  Always consider the liquidity of each investment and the associated costs if you should decide to sell.

Know the Risks

Prior to diving into foreign investments it is important to understand some of the main risks:

  • Currency Risk – one of the main risks to foreign investments is currency fluctuations.   Another factor that is critical when looking at foreign investments is the impact on changes in exchange rates compared with the Canadian Dollar (CAD).  Some ETFS and mutual funds attempt to minimize currency risk by employing various hedging strategies.
  • Political Risk – foreign governments may interfere with the operations of local corporations.  The stability of the government is certainly important for investors to get comfort on policy and taxation changes.
  • Regulatory Risk – many companies may seek out those countries with relatively weak regulations.  Foreign governments may be inclined to change various regulations which disrupt capital markets.
  • Liquidity Risk – the term liquidity refers to the availability of an investor to access or convert the investment into cash.   Many foreign investments have restrictions that limit the amount of trading or the frequency with which an investor may request redemption.  A market is considered liquid if an investor can convert the investment easily into cash.   Trading volume and bid-ask spreads are key indicators of liquidity.
  • Accounting Standards – There are economies around the world that do not have established accounting and auditing standards.  Others are quickly scrambling to catch up.  It is near impossible to assess the merits of an investment without true and accurate financial statements.  If financial statements exist they may be in a foreign language unknown to the investor and the standards may be different from domestic requirements.

Primer on foreign property

In 1996, legislation was passed requiring Canadian residents to disclose foreign property.  The threshold at that time was $100,000 Canadian, and the Canada Revenue Agency T1135 form was called Information Return Relating to Foreign Property.

There was plenty of discussion regarding the motives behind this new disclosure.  Some countries levy a capital tax based on net worth.  Others  have an estate tax.  The gathering of this information would certainly be useful if Canada one day ventured down this unpopular path.

Fourteen years later, we still have the same $100,000 threshold.  As you can imagine with the threshold staying constant, but prices rising over this period, more people today have to complete the T1135 form, now called Foreign Income Verification Statement.

Over the past couple of years, many Canadians have purchased (or have considered purchasing) US and foreign property.  We also have many people acquiring property in Canada and residing here who are citizens of other countries.

If you were a deemed resident of Canada in 2010, you have to answer the following question on your tax return:  Did you own or hold foreign property at any time in 2010 with a total cost of more than CAN $100,000?  If you do own foreign property of more than $100,000 then you are required to complete the Foreign Income Verification Statement (form T1135).

The types of foreign property are laid out into six categories:

  • Funds held outside Canada
  • Shares of non-resident corporations, other than foreign affiliates
  • Indebtedness owed by non-residents
  • Interests in non-resident trusts
  • Real property outside Canada
  • Other property outside Canada.

The form provides some further guidance on the property that is specified foreign property.  It also provides guidance on what is not considered foreign property including property in your RRSP, registered retirement income fund (RRIF) or registered pension plan (RPP); mutual funds registered in Canada that contain foreign investments; property you used or held exclusively in the course of carrying on your active business; or your personal-use property.

The above question and form (if applicable) is a regulatory requirement based on historical information or events that have already occurred.  Information is being shared between countries, and computer systems enable data to be audited more efficiently.  We recommend completing this form with help from a professional accountant who has appropriate tax knowledge.  Tax and financial planning today is more complicated, especially for clients who explore opportunities outside of Canada.

To help people with foreign property and income questions we gather as much information as possible.  This discussion begins with obtaining your accountants name and contact information.  Depending on the level of complexity, we would have an initial discussion with your accountant to obtain an understanding of your current tax situation.

Other information we gather are:  citizenship, residency, asset listing (including foreign property), and types of income (including foreign sources, such as pensions).  There are many US and foreign citizens who reside in Canada.  Tax and investment planning for these individuals are more complicated than Canadian born citizens who reside in Canada.

This is a difficult topic to discuss in a single column.  However, we have summarized our top ten items that we feel are important for people to discuss with their financial advisor and tax accountant :

  • Foreign House/Condo Purchase – If you have purchased real property in the US or foreign country is the property for your personal use or will it generate income?
  • US and Foreign Shares – If you have added shares of a US or foreign corporation to your portfolio, discuss the above reporting requirements and current/future tax consequences with accountant.
  • US and Foreign accounts Bonds – If you have added US or foreign government, state, municipal or corporate bonds, reporting requirements and tax consequences.
  • US and Foreign Bank Accounts – Factor into holdings and whether the T1135 disclosure is necessary.
  • UK Pensions – British expatriates are able to move pension benefits to Canada.  Speak with your financial advisor and accountant to discuss options.
  • Non-US Mutual Funds – American citizens residing in Canada should understand the changes to US tax for these investments.  Canadian mutual funds are now classified as a corporation rather than a trust.
  • Income Trusts and Pooled Funds – US citizens residing in Canada should understand the changes to US tax for these.
  • Registered Education Savings Plan – This type of account is classified as a foreign trust in the US (required IRA forms 3520 and 3520A) and we recommend that you discuss the reporting requirements and tax consequences with your accountant.
  • Tax Free Savings Accounts – This type of account is classified as a foreign trust in the US (required IRA forms 3520 and 3520A) and we recommend that you discuss the reporting requirements and tax consequences with your accountant.
  • US and Foreign Property – We recommend you speak with your financial advisor and accountant prior to purchases of foreign property to ensure you understand the tax and planning consequences.

 

How to benefit from a declining US dollar

Is the strength in the Canadian dollar good news for your investments?  It really depends on where you are currently invested.  If you’re primarily within Canada you may have felt little impact from our dollar rising to parity with the greenback.

Canadian investors most affected are those who have greenback-denominated investments as U.S. investments are negatively impacted when the U.S. dollar deteriorates.

We pay our bills in Canadian dollars and must calculate investment returns in the same way.  People with investments in the United States or other foreign securities should track the foreign exchange rate on the date of each purchase and sell.  Upon selling a position you will need to report the capital gain or loss in Canadian dollars on your tax return for taxable accounts.

Share Illustration

Four years ago an investor purchased 200 shares of General Electric (GE) at $30 US when the exchange rate was 1.00 USD to $1.40 CDN.  The adjusted cost base of the purchase in GE is $8,400 CDN ($30 x 200 x 1.40).

Let’s assume that GE is trading today at $41 USD and the CDN exchange rate is equal to the U.S.dollar.  At first glance the investor looking at their investment statement may feel they have a capital gain, after all the stock has increased from $30 to $41.  If the investor were to sell these shares today, the proceeds for Canadian tax purposes would be $8,200 CDN ($41 x 200 x 1.00).  The investor would realize a capital loss of $200 CDN even though the share price had increased by approximately 36 per cent.  The exchange rate difference resulted in a capital loss.

Currency exposure should play an important component of any investment decision including bonds, money markets, bank accounts, etc.  Prior to the end of the 2007 taxation year we encourage you to review your foreign denominated holdings.  To analyse the currency impact, you will need to determine the date you purchased your investment along with the exchange at that time.  This will assist you in estimating the adjusted cost base in Canadian dollars.  If you are unsure of the foreign exchange rate on a given day you may look it up on a foreign currency website such as www.oanda.com.  The next step is to look at these same holdings and calculate the current market value in Canadian dollars.  You may be surprised by the outcome of this exercise!

For the last couple of years many economists have been forecasting that the Canadian dollar would get stronger relative to the U.S. dollar.  Many investors avoided investing in U.S. denominated securities for this reason.  Now that we are at parity, what should investors be considering?  When seeking out U.S. denominated investments the following tips should be considered:

Tip 1 – Settlement

Investors with registered (RRSP, RRIF) and non-registered (cash, margin) accounts should consider the most advantageous place to hold foreign denominated securities.  If you have the option, we recommend holding foreign denominated securities within non-registered accounts.

Transactions within registered accounts settle in Canadian dollars.  Non-registered accounts can hold foreign currencies and also settle those transactions in that currency.  This applies to the initial purchases, income payments, and sells.

Tip 2 – Currency Spread

Every time one currency is converted to another there is a cost to the investor.  Some places may charge a service fee or transaction cost.  The biggest cost is the difference between the price that investors buy at (the bid) versus the price that investors sell for (the ask).  This is commonly referred to as the spread.  If your investment is held in a non-registered account you should consider maintaining a U.S. component.  You may ask your financial advisor to settle the transaction in U.S. dollars.  Proceeds from the sell of one U.S. denominated company may be used to purchase another U.S. investment without conversion costs.  Interest and/or dividends from U.S. investments may also be paid in U.S. dollars.

Tip 3 – Taxation

Certain foreign income is subject to a withholding tax and may be an absolute cost to you if the underlying investment is held in a registered account.  If the foreign investment is held in a non-registered account then Canadian residents may be able to claim a foreign tax credit for the amount withheld on their income tax return.

Tip 4 – Sectors

Many investors may feel that investing in the U.S. provides diversification by geography and currency.  Another great reason to consider foreign investments is to obtain exposure to different sectors.  Canada is very strong in the resource and financials sectors.  Countries such as the U.S. often play a part of a diversified portfolio in sectors such as consumer goods, technology and health care.

Tip 5 – Defensive Stocks

The term defensive stock is used for those companies whose financial results are not highly correlated with the larger economic cycle and will generally have better performance during recessionary periods.  Defensive sectors include utilities and consumer staples such as food, beverages, prescription drugs and household products.  Fear of a U.S. slow down or recession may be one reason why some investors may want to focus on Canadian domiciled investments or those outside of North America.  Some of the best defensive names are in the U.S.  Many of those same companies have significant international operations which may safeguard against a domestic slowdown.

Tip 5 – Time Horizon

Some economists are forecasting further strength in the Canadian dollar relative to the U.S. dollar.  Unfortunately no one knows for certain which way currencies will move.  Several variables impact the direction of currencies and may result in further weakness in the US dollar in the short term.

Investors with a longer-term time horizon and the risk tolerance to withstand currency fluctuations should look at all possible outcomes, this includes a U.S. dollar that begins to appreciate during your time horizon.

The argument for diversification and holding U.S. dollar investments makes even more sense when our dollar is strong and U.S. investments are cheaper.  Movements in a foreign currency may have a greater impact on returns than the movement in the stock price.

 

How will the rising dollar hit your investments?

Strength in the Canadian dollar relative to the U.S. greenback has benefited travellers heading south for a vacation.  Apart from a cheaper holiday, many Canadians are seeing the fall out from a strengthening loonie. Exports are becoming more expensive and affecting many industries.  Some reports also state that tourism levels are dropping as vacations to Canada have become more expensive when compared to other destinations.   

Is the strength in the Canadian dollar good news for your foreign investments?  As Canadians we are very susceptible to changes in foreign exchange rates.  Investors most affected are those that hold U.S. dollar denominated investments.  We pay our bills in Canadian dollars and must calculate investment returns in the same way.

Investors with U.S. or other foreign securities should track the foreign exchange rate on the date of each purchase and sale.  Upon selling a position you will need to report the capital gains or losses in Canadian dollars on your tax return.

Here’s some examples:

Share Illustration:  Two years ago an investor purchased 200 shares of General Electric (GE) at $30 US when the exchange rate was 1 USD = 1.3685 CDN.  The adjusted cost base of the purchase in GE is $8,211 CDN ($30 x 200 x 1.3685).  Today, GE is at $35 US.  At first glance many investors looking at their investment statement may feel they have a capital gain, after all the stock has increased from $30 to $35.  If the investor were to sell these shares today the proceeds would be $7,644 CDN ($35 x 200 x 1.092) realizing a capital loss of $567 CDN.  Although the share price had increased the deterioration in the currency resulted in a loss.

Bond Illustration

Five Years ago an investor purchased a $50,000 US corporate 5 year bond when the exchange rate was $1 US  = $1.5347 CDN.  The adjusted cost base of this corporate bond is $76,735 CDN ($50,000 x 1.5347).  Assuming that the exchange rate is 1.092 upon maturity, the proceeds would be $54,600 ($50,000 x 1.092).  It may be shocking for some to believe that on maturity the realized capital loss would be $22,135 on a $50,000 bond.

Bank Accounts

For individuals holding foreign currency bank accounts and term deposits the loss may not be realized for tax purposes unless the amount in the account is converted to Canadian dollars.  One strategy may be to convert the funds to Canadian dollars at least for a period of time to recognize the loss for tax purposes.

Review US Denominated Holdings

Investors may benefit from looking at their US holdings.  Determining the date you purchased your securities and the exchange rate on that day will assist you in estimating the adjusted cost base in Canadian dollars.  If you are unsure of the foreign exchange rate on a given day an excellent foreign currency website is www.oanda.com.  The next step is to look at these same holdings and calculate the current market value in Canadian dollars.  You may be surprised by the outcome of this exercise!

Tax Planning

For many years, investors had to deal with gains relative to foreign currencies upward movements.  Over the last few years, investors may have unrealized losses on their US dollar denominated holdings that they should be factoring in to their tax planning.  Capital losses may be used to offset current year gains.  At this time, Canadian taxpayers are able to apply any realized losses back three years or carry them forward indefinitely.

Currency Risk

The illustrations above highlight the effects of a strengthening Canadian dollar relative to the US dollar.  A deteriorating Canadian dollar has the opposite effect.  Economists attempt to provide guidance by offering targets on foreign currency rates and recently, that guidance suggests further weakness in the US dollar.

We do not want to suggest that investors avoid securities denominated in other currencies.  There are some very good investment opportunities beyond our borders.  A diversified portfolio has a portion allocated to foreign denominated investments.  Many Canadian companies conduct much of their business south of the border.  Currency fluctuation will certainly influence the demand for their goods and services.

Investors who want to reduce foreign currency risk from their portfolio should assess any currency hedges that may be in place for their respective investments.  Movements in foreign currencies may have a greater impact on your Canadian dollar return than the movement in the security price.

Before implementing any strategies discussed in our columns we recommend that you speak with your financial and tax advisors.

 

A Foreign Investing Menu

The last two columns discussed the importance of having foreign investments within a diversified portfolio.  We also highlighted some of the inherent risks.  Today, we will look  at the most common methods investors can use to obtain foreign exposure.

Where to begin?

We are fortunate today to have a variety of different foreign investment options available.  The four most common methods of obtaining foreign exposure are through direct US equities, Exchange Trade Funds (ETFs), American Depository Receipts (ADR) and Mutual Funds.

US Equities

In allocating foreign investments to the U.S., investors should be looking for both diversification and sectors that have a competitive advantage over their Canadian counterparts.  This is where US equities can play a unique part of a diversified portfolio in sectors such as health care, consumer goods, and technology.   Canadians are able to purchase publicly traded securities through US exchanges.

ETFs

Exchange Trade Funds (ETFs) are designed to closely track a domestic index, foreign index or specific sector.  They provide easy access to a wide variety of Global and International indexes.  When you invest in ETFs, you know exactly what you’re investing in as their components are generally disclosed every trading day.  ETFs have become a popular and simple way to add market exposure in a highly diversified, cost-effective way.   Investors buy and sell shares of ETFs on Canadian and U.S. exchanges.

ADRs

American Depository Receipts (ADRs) is one system of purchasing individual foreign securities through an American trust company or bank, which holds the security in safekeeping.  Some household names that trade as an ADR are:  Toyota Motor Corp, HSBC Holdings, ING Group, Sony, etc.  ADRs are generally quoted in U.S. dollars and trade on U.S. exchanges.

Mutual Funds

For years mutual funds have marketed the merits of investing in areas such as Asia, Europe, Latin America, The Middle East and Africa.  Our view on all mutual funds is that you have to be very selective, ensure that the portfolio manager has a proven methodology and a good track record.  Always consider the liquidity of each investment and the associated costs if you should decide to sell.  Some investors may own “International” and/or “Global” mutual funds.  There is a difference.  An “International” mutual fund generally refers to those that invest in securities outside of North America with no investments within Canada or the U.S.  A “Global” mutual fund invests throughout the world, including Canada and the U.S.

How much foreign?

Until this year, the government imposed a maximum limit of 30 per cent foreign content within registered (RRSP, RRIF, etc.) accounts.  This was eliminated with the 2005 federal budget approval.   With the removal of this regulation, many individuals may be left wondering what percentage of foreign investments they should hold.   Investment advisors should be able to assist you in determining the appropriate asset mix.  Remember to look at your Investment Policy Statement to ensure that the portion allocated to foreign investments is consistent with your overall investment strategy.

Investors may still feel uncomfortable branching off into foreign investments.  This uncertainty is not uncommon and a prime reason for discussing foreign investment options with your investment advisor.

 

Foreign investment risks

In our last column we reviewed where Canada fits in among the world’s largest exchanges.   Many investors have a “home country bias” that prevents them from looking at the many foreign investment opportunities because it is perceived as too risky.  It’s true that investments outside our border involve additional risks not present in Canadian securities, but we feel the risk of having no foreign exposure is greater.  Let’s look at some of the potential dangers.

Currency Risk

One of the main risks to foreign investments is currency fluctuations.   Another factor that is critical when looking at foreign investments is the impact on changes in exchange rates compared with the Canadian Dollar.  Using the U.S. dollar as an example, the loonie ended the year with a $1 US to $1.16 CDN exchange rate.  Some economists have a one-year forecast of $1 US to $1.11 CDN.  This would result in a Canadian dollar appreciation of 4.7 per cent. If this forecast is correct, and all else being equal, investors would be better off having Canadian dollar denominated investments.  It is quite possible for individuals with U.S. securities to have sold a position for a higher share price but incur a loss after the currency conversion.  As Canadians we pay our bills in Canadian dollars and we need to consider currencies when determining real returns.

Political Risk

Foreign governments cay interfere with the operations of local corporations.  The stability of the government is certainly important for investors to get comfort on policy changes.  Investors also want to know that if things go off track, will the rule of law prevail?  China is the perfect country to discuss political risk.  Investors should not ignore the fact that this one-party state is going through significant reforms.   The rules under which China operates today could change with little legal recourse.  Canada witnessed evidence of political influence on the investment climate in 2005 with the elimination of the foreign content rules for registered accounts, announcements regarding income trusts and the proposed changes on the tax treatment of dividend income.

Regulatory Risk

Many companies may seek out those countries with relatively weak regulations.  Countries without labour standards may have a competitive advantage over other countries that have stricter regulations.  The lack of environmental guidelines may increase profits but at what cost?  Environmental catastrophes can severely damage or bankrupt a corporation.  India is a good country to look at regarding regulatory risk.  Many corporations in both Canada and the United States have outsourced much of its operations to lower cost regions such as India.  Governments around the world change the regulation on certain industries and intervene in ways that affect the normal flow of the markets.

Liquidity Risk

The term liquidity refers to the availability of an investor to access or convert the investment into cash.   Many foreign investments have restrictions that limit the amount of trading or the frequency with which an investor may request redemption.  A market is considered liquid if an investor can convert the investment easily into cash.   Trading volume and bid-ask spreads are key indicators of liquidity.

Accounting Standards

Investors were outraged with the shortfalls that have been identified with the failures of corporate giants such as Enron or WorldCom.  These failures occurred in a country with established accounting and auditing standards and a strong regulatory body.  There are economies around the world that do not have established accounting and auditing standards.  Others are quickly scrambling to catch up.  It is near impossible to assess the merits of an investment without true and accurate financial statements.  If financial statements exist they may be in a foreign language unknown to the investor and the standards may be different from domestic requirements.

In our next column we will discuss the numerous ways that Canadian investors can add foreign exposure to their portfolio.  It is important when adding foreign investments that it is consistent with your overall portfolio strategy.   If you do not have a strategy that takes into account foreign investments we recommend that you discuss this further with your investment advisor.

 

Foreign Investing 101: Where Canada fits in

With our domestic market trading at historic highs investors are wondering how long it will last.  It may be a good time to consider increasing exposure to foreign markets, which is a component to a properly diversified portfolio.

How does Canada measure up?

Canada represents approximately 2.6 per cent of the world’s market capitalization.  Does this suggest that a diversified portfolio should have only 2.6 per cent invested in Canada?  Canada’s market capitalization represents the value of Canadian stock exchanges divided by the total value of approximately 50 stock exchanges around the world.  The market capitalization of the world’s largest stock exchanges are as follows:

United States

49.4%

Brazil

0.5%

Australia

1.2%

Switzerland

2.6%

Japan

10.8%

Mexico

0.5%

Finland

1.0%

Netherlands

2.3%

United Kingdom

8.8%

India

0.4%

Hong Kong

1.0%

Italy

1.9%

France

4.9%

China

0.4%

Taiwan

0.7%

Sweden

1.4%

Germany

3.7%

Russia

0.2%

Korea

0.6%

Spain

1.3%

Canada

2.6%

All Others

3.8%

Source:  Morgan Stanley Capital International – MSCI All Country World Free Index.

The MSCI indexes are widely used by investment firms and investors for benchmark purposes.  Among their indices the MSCI All Country World Free Index includes approximately 50 countries.

Why look beyond Canada?

If Canada’s relatively small size in world market capitalization doesn’t convince investors to consider looking beyond our border then let’s consider a few other factors.  First, why limit investment opportunities to the best companies in Canada when investors can expand that to the best companies in North America or the world?  Canada is very strong in financials and resources; however, other countries may dominate in other sectors.  Other reasons to look beyond our border are the relative strength of our dollar to other currencies and the rate of growth our economy is expected to grow relative to others.

Growth in 2006

At the end of every year economists around the world are busy generating reports.  They provide opinions on the outlook for the upcoming year for various economies such as the United States, Canada, Japan, China, India, etc.  Summarizing some interesting points regarding growth rates (real GDP – Gross Domestic Product) from a recent “Global Economic Research – Global Outlook” report written by Warren Jestin and Mary Webb:

  • Overall trend is global growth is slowing down
  • Emerging markets will continue to lead

North America

  • Canada’s growth rate is expected to be near three per cent, in line with the trend over the last couple of decades
  • The expected growth rate for the United States is forecasted to be slightly less than three per cent
  • Mexico is expected to outpace both Canada and the United States by at least half a percent

Europe and Japan

  • Canada’s three per cent growth rate may not sound that exciting unless you compare it to the 1 ½ to two per cent growth rate expected in Japan and many European countries

China and India

  • China is expected to top world charts with annual growth rates between 8 ½ to nine per cent
  • India’s growth rate is forecasted between seven to 7 ½ per cent this year
  • Both economies are growing at more than three times the average rate in the G7 (the seven leading industrial countries include US, Germany, Japan, France, UK, Canada, Italy)
  • Each nation has more people than the combined populations of the United States, the Euro Zone and Japan

Considering Foreign Opportunities

Although investors are comfortable investing in domestic companies that are close to home (known as “home country bias”), a properly constructed portfolio should contain foreign investments.   The next two columns discuss the additional risks and methods of investing in foreign securities.