Provincial
tax break attractive
Ontario’s latest budget included the introduction of something called Ontario Opportunity Bonds. The bonds, which will be exempt from Ontario tax, will not be directly offered or guaranteed by the Ontario government. Rather, they will be issued by the Ontario Municipal Economic Infrastructure Financing Authority (OMEIFA). On the surface these new bonds look attractive, but they’re not for everyone.
Below are
the basic details on the new issue of bonds, which closes soon.
Term: 5 years (mature May 6, 2008)
Interest
Rate: 4.25 percent, paid semi-annually
in May and November
Compounding: No – simple interest
Available
until: May 6, 2003
Further,
the interest paid is subject to federal tax but exempt from Ontario tax.
Just as mutual funds are sold by prospectus, these bonds are
sold via an Information
Statement. I would encourage anybody considering these bonds to read it
before buying.
GICs,
investment funds, conventional bonds, strip bonds, real return bonds, preferred
shares, provincial and federal savings are common fixed income investments but
this is not a complete list. When reviewing various fixed income options, one
must be careful to ensure that comparisons are fair and accurate. There are two
issues to address when doing comparisons:
reinvestment and taxation.
With
sufficiently large amounts of money, income spun off from things like preferred
shares and conventional bonds can be reinvested in the same or similar type of
investment. But without the availability of new Ontario Opportunity Bonds,
reinvestment simply isn’t an option, no matter what the amount.
If deciding
between buying these new bonds or Ontario strip bonds, a yield adjustment is
necessary. The yield on strip bonds, because the interest is built into the price
paid, is already stated in compound annual terms. Ontario Opportunity Bonds, on
a compound annual basis, offer a yield of 3.93 percent, before taxes.
Conventional
bonds, which also pay semi-annual interest, are directly comparable and yield
an average of 4.18 percent quoted as of May 1 for government of Canada bonds.
But such conventional bonds can be sold at any time because they are very
liquid – not so with Ontario Opportunity Bonds.
Taking
taxes into consideration gets a little trickier. Ontario’s highest tax bracket
for 2003 kicks in at a taxable income of $104,649. At that level, these bonds
will be relatively attractive since they’ll attract tax at an effective rate of
29 percent, versus the 46.41 percent applied to regular interest and 31.34 percent
rate attached to dividends.
While the
rates are slightly different, this is the case for taxable incomes of at least
$70,000 or so. Below that, dividend income is taxed much more favourably,
though it carries somewhat higher risk.
At lower
levels of income – i.e. $25,000 – the tax break shrinks and the mechanics of
dividend taxation make dividends a better deal, in my opinion. In this case,
dividends are taxed at a rate of just 4.48 percent while interest from these
bonds would attract tax at a rate of 16 percent.
It should
be very clear at this point that comparisons are very individualistic.
Once
purchased, there is no organized market to facilitate the trading of these
bonds. Investors are always free to privately sell their bonds to others, but
no real market will necessarily exist for such purposes.
Hence,
don’t count on any opportunity to sell these before their five-year term
expires.
OMEIFA’s basic purpose is to make it easier and cheaper for Ontario municipalities to borrow money. OMEIFA will borrow funds from the general public through the sale of these Ontario Opportunity Bonds. The rate payable on these bonds, which is 4.25 percent per year, is also OMEIFA’s cost of acquiring funds. Further, up to 50 percent of the interest costs on loans from OMEIFA to municipalities are expected to be subsidized by the Ontario government through subordinated loans to OMEIFA. The result: municipalities pay a lower rate of interest to OMEIFA, than if they raised money through traditional means.
Most of OMEIFA’s assets and cash flow will be dependent on amounts receivable from the municipalities to which it lends money. Put another way, OMEIFA’s credit rating will be a reflection of the credit ratings of the various municipalities. Despite their name, these bonds should not be associated with the province – in terms of safety – because they provide no guarantee of interest or principal for these bonds.
The nature of the tax exemption is awkward. When filing a tax return, investors must claim the full amount of interest, and pay tax thereon at both the federal and provincial levels. Ontario will then deem the provincial tax on the interest from these bonds to be an “overpayment of tax”, resulting in a refund. The refund, however, won’t be received until six to eight months after tax returns are filed.
These bonds
are most suitable for higher income investors wishing to hold safer investments
outside of tax-deferred savings plans. For the middle-to-low income class, the
attractiveness of these bonds diminishes. For everybody else, there’s no rule
of thumb, so keep in mind the limitations with respect to liquidity and the
potential default risks. As a result, make sure the after-tax yield that you
will enjoy sufficiently compensates for these limitations and risks.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.