The net result of mergers is that losses are being lost to the fund. They are more than the capital gains

By Jean Murphy | August 2004

Fund consolidation has been sweeping the industry for several years now and the bottom line may be that billions of dollars in tax credits are being lost as the industry streamlines and funds merge.

Federal tax rules say that both capital and non-capital losses of a terminating fund can be used to reduce capital gains only in the tax year in which the merger takes place, says Dan Hallett, president of Dan Hallett & Associates Inc. in Windsor, Ont. In other words, losses are “lost” to the fund if they cannot be fully absorbed in the year of the merger. This applies to both mutual fund trusts and corporations. The net result may be that some unitholders of merging funds have to pay more taxes post-merger than pre-merger.

Mutual funds incur two types of tax losses. Capital losses are generated when a security is disposed of and proceeds are less than the cost of acquiring them. They can be applied to reduce capital gains by either carrying them back three years or carrying them forward indefinitely.

Non-capital losses are generated when expenses (management fees, operating expenses) exceed the interest and dividend income of the fund. Non-capital losses can be applied against both capital gains and income, and can be carried back three years or forward seven years. Non-capital losses reported by the funds thus far will expire in 2010 at the latest. As a general rule, mutual funds carry losses forward because it’s not practical to carry them back in time.

But when it comes to fund mergers, the rules change. If a small fund holding big capital losses merges with a large fund, the losses of the smaller fund cannot be used to offset capital gains earned the next year by the combined fund. They can only be used in the year of the merger. That means the unitholders is on the hook for more capital gains taxes.

One the other hand, if the small fund had stayed independent and earned a capital gain the next year, it can probably offset most of the gain by the losses carried forward.

Hallett points out that some of the funds merging recently are on the small side because of heavy redemptions and/or losses. As a result, he says, many of these small funds have losses that, when expressed as a percentage of assets, are huge. Those losses are lost to the merged fund.

Dozen of mergers

Over the past two years, the largest fund companies have merged dozens of funds. Many have had large capital losses, sometimes equal to two or three times a fund’s assets.

The trend became pronounced in the funds’ 2003 fiscal years, and continued to some extent this year. As a result, fund losses at continuing funds rose sharply in 2003 (see table) as smaller funds, sometimes with large losses, were merged into larger ones. (It will be another year before data for the current year is available.)

For the 2003 fiscal year, capital losses at the largest fund companies rose to $22.8 billion, up considerably from $19.2 billion for all the funds the previous year.

Non-capital losses, which expire up to seven years after the year in which they are incurred, added another $2.1 billion, but that was down slightly from the $2.6 billion in 2002.

Although two-thirds of all funds reported capital losses in 2003, that number was down from three-quarters the previous year.
Large losses incurred during the market downturn aren’t going away, as the dollar value of the funds continued to increase in 2003.

Technology fund losses

As in previous years, international equity funds, particularly those with technology mandates, hold the largest capital losses. Three-quarters of all international funds were sitting with losses at the end of their 2003 fiscal years totalling $12.3 billion, up 32.2% from the $9.3 billion reported for the previous fiscal year. Almost all the funds with the largest losses, both on a dollar basis and as a percentage of assets, are foreign funds.

Losses for Canadian equity funds rose 43.8% to $4.6 billion in fiscal 2003, up from $3.2 billion in fiscal 2002. Fully two-thirds reported losses, compared with about 60% the previous year. For the most part, losses tended to increase from the previous year, probably as a result of consolidation with other funds. Losses for Canadian equity funds accounted for 16.8% of the total, off slightly from 17.1% the previous year.