Gotcha! Spot­ting the traps in last week’s quiz

The Globe and Mail (Prairie Edition) - - GLOBE INVESTOR - JOHN HEINZL IN­VESTOR CLINIC jheinzl@globe­and­mail.com Fol­low me on Twit­ter: @JohnHeinzl

Thanks

to every­one who took In­vestor Clinic’s sev­enth an­nual back-to-school in­vest­ing and money quiz. If you missed last week’s quiz, you can still take it (tgam.ca/quiz17).

As promised, today I’ll ex­plain some of the more chal­leng­ing ques­tions. Based on the feed­back I re­ceived from read­ers, some of the traps I laid were ex­tremely ef­fec­tive. Let’s start with ques­tion No. 6, which prompted the most e-mails from read­ers, some of whom in­sisted that my an­swer was wrong. Dave holds 100 shares of John­son & John­son in his TFSA. If J&J de­clares a quar­terly div­i­dend of 84 cents (U.S.), how much will Dave re­ceive if his bro­ker con­verts U.S. cash at an ex­change rate of 80 cents (U.S.) for every $1 (Cana­dian)? a) $67.20 (Cana­dian) b) $89.25 (Cana­dian) c) $98.55 (Cana­dian)

d) $105 (Cana­dian) Many read­ers chose d) $105, which is in­cor­rect. They mul­ti­plied J&J’s div­i­dend of 84 cents (U.S.) by 100 shares, then divided the prod­uct of $84 by the Cana­dian dol­lar’s value of 80 cents to get $105 (Cana­dian). And that would be cor­rect, ex­cept for one thing: In a tax-free sav­ings ac­count, U.S. div­i­dends are sub­ject to a 15-per-cent U.S. with­hold­ing tax. Dave would there­fore re­ceive $71.40 (U.S.) – i.e., 85 per cent of $84 – which works out to an­swer b) $89.25 (Cana­dian).

Keep in mind that U.S. with­hold­ing tax also ap­plies to reg­is­tered ed­u­ca­tion sav­ings plans, as well as to non-reg­is­tered ac­counts. The only way to avoid with­hold­ing tax is to hold your U.S. div­i­dend stocks in a reg­is­tered ac­count that is specif­i­cally for re­tire­ment pur­poses, such as an RRSP, RRIF or LIRA. These ac­counts are ex­empt from with­hold­ing tax un­der the U.S.-Canada tax treaty. Sev­eral read­ers were also tripped up by ques­tion No. 12: On Aug. 23, Royal Bank of Canada raised its quar­terly div­i­dend by 4 cents to 91 cents a share, payable on Nov. 24 to share­hold­ers of record on Oct. 26. To re­ceive the div­i­dend, an in­vestor would need to buy the shares: a) On or be­fore Nov. 21 b) On or be­fore Oct 25 c) On or be­fore Oct. 24 d) On or be­fore Oct. 23 To get the cor­rect an­swer, you would need to know about a re­cent change in the set­tle­ment pe­riod for stock trades. Pre­vi­ously, trades set­tled – that is, shares and cash ac­tu­ally changed hands – three days af­ter the trade date. This was known as “T+3”. As of Sept. 5, how­ever, the set­tle­ment pe­riod was short­ened to two days, or “T+2”.

As a re­sult, one would need to buy the shares on Oct. 24 or ear­lier in or­der to be a share­holder of record on Oct. 26 and re­ceive the div­i­dend. So the cor­rect an­swer is c. An­other ques­tion that had some read­ers scratch­ing their heads was No. 4: In a non-reg­is­tered ac­count, Gla­dys buys 100 shares of Bank of Mon­treal at $55 and 200 shares at $70. She then sells 200 shares at $80 (and pays the cap­i­tal gains tax). If she later con­trib­utes the re­main­ing 100 shares to her tax-free sav­ings ac­count when the price is $90, she would re­port a cap­i­tal gain of: a) $2,500 b) $3,500 c) $5,500 d) zero The first step is to cal­cu­late the cost of the 300 BMO shares Gla­dys buys. That’s easy: $19,500 ($5,500 plus $14,000). Her cost per share is there­fore $65 ($19,500/300). Now, the key thing to un­der­stand is that when Gla­dys sells 200 shares at $80 each, her cost per share for the re­main­ing 100 shares doesn’t change – it’s still $65 a share. Trans­fer­ring those 100 shares in-kind to a TFSA is known as a deemed dis­po­si­tion and the tax con­se­quences are the same as if she had sold the shares. Her cap­i­tal gain would there­fore be the $9,000 value of the shares at the time of dis­po­si­tion mi­nus their cost of $6,500 ($65 times 100), which gives us an­swer a) $2,500. Ques­tion No. 3 stumped a few peo­ple, but the ex­pla­na­tion is rel­a­tively straight­for­ward: Com­pany XYZ trades at a priceto-earn­ings (P/E) mul­ti­ple of 17. Its earn­ings yield is: a) 8.5 per cent b) 6.5 per cent c) 5.9 per cent d) un­known The price-to-earn­ings (P/E) mul­ti­ple is the share price divided by the earn­ings per share over a 12month pe­riod. A P/E of 17 means an in­vestor has to pay $17 for every $1 of earn­ings. The earn­ings yield is the re­cip­ro­cal of the P/E: If you get $1 in earn­ings from a stock that costs $17, the yield is $1/$17 or about 5.9 per cent, which is an­swer c. Fi­nally, we’ll look at ques­tion No. 14. In a non-reg­is­tered ac­count, San­dra buys 100 shares of Proc­ter & Gam­ble at $71 (U.S.) when the Cana­dian dol­lar is trad­ing at 90 cents (U.S). She later sells the shares for $88 (U.S.) when the loonie is at 75 cents (U.S.). Her cap­i­tal gain is: a) $1,888.89 (Cana­dian) b) $2,060.61 (Cana­dian) c) $2,266.67 (Cana­dian) d) $3,844.44 (Cana­dian) To de­ter­mine the cap­i­tal gain (or loss) on a for­eign stock, you must cal­cu­late the cost in Cana­dian dol­lars us­ing the ex­change rate that was in ef­fect on the pur­chase date. You would then sub­tract the cost from the pro­ceeds, also in Cana­dian dol­lars, us­ing the ex­change rate in ef­fect on the sale date. In the ex­am­ple, the cost was $7,100 (U.S.)/$0.90 (U.S.), or $7,888.89 (Cana­dian). The pro­ceeds were $8,800 (U.S.)/ $0.75 (U.S.), or $11,733.33 (Cana­dian). The cap­i­tal gain is there­fore $11,733.33 mi­nus $7,888.89, which is d) $3,844.44.

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