current trends and issues in financial planning 2006 edition

Current Trends and Issues in Financial Planning

2006 Edition

Roxanne Eszes, CFPCleartech Documentation & [email protected]

2006 Edition CE CourseOver 160 pages of new material

Consolidates new developments in one place

Covers a wide range of topics across the CFP syllabus

Qualifies for 10 CE hours with exam

20 question M/C exam

– 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

Professional Practice Update

– FPSC Practice Standards now in force

– What happened to Fair Dealing Model?

– CSA’s Registration Reform Project

More Course Highlights

Economic Update

– Review of Canada’s economic framework

– Recent Canadian economic developments

– External influences

– Risks to Canada’s economic outlook


Personal Finance Update

– Recent statistics on consumer spending

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


Income Tax Update

– Federal personal income tax parameters for 2006

– Synopsis of 2005 and 2006 Budget proposals of interest to CFPs


Retirement Planning Update

– Creditor protection for RRSPs upon bankruptcy

– Pension funding concerns

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

– New stats on retirement life expectancies – from OAS study


Investment Planning Update

– Structured Products• Closed-end funds• ETFs• Principal protected notes (PPNs)• Split Share corporations

– Income trust developments

– LSIF developments

Today’s Presentation

Income Tax Changes (Budget 2006 and others)

Principal protected notes

Split share corporations

Basic Personal Amount

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

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

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

Lowest Federal Tax Rate

16% in 2004

Liberals cut this to 15% in 2005

Conservatives increased it to 15.25% in 2006

15.5% in 2007 and later years

Middle and Top Tax Brackets

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

Never passed into law

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

Child Disability Benefit (CDB)Budget 2006 increased CDB to $2,300

effective July 2006

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

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

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

Universal Child Care Benefit (UCCB)

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

For all children under 6 years old

Taxable to lower-income spouse

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

GST Reduction

From 7% to 6%, July 1, 2006

No change to GST credit

No change to GST rebates on new housing

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

Taxpayer deemed to dispose at FMV, resulting in capital gain

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

Budget 2006 makes inclusion rate 0%

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

Donations, continued

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

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

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 CorpsOrdinary dividends grossed up to 125%,

then 13.33% tax credit

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

Applies beginning 2006

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

Dividends, continued

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

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

Tax comparable to income trusts

Dividends, Tax Planning

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

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

Tax Grab Bag

Canada Employment Credit (2006)– 15.25% of $250 in 2006 = $38.13– 15.5% of $1,000 in 2007 = $155.00– Self-employed people would have to

incorporate and become employees to receive this

Tax Grab Bag

Tools Tax Deduction (after May 2, 2006)– tools required by employer, over $1,000 but

under $1,500 – max. $500 deduction in any one year

Textbook Tax Credit (2006)– 15.25% of eligible amount – $65/month full time study, $20/month part

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

amounts

Tax Grab Bag

Scholarship income (2006)– Full amount tax free (used to be only first

$3,000)

Mineral exploration expenses tax credit– 15% of expenses passed on through flow-

through shares (agreements after May 2, 2006 but before March 31, 2007)

Pension credit (2006)– pension income amount increased from

$1,000 to $2,000 = new credit of $152.50 for 2006

Tax Grab Bag

Children’s Fitness Tax Credit (2007)– 15.50% on up to $500 of eligible expenses =

tax savings of $77.50

Public Transit Passes (July 1, 2006)– 15.25% on cost of monthly or annual transit

passes

Adoption Expenses Tax Credit (2005)– 15% on up to $10,000 (2005), indexed– only in year adoption is finalized

Tax Measures for DisabledExpanded eligibility for DTC, and thus

for the disability supports deduction

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

Clarified eligible medical expenses (no more hot tubs)

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

Business Income Tax Changes

General Corporate Tax Rate

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

– Reduce this to:

• 20.5% on Jan. 1, 2008

• 20% on Jan. 1, 2009

• 19% on Jan. 1, 2010

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


Small Business Limit

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

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

– Must still be shared between associated corporations


Small Business Tax Rate

– Rate to decrease from 12% to:• 11.5% in 2008• 11.0% in 2009

Non-capital Losses and ITCs

– Carried back 3 years

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

Principal Protected Notes

Combine exposure to underlying securities with a principal guarantee

Maturity: 7 to 11 years

Sold via offering memorandum

Trade on exchange or secondary market facilitated by issuers

43 issues on the TSX

PPN Guarantee StructuresZero coupon bonds – 60% to 70% of investors’

capital, depending on term to maturity and interest rates

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

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

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

PPN Guarantee Structures

Constant Proportion Portfolio Insurance

Time

Notional Strip Value or Floor

Maturity

Principal Guarantee

Value of PPN’s assets

PPNs – CPPI

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

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

Requires constant supervision and quick action if things go sour

PPNs – CPPI – Allocation Grid

Cushion (% of original PPN assets)

Allocation to Underlying Assets

Allocation to Strip Bond

≥ 40% 200% 0%

≥ 40% <50% 150% 0%

≥ 30% < 40% 100% 0%

≥ 20% < 30% 75% 25%

≥ 15% < 20% 50% 50%

≥ 10% < 15% 25% 75%

≥ 5% < 10% 15% 85%

≥ 0% < 5% 10% 90%

< 0% 0% 100%

PPNs – Underlying InvestmentsOriginally (1992) used well know stock

market indices

Progressed to broader indices

Mutual funds and foreign markets in late 1990s

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

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

PPNs - TradingMany trade on an exchange, but could trade at

less than NAV

Others trade via secondary market, via FundSERV

Some offer redemptions on specified dates (monthly)

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

Redemption fees calculated either as % of original investment or NAV

Each PPN is unique, so ask before buying

PPNs – Performance Caps

Gains may be capped, either annually or cumulatively

Annual caps can be particularly disadvantageous– Good performance is capped, bad

performance isn’t– One bad year can wipe out earlier

capped years, lowering compounded annual return

Some PPNs are callable

PPNs - FeesPPNs repackage mutual funds, hedge

funds, etc., which have their own fees

PPNs add another layer, could include:– Sales charges (4 to 7%)

– Risk transfer and management fees (1%)

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

– Incentive fees (10% to 20% of growth)

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

– Redemption fees (up to 5%)

PPNs – Risks Despite Guarantees

Inflation Risk !!!

Credit risk – not covered by CDIC

Investment risk

Liquidity and marketability risks

Leverage can magnify losses

Lack of disclosure

PPNs - Taxation Investors generally don’t receive payments

until maturity

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

Payments at maturity– Excess of amount received over investment (less

accruals) is taxed as interest income

Disposition prior to maturity– Difference between proceeds (less accrued amounts)

and cost results in capital gain/loss

Do-it-yourself PPNs Invest a portion of your capital in a strip bond

Use the balance to purchase investments of your choice

Advantages– Lower fees– Greater transparency– Greater liquidity

Disadvantages– Investment knowledge– Not all investments are accessible (e.g. hedge fund

minimum purchase limits)– Must accrue interest income on the strip annually

Split Share CorporationsMutual fund corporation that issues 2

types of shares: capital and preferred

Each type issued in equal numbers

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

Initial offering price of capital and preferred shares can be different

Afterwards both shares trade on exchange

Split Share – Portfolio Investments

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

Now invest in common shares of more than one company, usually in the same industry– 5Banc Split Corp – 5 big Canadian banks– Financial 15 Split II Corp – 15 banks and

insurance companies (Canada and US)

Split Share – Preferred Shares

Receive fixed cumulative dividend + Return of capital upon maturity

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

Do not share in capital growth of underlying assets

Have first claim on assets upon maturity

Split Share – Capital Shares

Exposure to the capital appreciation of underlying investments

May benefit from an increase in dividends paid by underlying investments

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

Split Share Corps - Leverage

Built-in, low-cost leverage

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

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

No interest charges or margin calls

Split Shares – Option Writing IncomeMany split share corporations try

to boost returns by selling covered call options on underlying stock

Premiums accrue to capital shareholders

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

Split Shares – Redemptions upon TerminationCorporation terminates after 5 or

10 yearsSells underlying investmentsDistributes proceeds (net of

expenses)– preferred shareholders get first claim,

return of original investment– balance goes to capital shareholders

Split Shares - Retractions

Most corporations provide for periodic retractions/redemptions

Must maintain an equal number of preferred and capital shares outstanding

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

Split Shares - FeesFront-end sales charges (3% to 6%), may differ

for preferred and capital shares

Retraction fees (0% to 5% of NAV)

Administration fee paid to manager

Base management fee paid to manager

Performance fee paid to manager

Service fee paid to dealer

Initial offering expenses, ongoing operating and administration expenses

Split Shares – Risk FactorsLeverage – magnifies losses as well as gains

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

Market and Economic Risks – affect performance of underlying shares

No voting rights

Lack of diversification

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

Split Shares - TaxationOrdinary dividends – subject to gross up and

tax credit scheme

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

Capital gains/losses prior to maturity– 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

– Losses cannot be distributed

Capital gains/losses at maturity – normal rules apply

current trends and issues in financial planning 2006 edition

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