Borrowing to Invest in Dividend Stocks

In Canada, the CRA allows one to deduct interest expenses (Line 221 in the 2011 tax return) used for income producing investments from their net income, which results in lower taxes paid by an individual in any given tax year. I was curious as to whether or not borrowing to invest in dividend paying stocks would result in more income after taxes. To investigate this, I created a spreadsheet model to test a number of scenarios. The results I found were pretty interesting, and are summarized below:

Scenario 1 Scenario 2 Scenario 3
Employment Income $100,000.00 $100,000.00 $100,000.00
Dividend Income $0.00 $425.00 $500.00
Interest Paid $0.00 $425.00 $425.00
CPP $2217.60 $2217.60 $2217.60
EI $786.76 $786.76 $786.76
Employment Credit Amount $1065.00 $1065.00 $1065.00
Ontario Health Premium $750.00 $750.00 $750.00
Loan for Investing $0.00 $10,000.00 $10,000.00
Loan Annual Interest Rate n/a 4.25% 4.25%
Dividend Yield n/a 4.25% 5.00%
Net Income $100,000.00 $100,000.00 $100,075.00
Federal Taxes $17,578.41 $17,525.22 $17,535.34
Provincial Taxes $9726.15 $9,696.66 $9,704.51
Total Taxes $27,304.56 $27,221.88 $27,239.85
Income After Taxes $72,695.44 $72,952.37 $73,040.15

Some notes about the above. First, to keep things simple I used employment income of $100,000. I wish I made that much, but it makes things simpler for the model. $100,000 net income simplified the Ontario Health Premium, which was $750.00. I also assumed the maximum for CPP and EI. All of these numbers are based on the 2011 tax year for the Province of Ontario. And as one final check, I punched the same numbers into the Canadian Income Tax calculator found at Tax Tips and came up with identical results.

So, what do those results tell us? Scenario 1 is the control scenario, where we don’t borrow and don’t receive dividends. In that scenario, an individual pays out $27,304.56 in income taxes for the given year. Scenario 3 was a more realistic scenario: borrowing to invest in a company whose dividends were higher than the borrowing interest rate. Thanks to the tax credits one receives on dividend income, and the fact that interest income is deducted from your net employment income, the total taxes paid were less than in Scenario 1 by $64.71. What was surprising Scenario 2: borrowing to invest, and then purchasing shares in a dividend paying corporation with a dividend yield identical to the interest rate on the loan, yielded less overall taxes than Scenario 1 by $82.68! This means that borrowing to receive dividends where the net gain between interest payments and dividend income is $0.00 still yields lower taxes.

Of course, there are a couple of caveats to this approach. First off, when you borrow, you have to pay off the principal as well. However, if you are borrowing to invest in quality companies, then in theory the company’s share price should increase, so over time you could unload your position to pay back the principal of the loan. Also, most loans require you to pay both interest and principal. CRA rules only allow you to deduct the interest payments, not the principal payments; this means that your net income before taxes would be lower than in the model here, which assumes that you never pay down the principal. Finally, when you do go to sell the position, you will be hit by a capital gains tax.

Given the caveats, one, the extra cash in hand is less than $100 (which is less than 0.1% of $100,000 net income), two, the extra work involved, and three, the risks of the company’s share price dropping, this strategy may not be worth it. However, it was still an interesting exercise; no matter which way you cut it, you are still technically better off since you end up with more cash in pocket at the end of the day.

Analysis: Calian Technologies (CTY.TO)

As you would expect from the company name, Calian Technologies is a Canadian based technology firm which operates in two industries: Systems Engineering and Business & Technology Services (BTS). The company has been in business for over a decade, but they only started issuing dividends in 2003. Even then, the company has managed to increase their dividend every year, along with a special dividend of $1.00/share in 2010. Year over year, their share price CAGR is 14.10% from 2003-2011.

Taking a look at a graph of dividend payouts vs. their dividend payout ratio, they have had consistent dividend increases since 2003. CAGR for dividends is 24.88%, which excludes the one time special dividend in 2010. Their dividend payout ratio has had a range of 17%-56% (highest was in 2011), but they have remained consistently below 60% since issuing a dividend. THe spike in 2010 relates to the special dividend and actually pushed their dividend payout ratio to 102%.

Compare the dividend payout ratio to EPS, and two things are clear: EPS is on a constant upward trend with slight dips, but even with these dips the dividend payotu ratio has stayed consistently low; this shows me that management has taken a measured approach to delivering a constantly growing dividend, but ensuring that the dividend growth does not outpace EPS growth.

Three other indicators I like to take a look at are the P/E ratio, and ROE, illustrated below. ROE CAGR has been 2.85%, which isn’t stellar, but it is still an upward trend. P/E ratio has remained consistently below 15, and while the P/BV has broken 1.5 a few times, the combined P/E×P/BV has still stayed below 25.0.

As of the 2011 fiscal year, Calian had a P/E ratio of 10.1554, P/BV ratio of 2.1275 giving a P/E×P/BV of 21.6056, which is within the range at which I would consider buying a position. However, those numbers are based on a share price of $17.35. Currently (closing of July 20, 2012) CTY.TO is trading at $20.73 on the TSX, which bumps P/E to 12.1338 and P/BV to 2.5420, pegging us at a combined value of 30.8437. This is a touch high; I do like the dividend yield which currently sits at 5.07%, but would prefer to jump in at the sub-$20 mark.

Disclosure: No CTY.TO. As of Sept 2012 I hold CTY.TO.