Wednesday, February 18, 2009

Fair Accounting of Capital Losses

As previously posted, fiscal laws are messy. Not only that, but some are unfair in the sense that they penalize low-income taxpayers. Capital losses are a very good example of this. Using the settlement method (which is the standard method used to calculate capital gains and losses on shares in Canada), the value of securities is only taken into account when an individual executes transactions. Though this method has the advantage of being very simple, minimizing tax liability with it requires a crystallization of losses through actual transactions. When dealing with shares, such transactions cost about 20$ per security (plus management fees).

Individuals with valuable portfolios can crystallize losses on a daily or monthly basis, maximizing their capital losses at all times, whereas their poorer compatriots can't afford 20$ per crystallization (this number may seem low, but someone who owns many different securities will see the 20$ multiplied by the number of securities that he holds).

Since market data can easily be collected for actively traded securities, I would recommend amending the capital taxation laws so that losses are automatically crystallized without needing to sell and buy back the securities for any holding of less that 0.1% of the outstanding number of that security. An even better method would be to bring transaction costs down to 0$, but that's more complicated.

Keeping USDs on Income Account

Fiscal laws are always a mess. In Canada, superficial loss and stop loss rules make them even more so.

Upon selling a property, the taxpayer always has a taxable gain or loss. This allows the taxpayer to choose which instruments he wants to sell in order to defer taxable gains for as long as possible. For very liquid instruments, transaction costs involved in selling and then immediately buying back instruments are low. This allows taxpayers to crystallize losses when instruments are trading at a low value.

The Canadian government tried to somewhat patch this loophole by enacting the superficial loss and stop loss rules. In short if you buy back the same instrument within 30 days of selling it, the loss is denied, but can be claimed when the instrument is sold later on. Gains are always taxable immediately.

It was easy to get around this rule by having an affiliated party do the buying: your spouse, your RRSP, your trust or your company could be the other party. These loopholes were patched as well: any affiliated party that buys securities sold within +/- 30 days also triggers the superficial or stop loss rules.

When the selling party is a physical person, the denied loss is transferred to the affiliated person. When the affiliated person sells the instrument, he can claim the loss. When the selling party is a moral person (RRSP, trust or corporation), the loss stays with the seller. It can be claimed by the seller only when the buyer disposes of the security.

This rule is particularly unfair when a person sells an instrument at a loss and buys this same instrument within his RRSP. The loss is transferred to the RRSP, but since the RRSP does not pay any taxes, the loss cannot be claimed against any gains. Worse yet, it's not possible to transfer the loss out of an RRSP, since the RRSP is not a physical person.

Though it's a logistic burden, it's very easy to hold different instruments in RRSP and non-RRSP accounts. The one instrument which is very likely to be held in both accounts is the USD. You can't get around holding cash when trading stocks! So any foreign exchange losses resulting from USD trades have a tendency of being transferred to an RRSP and die there!

Well, there is good news on this front. One can elect to place a given instrument in the income account forever. That's right, once you've elected to hold USD in the income account, you can never bring them back into the capital account. Superficial loss and stop loss rules don't apply to property held in the income account, for some obscure reason. The downside is that gains are taxed as income rather than as capital (at full rate rather than half rate). The upside, is that losses can be applied against other income including salary at the full rate (rather than not at all). Since foreign exchange fluctuations have an a priori expected value of zero (as compared to shares or bonds which nominally increase in value over time), holding USD in the income account results in a better hedge than holding them in the capital account! When factoring in utility, there is absolutely no reason to hold USDs in the capital account. Thank God!