Be wary of Liberal plan for labour-sponsored funds
There are some admirable proposals in the platform of the new Liberal government that was sworn in this week.
There are also some that I think should be immediately relegated to the darkest, dustiest corner of the political attic, hopefully to never again see the light of day.
One of the changes is the promise to restore the federal tax credit for labour-sponsored venture capital funds. At first glance, it’s almost inconceivable that any government would want to resurrect a program that, for the most part, was a dismal failure and cost investors millions of dollars in losses.
In fact, there is some method to this seeming madness, which I’ll get to in a moment. But first, some background.
Way back in 1988, the federal government introduced a program designed to channel money into start-up businesses with the goal of promoting innovation and creating jobs. Investors in venture capital funds sponsored by labour unions were allowed to claim a tax credit for their money, up to a fixed limit. After a tepid initial response, Ottawa sweetened the pot in 1992 by raising the tax credit to 20 per cent and the investable limit to $5,000. Many provinces, including Ontario, matched the feds.
The math for someone buying these shares in an RRSP was almost irresistible. On a $5,000 investment, the federal and provincial tax credits saved $2,000. A taxpayer with a 40-per-cent marginal rate received a tax deduction of another $2,000 for the RRSP contribution, reducing the real net cost of the shares to only $1,000 — one-fifth of their face value.
Not surprisingly, the money poured in and new venture capital funds sprouted like mushrooms, specializing in everything from technology to entertainment. During the 1996 RRSP season, about $700 million was invested in these funds in Ontario alone.
Alarmed at the tax drain, the finance minister of the day, Paul Martin, cut back the credit to 15 per cent in his 1996 budget and the provinces followed suit. Sales slumped sharply, dropping back to $200 million in Ontario in 1997 and $125 million in 1998. At the same time, investors were discovering that the tax breaks that lured them in were a trap.
Returns in many cases left a lot to be desired, and the high-tech crash of 2000-2002 really burst the bubble. Most of the funds had bet heavily on start-up technology businesses, some of which went under. The Triax Growth Fund posted an average loss of 32 per cent per year over the three years to May 31, 2003. Several other funds recorded annual losses in excess of 20 per cent. Desperate investors who wanted to get out suddenly discovered they were locked in for eight years. Under the terms of purchase, selling sooner meant repaying the tax credits, which would only add to the losses.
Some funds merged while others suspended redemptions. To this day, there are still restrictions on some of the surviving funds.
Investors were understandably disenchanted and the cash flow dried up. The apparent death knell came in 2005 when the Ontario government announced it would discontinue its 15-per-cent tax cred- it. In 2013, the late federal finance minister Jim Flaherty stated that the federal credit would be phased out as well.
That prompted a howl of protest from the remaining labour-sponsored funds, led by Gaétan Morin, who is now CEO of Quebec’s huge Solidarity Fund (more than $11 billion in assets). He called the decision “irresponsible” and vowed to fight it.
In its 2015 annual report, Solidarity claimed that revoking the federal credit had cost the average Quebec contributor $402 in the 2014 tax year and vowed to continue its “sustained efforts” to lobby Ottawa for its restoration.
Therein lies the reason for this plank in the Liberal platform. The party desperately wanted to make inroads in Quebec and this was one way to help achieve that. The platform commits the party to reinstate the 15-per-cent federal tax credit to “help support economic growth and help Canadians save for their retirement.”
It goes on to say that in Quebec, these funds help 650,000 people save money “while investing in Canada’s entrepreneurs.”
Not surprisingly, Mr. Morin called the move “good news” and said it “shows that the prime minister designate understands the importance of the Fonds de solidarité FTQ for our economic future.”
A few labour-sponsored funds have made profits for investors over the past decade, but not one has exceeded a 5-per-cent annual gain. Over the 12 months to Sept. 30, the average fund in this category lost 4.8 per cent.
Quebec’s Solidarity Fund hasn’t been a disaster, but its track record is mediocre.
As of May 30, the 10-year average annual compound rate of return was 4 per cent. The Canada Pension Plan Investment Board has returned about double that.
Quebecers who contribute to Solidarity will undoubtedly welcome the return of the federal credit. Everyone else should approach this tax break with extreme caution. History is not on our side. Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. His website is BuildingWealth.ca. Follow Gordon Pape on Twitter: @GPUpdates.