Doing Well by Doing Good

With many Canadian corporations being bought out or going private, many investors face hefty capital gains taxes. For example, BCE, the most widely held public Canadian company, is likely to go private within the next six months. Many of its shareholders have owned the stock for decades and so have a relatively low adjusted cost base. The shareholders’ good fortune in realizing this gain must be weighed against an unpleasant necessity: a big tax bill.

However, there are techniques that will lessen the tax pain while simultaneously advancing a worthy cause. There are many charities in Canada and most Canadians have their favourites. For some years, there has been a mild incentive for investors to donate highly appreciated shares instead of cash. A recent change in the Income Tax Act has increased the incentive for these donations in kind. The change makes it attractive to help your fellow man and reduce the tax bite at the same time.

When told of this, people often say, “That sounds like a good idea. Suppose I want to avoid having anything added to my tax bill next April. How many shares must I donate to wipe out the tax on the capital gains on the other shares I’m selling (or being forced to sell)?” If the donation is valued at over $200, there is a relatively simple formula to determine what fraction of the shares should be donated in kind to zero the tax cost.

First, determine the value of two ratios. Let

g = the gain in your shares divided by total current value, and
t = your marginal tax rate divided by the maximum marginal rate in your province.

Then donating a fraction of your holding equal to

offsets your entire tax liability on the sale of the remainder, leaving your overall tax bill as if the sale of the shares had not occurred. (If you subscribe to the Annie Liebowitz school - "In real life ... there is no such thing as algebra." - you may prefer to use a convenient calculator.)

Some examples of how the formula works may be instructive.

If you have owned BCE for decades, cost as a fraction of current market value might be negligible and g could be close to one. If you are also in the top tax bracket, i.e. t is also one, then donating 1/3 of the total position in kind, i.e. as shares, to a charity allows you to realize the entire proceeds on the sale of the other 2/3 and the net effect is that no additional tax is payable.

If your gains and your tax bracket are more modest, the fraction that must be donated is much smaller. Suppose BCE is up 50% since your purchase, which would make g = 1/3, and your marginal rate is about half the top rate, which is approximately true for the lowest tax bracket in most provinces. Then you can sell 12 shares outright for every share you donate to charity without increasing your income tax at all.

The technique and formula are useful in other circumstances as well. It may not be a buyout that has you concerned about capital gains taxes. Many portfolios have share positions that have appreciated considerably since purchase. The uncomfortable prospect of taxes on sale stops investors from doing what prudence dictates: diversifying the portfolio. Donation in kind of a fraction of the position can alleviate the problem.

In order for this technique to work, you must donate securities (shares, bonds, mutual fund units) to the charity. Selling the securities and donating part of the proceeds from sale in cash will result in smaller tax savings. Check with the charity beforehand to verify that they have the ability to accept donations in kind and, if so, to what account and broker the donated securities can be transferred.

If you have done well with your investments, consider doing some good too. It can cost less than you imagine.