The Calculation Tools
Many kudos go to TaxTips.ca's free Borrow to Invest Calculator that takes account of different tax rates in the various provinces (and shows how the bottom line can vary a lot across the country). We have used the calculator for our examples.
The yield to redemption on the preferred share example has been figured out using Shakespeare's yield to call calculator.
Example 1 - Leveraging a Canadian Equity ETF
Our first example uses the most popular Canadian equity ETF, the iShares S&P TSX 60 Index Fund (TSX: XIU), which features several desirable qualities:
- Diversification: This ETF holds shares of the 60 biggest companies in Canada, as determined by their market capitalization. Default risk is more or less nil, though of course there can be severe market dips of up to 40% as investors well know having passed through the 2008 crash.
- Passive Index Tracking: XIU only occasionally trades when the index itself changes. That meets our goal of trade minimization to defer paying capital gains. We note that despite its passive investing strategy, even XIU has unavoidably not been perfect in this regard in the past, as can be seen in the hefty capital gains distributions in some recent years, like 2006 (see the Distributions for XIU here).
- Canadian Equities: The Canadian-only holdings mean that dividends distributed to the investor are eligible for the enhanced dividend tax credit, another tax advantage.
- Healthy Dividend Yield: XIU's dividend yield is currently around 2.3%. This cash income to the investor will help meet a substantial part of the cash outflow for interest on the loan taken out to invest, thus lessening the potential for strain and stress on the investor.
- Investment in Taxable Account: this is to take advantage of the deductibility of loan interest, the favourable tax treatment of capital gains and the tax credit for dividends.
- Investor Taxable Income: $60,000 or $120,000. The investor's job earnings provide the stable base to support the leveraged investing. We compare what happens with either middle income or a high income investor.
- Amount Borrowed: $50,000. We use the same amount for comparing the middle vs higher earning investor, though the latter could probably easily manage a bigger loan.
- Loan Interest Rate: 4%, based on secured loan rates commonly available now per Fiscal Agents Consumer Loans.
- Investment Time Horizon: 15 years, to allow for market swings up and down and increase the chances that the net market return over that period will be positive and reasonably close to our expected return.
- Expected Return: 6%, a total of the current 2.3% dividend rate plus capital gains to make up the rest. As we wrote about in our previous post, that seems a reasonably conservative and achievable figure given the current TSX market level.
A) TaxTips calculator screenshot below for an Ontario investor earning $60,000 of other taxable income.
- Despite loan interest payments of $2000 per year (4% of $50k) the disposable income difference after tax only requires a net cash outlay of $264 at most in year 2, which declines and becomes positive - the investor receives cash in pocket - from year nine onwards.
- After 15 tears, the investor is better off by a total cumulative amount of $34,665, i.e. net of the loan. That's a very nice gain, providing of course all goes according to the assumptions.
B) Summary Table By Province and Taxable Income Level
- Income level makes little difference overall within each province. The net gain is very close to the same whether income is $60,000 or $120,000.
- Provincial tax rates make a substantial difference in the net gain, almost a 20% difference between the highest / best in Quebec (over $40,000) and the lowest / worst gain in Nova Scotia ( about $34,000).
Example 2 - Leveraging a Canadian Split Share Preferred
Our second example uses Big Bank Big Oil Split Corp (TSX: BBO.PR.A) as the investment. Its features:
- Redemption Date & Exact Return: On 30 December 2016, the investor is promised the $10 redemption value, which means the current $10.25 market price will converge by that date to the $10 amount. The fixed duration of the investment allows us to compute the exact return, or yield, that our investment will achieve, using the above calculator from Shakespeare, in this case 4.58%. In addition, the investment held to maturity will produce only dividend income for tax reporting each year. There will be a small capital loss ($10.25 - $10) to report, only at maturity.
- Dividend Yield: Note that the current dividend payout is 5.12%, which exceeds the total yield due to the capital loss.
- Investment Grade: Backed by the value of the corresponding Split Capital shares (see our discussion of how Split Preferreds work here), which are invested in a portfolio of shares of six Canadian banks and ten oil and gas producers, DBRS rates BBO.PR.A as P2-low, which is investment grade and thus well protected against default.
- An Alberta investor with $60,000 taxable income would be $3,340 richer after 5 years. (The total gains are less in total than for Example 1 since the investment only lasts 5 years.)
- Net after tax cash flow is positive every year (we do not show the TaxTips screenshot of this result). The investment should sustain the loan on a cash basis.
- Provincial differences are even more pronounced, with Quebec, still at the top of the list, gaining twice (!) as much as the perennial heavy tax bottom feeder, Nova Scotia.
Caveats and Cautions:
The results depend on the assumptions. That the loan interest rate will stay at 4% is unlikely. Plugging in different numbers to the calculator, for example to see what a 5% interest rate might do to the net result, or a much smaller capital gain on XIU, could show how much leeway there is for a profitable outcome. Another variation would be to make the loan amortize, which would progressively reduce the loan and the leverage and thus the risk, over the investment horizon. An amortizing loan could enable you the investor to lock in a fixed loan interest rate. It would also indicate the cash flow required and give you an idea whether it would be supportable. Finally, to be sure of what you are doing, it may be wise to consult a professional.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.