Assiduous Reader pugwash asked on another thread:
The discussion ten days ago on this excellent blog about the impact of tax on premium bonds led me to consider if there is there a tax downside to owning premium resets.
How is the capital loss between the purchase price of say $28 in todays market and the call price of $25 dealt with?
Not many of us have capital gains to use as an offset!
He was referring to a comment by prefhound on my essay The Bond Portfolio Jigsaw Puzzle. And, naturally enough, his use of the phrase “excellent blog” virtually guaranteed a response!
In order to investigate the problem of tax effects, we need:
The last two requirements are permanently linked on the right-hand panel of this blog under the heading “On-Line Resources”. Note that we don’t really need the “FixedResets” version of the calculator; since we’re only going to be calculating yield to the first call, the regular version will do the same job; but we’ll use the souped-up version anyway. Why not?
Calculations will be performed for an Ontario resident with taxable income of $150,000. Ernst & Young claims the marginal rate on capital gains is 23.21% and the marginal rate on dividends is 23.06% (compare to the marginal rate on income of 46.41%, which is not used in this calculation).
pugwash specified a price of $28 for discussion, so for discussion purposes we’ll examine HSB.PR.E, which closed last night at 28.01-15. It pays 1.65 p.a. unitl the first Exchange Date 2014-6-30, when it resets to GOC5+485, or is called at 25.00.
The dividend rate of 1.65 implies quarterly payments of 0.4125. For taxable accounts, we will assume that this is reduced by 23.06% to 0.3173775. Dividends are paid at the end of June/Sept/Dec/Mar and the next ex-date is March 11 (estimated) so we’ll get the next dividend.
It should be noted that a horrifyingly precise calculation will not pay the tax on day of receipt, as assumed in the above paragraph, but pay annual taxes in the following calendar year. HIMIPref™ does this calculation, but the current calculation using the spreadsheet software doesn’t.
The maturity price is 25.00, which is all we need for the non-taxable calculation, but taxable accounts with capital gains will be able to claim the 3.01 capital loss until maturity. The tax rate of 23.21% on capital gains implies that this deduction will be worth 0.698621, so a taxable account with capital gains to offset the loss may use a maturity price of 25.698621.
Having accumulated the data, we can fill in the calculation spreadsheet:
| HSB.PR.E Yield-to-Call Calculations |
| Data |
Non-Taxable |
Taxable with Capital Gains to offset loss |
Taxable without Capital Gains to offset loss |
Current Price |
28.01 |
| Call Price |
25.00 |
25.698621 |
25.00 |
| Settlement Date |
2010-1-28 |
| Call Date |
2014-6-30 |
| Quarterly Dividend |
0.4125 |
0.3173775 |
0.3173775 |
| Cycle |
3 |
| Pay Date |
31 |
| Include First Dividend |
1 |
| First Dividend Value (if different) |
[blank] |
| Reset Date |
2014-6-30 (irrelevant) |
| Quarterly Dividend After Reset |
0.4125 |
0.3173775 |
0.3173775 |
| (irrelevant) |
| |
| Annualized Quarterly Yield to Call |
3.43% |
2.61% |
2.04% |
| Effective Tax Rate |
0% |
23.91% |
40.52% |
Note that the calculated yield on the taxable account with no capital gains (2.04%) is a little harsh, because it does not reflect the fact that the investor will have a capital loss of 3.01 that may be used at some time to offset future capital gains. However, if he never makes any capital gains, this asset will be worth zero.
Note also that the effective tax rate for a taxable account with capital gains (yield of 2.61%, effective tax rate of 23.91%) is in excess of both the capital gains rate and the dividend rate. This is because the investor is paying tax up-front (when the dividends are received) and receiving the benefit of the capital loss later.