PERFORMANCE ANNOUNCEMENT

As Of: February 13, 2004

Tail Wags Dog

When Tax Changes Determine Investment Decisions

      In general, I am against high taxes because it means the government is allocating resources (usually inefficiently) instead of the free market. However, I have trouble working up a lot of sympathy for people who complain about paying taxes. After all, if you are paying taxes, it means you are making money; and making money is the goal. Thus maximizing profit should be the primary investment objective, and minimizing taxes is usually relegated to a secondary consideration.

      That being said, 1) There is no reason to pay any more taxes than is legally required, and 2) Minimizing taxes should drive the investment strategy when it maximizes the net after-tax result. The new lower dividend tax rate of 15% is a good example. Many people do not realize that the new lower 15% rate comes with some restrictions. Investors who purchase on margin and are used to taking a deduction for margin interest may be surprised to learn how the tax changes have complicated their lives.

      The basic rule for deducting interest paid for a loan to make investments says that the amount of deduction cannot exceed interest and dividend income from investments for the year. Additionally, the new rule says that if you apply your dividend income against margin interest to receive a deduction, you will not be able to receive the lower 15% tax rate on dividends. For some people who elect to deduct margin interest, their tax on dividends could be as high as 35%. Therefore, the investor now has to choose between deducting margin interest or using the lower 15% tax rate on dividends.

      Upon first look, it may seem that taking the margin interest deduction is still the better choice. Consider the example of a stock that pays a 3% dividend and appreciates 8% over the course of a year. The investor's total return is 11%. The tax on the dividend at a 15% rate is (.15 x .03 = .0045) less than ½ of one percent. Thus, the investor receives about 10.5% (not counting the tax on his capital gain). The same investor purchasing on margin invests the same amount of cash but owns twice the amount of stock. Thus the investor receives a 16% return on his investment from capital gains plus 6% from dividends, or a 22% total return. In the highest tax bracket, his return from dividends drops to about 4%, making his total return about 20% (not counting the tax on his capital gain). Additionally, a deduction can be taken for the margin interest paid. The interest deduction would typically be higher than the dividends received. Obviously a 20% return is better than a 10.5% return. (Please notice we are not taking into account the considerable risk factors that enter when margin is used.)

      In spite of the exercise just completed in the previous paragraph, purchasing on margin may not be the best choice. In recent years numerous derivative contracts have been invented and are now publicly traded. Futures contracts and options contracts are the most prevalent. These derivatives can provide the same or more leverage than purchasing on margin, and may not have the adverse consequences of disallowing the lower tax rate on dividends. Consider the example of someone purchasing Anglogold Ltd during the past year. While the price of gold moved from about $360 per ounce to $400 per ounce, Anglogold Ltd stock rose about 80%. If timed perfectly and purchased on its low of $27, an investor could have made a 160% return by borrowing $2,700 to purchase 200 shares instead of 100 shares. But as an alternative, for less than $2,000 the same investor could have purchased 100 ounces of gold in the form of a futures contract. As gold moved up $40 per ounce, the investor would have received his $2,000 back plus a profit of an additional $4,000. He would have had a far higher return and not impacted the tax on dividends received from other stock investments or an additional purchase of shares of Anglogold Ltd. Similar examples can be shown by employing the leverage offered by options. Thus, well informed investors may be encouraged by the tax law changes to investigate other markets and other forms of investment to both increase returns and minimize taxes.

      Please Note: Lennox Financial is not in the business of giving tax advice. The tax code is very complex and specific situations may vary considerably from the expected normal result. Individuals are encouraged to consult their own tax experts before basing any investment strategy on a particular tax outcome.