In a surprise move, the Canadian government is removing restrictions on foreign holdings in tax-deferred accounts. In the long run, this should prove to be a positive measure for Canadian investors, and possibly for the U.S. stock markets.
We Canadians are used to the government unnecessarily interfering with our lives -- and taxing us so that they have the funds to do such interfering. We have high taxation, no tax relief on mortgage interest payments, and although we have many social benefits, such as universal health care, most of us wonder whether the price we pay is over the top. The Fraser Institute calculated Canada's "Tax Freedom Day" as June 28. Tax Freedom Day is the day that we've covered all levels of government taxes, fees, and other payments, and start earning for ourselves. By comparison, for 2004, the Tax Foundation calculated Tax Freedom Day as April 11 in the United States.
The one benefit that we do cherish is our tax-deferred Registered Retirement Savings Plans (RRSP), where we're allowed to contribute to our own savings plan and get a tax rebate for doing so. This is quite similar to IRAs and Roth IRAs in the U.S., with one major exception: The allowable contributions can be much higher and are tied to a percentage of gross earned income. RRSPs are also tax-deductible no matter the level of earned income.
How RRSPs work
Canadians are allowed to contribute up to 18% of their earned income, with a maximum of $16,500, to their RRSPs. This maximum rises to $18,000 in 2006, and by 2010 it will be $22,000. Of course, few Canadians can contribute to the $22,000 upper limit, as it equates to an annual salary of $122,000. Even at the average earning level of $43,000, a full-time employee can contribute $7,740 per year, approximately double the IRA limit (excluding Roth IRAs). If an employee and his employer contribute to a Registered Pension Plan (RPP), the amount contributed to the RPP is deducted from the allowable RRSP contribution.
The RRSP contributions can be invested in cash, mutual funds, Guaranteed Investment Certificates (GICs), stocks, bonds, exchange-traded funds (ETFs), mortgages, covered call options, put options (if the account has cash to cover), and (just added) gold, silver, and coins. The investments can increase tax-free, and interest and dividends are not taxed inside the plan. When the plan holder reaches age 69 the RRSP will have to be converted into a registered retirement income fund (RRIF). The RRIF can hold the same investments, but there must be a minimum annual withdrawal of funds, according to the Canada Revenue Agency schedule.
The government will then tax the withdrawals as income at the plan holder's marginal tax rate. The greatest benefit accrues to those who contribute at high marginal tax rates and withdraw at lower marginal rates in retirement.
When the Foreign Content Rule is to change
The changes in the foreign content rule were announced by Canadian Finance Minister Ralph Goodale in this year's February budget. However, the rule changes will not take effect until the parliament enacts the budget legislation. According to the finance department's website, "Legislation to implement the Budget 2005 tax measures will be prepared for early tabling." Past budgets have taken anywhere from June of the same year to February of the next to get through parliament. So Canadians out there shouldn't ignore that 30% foreign content link just yet -- or you'll be penalized by Revenue Canada. The good news is that when the budget is enacted, the tax changes will be retroactive to January 1, 2005. No word from Revenue Canada on whether it will refund penalties incurred for exceeding the current 30% limit before the budget becomes law. My advice is to stick with the 30% limit for now and do not risk incurring a penalty.
The effect on American stock markets
Canada has about one-ninth the population of the U.S. and doesn't generally have a large impact. However, according to their respective governments, Canadians currently save about 4% of their income, compared with 1% for U.S. citizens. There is an approximate (approximate because government statistics are based on different criteria) 10% to 15% average wage differential in favor of U.S. citizens, but this cannot overcome the savings rate differential. By rough calculation, the average U.S. citizen saves less than $400 per year, compared with $1,300 for Canadians.
However, most Canadian financial commentators don't foresee the removal of foreign limits having much of an effect. Most investors currently have ways of getting around the 30% limit -- through legal loopholes like clone funds, and because Canadian stock funds are allowed the 30% foreign limit and yet still retain status as Canadian investments. For example, the Templeton International Stock RSP Fund mimics the popular Templeton International Stock Fund. Clone funds use derivatives that are technically not foreign content, and are yet approved by the Canada Revenue Agency. Clone funds will close under the new rules and will be rolled into the funds that they mimic, which should save investors up to 0.5% in additional fees that the clone funds charge.
Another reason that there is unlikely to be an exodus from the Canadian to the U.S. market is the recent history of exchange variations. Since late 2002, the Canadian dollar has moved from $0.625 to $0.82, a 31% raise. Most commentators believe that the Canadian dollar is likely to rise to at least $0.90, and possibly reach par with the U.S. dollar, over the next few years. I think this may be the case in the short term, but over the long term I would not consider the Canada-U.S. exchange rate as material in the decision to buy shares in U.S. companies, particularly for those U.S. companies with large international sales.
What's in it for Canadians?
The short answer is a much better overall portfolio performance. In the past 20 years the international market as tracked by the MSCI Global Index has outperformed the Canadian market by 2%. This does not sound like a significant outperformance until you consider the effect of compounding over the long haul.
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The Canadian market represents less than 3% of the world's market and is heavily dependent on the financial and resource sectors while substantially missing out on significant sectors like health care. The U.S. market is not only 10 times larger (at least) but also offers access to major global companies through the New York Stock Exchange. These companies are listed as American Depositary Receipts (ADRs) and can be bought and sold like shares in U.S. companies.
The U.S. also has most of the truly outstanding worldwide franchises that have demonstrated consistent, decades-long outperformance. There simply are no Canadian equivalents to Coca-Cola (NYSE: KO ) , Wal-Mart (NYSE: WMT ) , Microsoft (Nasdaq: MSFT ) , or Pfizer (NYSE: PFE ) .
According to research at Canadian mutual fund company ScotiaMcLeod, the optimum risk-reward balance for Canadians is achieved with 40% foreign content. However, they measure risk by volatility (volatility of stock price and currency exchanges), which for longer-term investors is likely to be smoothed out. Scotia recommends a 50-50 ratio of foreign to domestic stocks for the average Canadian investor. While I believe it depends on each individual, I for one will be taking advantage of the new rules when they come into effect.
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Philip Durelldoes not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy.