|Update June 2005:The federal government enacted legislation removing any international limit to sheltered funds. Therefore, this topic has become redundant in portfolio management.|
Income tax law presently allows RRSPs and RRIFs to have up to 30% invested in foreign content. The limit used to be only 10%, but it was raised in stages several years ago. Some critics call for the removal of any foreign limit, saying that the market-place will determine a balance.In Britain, for instance, where there are no limits, 30% tends to be allocated internationally.
The Tax Act imposes penalties of 1% per month for each month in which the foreign content assets exceed the limit. The measure is applied account by account, not on a pooled basis. The trustee of the RRSP/RRIF is responsible to enforce and administer these rules.
The limit is outwardly simple to understand, but in reality it is full of tricks and traps. The limit is calculated on “book values“, not “market values”. If there is a significant difference between the two amounts, your actual asset allocation to foreign markets may differ significantly as a result. “Book value” figures mean the amounts that you paid for the financial instruments in your RRSP/RRIF.
A common, significant source of differences between book and market values is strip bonds. While you own a strip, it increases in value from when you buy it to when it matures. However, only the initial purchase value contributes to your foreign eligibility. The longer the strip bond maturity, the more significant the difference between book and market values. Thus, holding a large proportion of strips in your portfolio can hamper significantly your foreign content room.
Dividend reinvestment also affects foreign content. If you own mutual funds to achieve your foreign diversification, the dividends received as more fund shares increase your foreign content. Thus, if you maintain precisely the legal limit, the dividend reinvestment will carry you over the maximum.
We have observed an anomaly in the financial system when an individual transfers an RRSP or RRIF to another trustee. The out-going trustee merely hands over the securities. As a result, the incoming trustee has no access to the historical book values of all of the assets transferred. Instead, the in-coming trustee uses the market values at the date of transfer as the new book values. This can be an advantage or disadvantage, depending on the situation. Withdrawals can have an inadvertant impact on the foreign content status, depending on what assets are withdrawn. For instance, if your portfolio is precisely at the legal limit and you withdraw Canadian assets, your foreign proportion on the remainder will rise above the limit.
Realizing portfolio gains and losses can also cause problems. If you had a large gain on a foreign stock, sold it and reinvested the proceeds in a new foreign stock, your foreign book value would increase, potentially taking you over the limit. The same thing could occur if you realized a loss on a Canadian investment.
There are a few defensive strategies to avoid these problems:
- First, you can target your foreign content at, say, 1% or 2% below the legal limit to leave some room for unanticipated problems.
- Second, you can address all or most of your foreign investing in your non-RRSP portfolio. Of course, this only works if you have a non-RRSP account!
- Third, you can review your portfolio and trigger a gain (or loss, as needed) by selling an investment and immediately buying it back, thus creating a new “book value”.Transaction costs likely can be negotiated with your financial institution in this scenario.
- Fourth, if you have multiple RRSP accounts with different institutions, you can consolidate those with extra Canadian content into the account which is off-side the limit.
- Fifth, you can ignore the whole thing and accept the occasional 1% per month penalty as a small cost of earning superior returns in the international arena.
- A sixth way to achieve international diversification without stressing your limit is to invest in Canadian companies with heavy international operations. Three Canadian companies were ranked in the world’s top 100 transnational corporations. Based on revenues and assets abroad, Thomson Corp, Seagrams and Alcan Aluminum were ranked 57th, 68th and 83rd respectively. Shell, Exxon and IBM were the top three. When ranked based upon assets, revenues and employees abroad, Thomson actually ranked third.