Note that this report pertains most directly to portfolios operated under the guidelines, rules, and disciplines of Market Cycle Investment Management (MCIM). MCIM produces disciplined “High Quality Growth & Income Portfolios”, designed to maintain and/or to grow income regardless of the direction taken by markets or interest rates.
Both markets have been good to MCIMers this year: Investment Grade Value Stock Index (IGVSI) equities produced plenty of profits and dividend income, while the income Closed End Funds (CEFs) produced much higher yields than many “experts” would admit even exist… and occasional profits.
On the negative side, new equity investment opportunities were scarce, and many income CEFs reduced their payouts slightly, reflecting more than six years of historically low interest rates. I suspect that both conditions will be reversed soon.
A recent (unaudited) review of known MCIM “Working Capital” produced some interesting numbers, even without including year end dividends:
• Roughly 35% of total realized income was disbursed
• Nearly 25% of growth purpose capital remained in “smart cash” reserves for scheduled disbursements… and anticipated lower prices on equities. (Smart cash comes from income and profits)
• Roughly 65% of total earnings was reinvested in new and old securities
• New “Working Capital” was produced at a rate somewhere between 9% and 10%
• Less than 20% of investors made additions to investment programs, eschewing income yields in excess of 6%
• None ot selected MCIM portfolios lost Working Capital… even after culling “poorest performers” throughout the year.
“Working Capital” (total cost basis of securities + cash) is a realistic performance evaluation number…. it doesn’t shrink either during corrections or as a result of spikes in interest rates. It continues to grow so long as dividends, interest, profits and deposits exceed realized losses and disbursements.
Using the “Working Capital Model” facilitates preparation for future income needs with every decision made throughout the history of an investment program… MCIM working capital grows every month, regardless of changes in market value, so long as the investor disburses less than the portfolio is producing.
Year end is always a good time for investors to review asset allocation and projected income needs… if you are over 50 and haven’t considered the subject, it’s time to do so. If you expect to start withdrawing from your portfolios in the next few years, you need to determine if asset allocation changes are necessary.
If your income allocation is not generating at least 6% in spending money, or 401k balances are subject to shrinkage when the stock market corrects, it’s time to deal with these problems.
If you are not taking advantage of 6%+ tax free yields (and a higher range in taxable CEFs), you owe it to yourself to investigate the opportunities.
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So is there a “Grinch” in your 2015 portfolio performance future? What’s likely to happen?
The Stock Market is about to finish 2014 at the highest year end number ever recorded, and with each new “ATH”, the likelihood of a market correction increases… this 6.75 year rally is the longest, broadest, and most stubborn in stock market history.
So long as income investors are abused with artificially low rates, a gradual reduction in yields is likely to hold income CEFs around current prices… higher future rates are already anticipated in current market values.
Once higher rates become reality, there are several reasons why CEF prices should firm and, over the longer term, rise, with increased income production…
But even if the correction starts tomorrow, what has nearly 40 years of financial history taught us about the MCIM “much-higher-quality-and-income-than-any-other-form-of-investment-portfolio” methodology?
The IGVSI universe, high quality ADRs, REITS, MLPs, Royalty Trusts, plus Equity and Income CEFs should logically have been expected to fare better than the stock market averages during the three financial crises of our lifetimes. Many MCIM users can attest to this, but the logic is clear.
Every security produces income, and reasonable profits are always realized. New equity investments are only made when prices have fallen 20% or more; income securities are added to at lower prices to reduce cost basis and increase yield. Not to mention the fact that MCIMers invest only in the highest S & P quality ranked companies, filtered further by dividend history, NYSE, and profitability.
MCIM users were low on equities in August 1987 but fully invested by November; they owned no mutual funds, no NASDAQ securities, and no IPOs in 1999; they lost virtually no working capital, reinvested all earnings, and rebounded quickly from the financial crisis.
So if the rally continues, Working Capital growth will continue right along with it. But when the correction comes along, cash reserves and continued income will likely be available to takes advantage of new opportunities that arise in the MCIM select group of potential investment securities.
The longer the correction (the financial crisis took roughly 20 MCIM months to reach bottom on March 9 2009), the more Working Capital will be available when the next round of stock market all time highs is upon us.
And again, most importantly I believe, all programmed income payments will be made on time and without dipping into capital…
In 2004 I wrote a book (with my friend Pamela Clarke and published by Insomniac Press) called Resources Rock: How to Invest and Profit from the Next Global Boom in Natural Resources. Since taxes are fresh in everyone’s mind at this time of year, I thought I’d reproduce a chapter in the book that explains one of Canada’s most flexible and robust tax planning tools. It’s not widely understood but has the advantage of being 100% legitimate – it is written right in our tax code. Here’s the chapter:
“Certainty? In this world, nothing is certain but death and taxes,” said American scientist Benjamin Franklin over two hundred years ago. The only difference these days is that while death is still final, taxes can be deferred or reduced. Canadians didn’t always have to worry about taxes. Income tax was introduced as a temporary measure (sounds like the GST saga) to help cover the country’s military expenses during World War I. By 1948, the wars were over, but the government decided to not surrender. Instead, the Income War Tax Act became the Income Tax Act. Since then, Canadians have had to declare income from all sources, including capital gains on the sale of investments or property. We’re allowed to deduct some expenses and there are a few tax credits, but by and large, there aren’t too many opportunities for us to reduce our taxable income. Taxes are steep and vary greatly depending on where you live.
But that’s not all. You pay tax on everything you earn as well as on everything you buy. Take the price of gas, for example. It was pumped up to over $1.40 a liter in some provinces and more than one-third of the price was taxes: provincial sales tax, GST, and something called the Federal Excise Tax. It hurts even more if you consider that you’re paying for the gas taxes with after-tax dollars. Ouch.
One of the best means of minimizing the pain is to take advantage of all the tax deductions that you can. Standard ones include childcare expenses, family support payments, moving and medical costs, and of course, RRSP contributions. Unfortunately, not too many taxpayers are familiar with the deductions that are available from investing in the “flow-through” shares of junior Canadian resource companies, or ventures that qualify for the Canadian Exploration Expense (CEE). You should consult your tax advisor for precise information on the benefits of these deductions for your portfolio, but in the meantime, here’s a brief introduction to these tax-deductible investments.
Buried deep in the Income Tax Act (Section 66 (1) to be exact) there’s a clause that says:
“A principal-business corporation may deduct, in computing its income for a taxation year, the lesser of (a) the total of such of its Canadian exploration and development expenses as were incurred by it before the end of the taxation year…”
The Section goes on ad nauseam, but only tax accountants need to get into that level of detail. What you do need to know from the clause is that most junior energy and mining companies spend all of their money on exploration programs and usually have little or no revenue. Because they have virtually zero income, they’re not able to use all the tax deductions that they’re entitled to as a resource exploration company. Mining companies are allowed to deduct prospecting, drilling, geological or geophysical expenses, but if they don’t have any revenue, then these deductions remain unclaimed or“wasted”.
In a rare moment of generosity, the government decided to allow exploration companies to give up those tax deductions and pass them on to people who can use them. Companies can bundle the tax deductions with their shares, then sell them to investors and use the proceeds from the sale of these shares to finance their exploration projects. The ventures don’t mind selling off their unused deductions. If they can’t afford to keep digging or drilling, they’ll be out of business anyway. These deductions, sold as shares, are called “flow-through shares” because they transfer the tax deductions from the company to the investor.
In other words, the government allows a tax deduction that would usually only be granted to an exploration venture to be passed on, or “flow-through,” to their investors. It’s a win-win situation as the company gets the money to finance their exploration work while investors can claim up to 100% of their investment as a tax deduction. The government created this program as a means of encouraging people to invest in resource exploration companies. That’s nice of them, but given our incredibly high tax rates, it’s a good idea to understand how investing in exploration—either in flow-through shares, or in shares of a limited partnership that owns a portfolio of flow-through shares—can help you lower your taxable income.
Investors can buy flow-through shares directly from a company, or own them indirectly by purchasing units in a limited partnership specially created to buy shares in a portfolio of several junior exploration companies. Buying units in a limited partnership can be beneficial for individual investors because it gives them the tax deduction from the flow-through shares, in addition to reducing their investment risk. A limited partnership can usually buy a much greater variety of flow-through shares than an individual investor could afford to purchase on their own. Therefore, investors in a limited partnership end up owning shares in a basket of startups, rather than just in one venture. Given that a lot of exploration companies could go bankrupt or walk away from their projects, buying shares in several of them minimizes the risk that you could lose your entire investment. The answer varies from one investor to another, but as long as the exploration company – or companies if they’re in a portfolio owned by a limited partnership – spends all the money they raised from selling flow-through shares on eligible exploration expenses, then almost the entire amount invested in the shares can be deducted.
A word of caution: Don’t let the tax appeal of flow-through shares affect your decision-making skills as an investor. Remember that even though the tax deductions alone are beneficial, you’re still investing in the riskiest side of the resource industry. It is possible for you to lose all your money if the exploration team repeatedly comes up empty-handed. On the other hand, investing in an exploration startup by means of flow-through shares does mitigate the risk of losing your investment to some extent. Depending on your marginal tax rate, the after-tax cost of buying the flow-through shares (or portfolio of flow-through shares) is virtually cut in half, compliments of the government .
In the Economic Statement and Budget Update of October 18, 2000, the Minister of Finance announced a temporary, 15% investment tax credit (applied to eligible exploration expenses) for investors in flow-through shares of mineral exploration companies. Oil and gas exploration companies were excluded. This announcement introduced a credit, known officially as the Investment Tax Credit for Exploration(ITCE), which reduces an investor’s federal income tax for the taxation year during which the investment is made. Although deemed ‘temporary’, after expiring at the end of 2005, the credit was re-introduced effective May 2,2006 and is currently subject to annual review.
The ITCE is a non-refundable tax credit that can be carried back three years or carried forward twenty years. So if you invest in flow-through shares (of mining exploration companies only) this year, you can use the deduction any time up to 20 years in the future, or back three years. It’s a real bonus being able to use this deduction when you need it the most. Keep in mind, however, that the ITCE has to be reported as income in the year after you claimed the tax deductions from the flow-through shares. The only downside is that when you sell your investment, or trigger a “deemed disposition”(which means the government thinks you’ve unloaded the investment even if you haven’t actually sold it), then you’re on the hook for capital gains tax. That’s not so bad, as capital gains tax rates are better than regular income tax rates.
Let’s look at how these tax credit programs can help you reduce your taxes. For example, if you live in Ontario and your annual taxable income is $300,000, and you’re taxed at the highest marginal tax rate of 46.41%, then you’d pay $139,230 in tax. (Of course, to make it simple,we’re unrealistically assuming there are no personal exemptions or other allowable deductions and that all income is taxed at the same rate.) If you invested $50,000 in flow-through shares, and the entire amount qualified as a CEE, then 100% of your investment could be deducted from your taxable income. Your taxable income is reduced to $250,000 and you now owe $116,025 in taxes—a savings of $23,205! That’s a nice chunk of change that stays in your pocket.
It can get even better. If a part of your investment in flow-through shares is with companies that are exploring for metals and minerals that are eligible for the Federal Investment Tax Credit, you’ll get an additional tax credit of $7,500. That extra credit would cut your total tax bill down to $108,525. In a perfect world, you could save yourself $30,705 in taxes. Serious money by any standards.
In addition to these federal government programs, there are several provincial flow-through initiatives that we won’t address here as they vary tremendously from one province to another. Flow-through shares are starting to sound like they’re the best discovery since Chuck Fipke dug up some diamonds in the Northwest Territories. As wonderful as they are, keep in mind that since money is made and taxes are paid in the real world, things aren’t always as rosy as simplified examples in a book on investing. Before buying into the example above, remember that:
Taxes Vary: Everyone pays taxes on a sliding scale, so not all of your income is taxed at the top marginal rate.
Diversify: Your entire portfolio should never be solely invested in just mineral exploration stocks—diversification is advisable even for investors with an incredibly high tolerance for risk.
No Guarantees: An exploration company is obligated to spend 100% of the money it receives from selling flow-through shares on expenditures that qualify for tax deductions, but if for some reason it doesn’t, then you can’t claim 100% of the deductions.
The bottom line is that there are many variables that will influence the impact of flow-through shares on your tax situation. Investment advisors can provide details on the limited partnerships or flow-through shares that are available in the market today. Ask them to help you research and screen limited partnership funds so you end up investing in a portfolio of companies that meets your investment objectives.
That’s the end of the chapter, and before you say this is more complicated than it’s worth let me excessively simplify and round in order to provide an example of how powerful this tool can be.
Imagine you’ve sold an income property for $500,000 and long ago used up your personal capital gains exemption. To keep it simple, you are not subject to minimal tax and are at the highest marginal tax bracket which I will round to 50%. Let’s ignore all the other deductions and stuff too. Your options are:
1. Report the proceeds as income and let the CRA (government) keep half of your money.
2. Invest the entire sum in one (or more) flow-through limited partnerships.
Let’s examine #2. The $500,000 can now be deducted against income, so your taxable income (money going to CRA) is reduced – you keep half at 50% tax rate or (roughly) $250,000. So far you’re no worse off right? Even if your get nothing back (I’ve never seen this happen personally and I’ve managed dozens of these funds myself) you’re no worse off.
Say after two years (the lifespan of most of these funds) you get your whole investment back (it happens). Once the fund is wound up your $500,000 is now subject to capital gains tax (roughly 25% rather than 50%) so you’ll net $375,000. Isn’t keeping the extra $125,000 for yourself worth the effort? Whether you end up with half that amount, or double you are still ahead.
By the way, when a flow-through limited partnership is ‘wound up’ your money is usually rolled into a more liquid mutual fund – you can leave some or all the the money in there and not pay the capital gains taxes until you redeem. If you can afford it, use the tax shelter every year and watch your tax savings grow over time. You will have to pay a tax accountant (since filling out the tax returns correctly is critical and often you have to re-submit them when you receive additional or more precise information from the fund company after-the-fact), and seek advice from a good investment advisor. If either of them tells you not to do it without a really good explanation….it’s because they don’t understand them or want to avoid the added work. Find someone else.