Muddled Tory Re-investment Proviso Harbinger of Hell

January 17, 2006

Late last week, Canada’s Conservative party vaguely revealed, in a speech by leader Stephen Harper, a new tax proposal in their election platform. While details are as yet scant, it reportedly would allow deferral of tax on capital gains provided that proceeds of sale are re-invested within six months. Apart from the predictable opposition Liberal party gainsaying, most media reports I’ve seen (e.g., at GlobeInvestor.com) take a rather benign and uncritial view of this proposal. In the January 14 National Post, J. Chevreau’s article at least mentions the possibility of “the devil being in the details”.

It is a bit risky to criticize something before all the details come out. Nevertheless, it is not hard to extrapolate at least roughly how a policy like this must work, given the stated goal and current rules on related matters of capital gain taxation. Doing this it appears all but certain that a very nasty devil must be hiding in the details.

First, I am entirely in favour of eliminating tax on capital gains. It’s my firm belief that taxing capital gains on equity securities is (in the long run) unjustifiable double taxation, and is entirely inconsistent with the elimination of double taxation of dividends. (More about this well below.)

What bothers me deeply about the proposal is its proviso “subject to re-investment within six months”. Apparently no details have yet been given on how this would work, but a reasonable guess might be something like this:

1 When capital property (stock, bond, fund unit, real estate, etc.) is sold at a gain, the proceeds go into a “notional cash account” and bring with them a cost base equal to that of the property sold. This cost base is averaged in with any pre-existing cost base for money already in the notional account (much like current identical property rules).

2 When new property is purchased (“re-investment”), one has the option of allocating all, or part, of its purchase price with money from the notional account, and pro-rating the cost base of that money into the purchase’s cost base.

3 Six months after any money enters the notional account, that amount of money is reduced by any amounts allocated to re-investment as above, and the remainder is then deleted from the notional account, whose cost base is then re-calculated to reflect the deletion. The capital gain originating from the original sale which created the deleted funds would be taxed as currently.

This is clearly an utter bureaucratic and accounting nightmare. A number of problems are immediately seen, the most significant one of which I list first:

* The cost base of any single property could depend upon ALL of the other properties one had ever sold previously (anytime after the proviso came into effect). I.e., the effects depend globally on one’s investments, and can propagate forward indefinitely!

* Tracking the evolution of the notional cash account and its attendant cost base, as described above, is an onerous task. Most Canadians today have enough trouble calculating capital gains under present rules. Keeping track of the above would daunt almost anyone. Also, no brokerage or fund company could do it, because they don’t know about all your property transactions. So people would either not do it and gain no benefit, do it themselves and make a mess of it and constantly revise their tax returns, or go to accountants, who would be very happy indeed, and whose fees would eliminate any benefits of tax deferral.

* Similarly, can you imagine a CRA tax audit in the far future, where you would have to document and explain your entire capital property activity’s history over prior decades just to justify the capital gain on a single security that was sold without re-investment?!

* If property is sold in November or December, the six month period expires after the corresponding tax return is due on April 30. Thus one might not even know by tax time whether the proceeds have been re-invested, yet one has to decide whether to declare a taxable gain or not.

* If bonds are eligible re-investment options, this leaves open the possibility of short term bonds, money market instruments or money market funds too. But if you can “re-invest” in such short term products then, effectively, the six month period could be extended forward indefinitely.

* If a capital gain is transferred from a stock to a bond via re-investment, and the bond is held to maturity, is the capital gain thus converted into interest? One might expect this would be the default behaviour — a punitive result since interest is taxed at the highest rate.

Given such problems (and there must be many more), it is clear the six month re-investment proviso, or any similar thing, is an absolutely untenable disaster with onerous accounting and legislative special casing consequences. What should be done instead is very simple: phase out capital gains taxes by reducing the inclusion rate from 50% to 0% in a timely and orderly manner.

All of this makes me wonder if, in fact, the Tories really want to just eliminate the capital gains tax entirely (as should properly be done), and that they are using the proviso as a temporary political smokescreen to deflect opposition criticism before the election.

Returning briefly to why taxing capital gains on securities is undesirable: For stocks, capital gains are driven by two factors: corporate net earnings and investor sentiment; but the sentiment factor is bounded and averages out over time, while corporate earnings are already taxed, so taxing the stock gains they produce is duplicate taxation. As for bonds, their prices are determined by interest rates, and do not “grow to the sky” since interest rates tend to remain bounded from below. Hence taxing bond capital gains is, in the long run, also a horribly inefficient and counter-productive exercise for the CRA to engage in.

Unfortunately, some of those most knowledgeable might not be motivated to speak out against the Tories’ misguided re-investment proviso. Not accountants, who stand to benefit. Not pension funds, who are unaffected. Mutual fund companies may not like the tax cut in any form, as it would help investors flee poorly performing managed funds. Investors need to raise a firestorm of criticism before the oncoming train runs over them.

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