Advisors with clients holding units of corporate-class funds may want to complete any portfolio rebalancing for their clients while there’s still time to defer taxes on any capital gains.
As of this yearend, corporate-class mutual funds will be losing the benefits of tax-deferred switching among the various funds held within such a corporate structure. This benefit allows capital gains that normally would be triggered when units in a fund are sold at a profit to be deferred until the year in which the unitholder sells all holdings in the corporation. (Conventional mutual funds are structured as trusts and do not offer this deferral of taxes.)
This 30-year old tax break is gone as of Jan. 1, 2017. “If there is any rejigging to be done to prepare the portfolio for the next phase of the client’s investment life cycle, or any rebalancing back to the client’s strategic asset mix, then financial advisors need to be mindful to get that done before the end of the year,” says Dan Hallett, vice president and principal at HighView Financial Group of Oakville, Ont. “Trades should be done in time to make sure they settle by yearend. Don’t push it to the eleventh hour.”
The new rules mean that any mutual fund unitholder switching funds within a corporate-class structure will be considered to have made a disposition at fair market value for tax purposes, and any gains beyond the cost base will be taxable.
Previously, corporate-class funds were useful tactical strategies. These fund families allowed unitholders to make short-term changes in their asset class exposures to benefit from changing market trends without triggering tax consequences when selling those fund units, says Peter Bowen, vice president, tax and retirement research at Toronto-based Fidelity Investments Canada ULC. Now, the 74 corporate-class funds offered by Fidelity are a better fit for a longer-term strategic approach, he adds.
“We believe corporate-class funds continue to offer significant value,” says Bowen. “The reality is that not all that much switching ever took place, as investors tend to stick to a financial plan. Clients can continue to benefit from the other tax advantages that corporate-class funds offer relative to conventional funds.”
The primary continuing benefit of corporate-class funds is the ability to pool the income and expenses of all funds in the fund family, thereby minimizing or deferring taxable distributions overall. The structure is particularly useful for income- oriented funds that tend to produce returns in the form of fully taxable interest or for foreign equity funds that throw off dividends ineligible for the Canadian dividend tax credit. Reduction of taxes can be achieved by offsetting fully taxable income earned on these kinds of funds with unused expenses and loss carry-forwards transferred from other funds in the specific fund family.
“Distributions paid by corporate-class funds tend to be lower than for regular funds and can only be in the form of eligible Canadian dividends or realized capital gains, which offer tax advantages relative to regular income,” says Frank DiPietro, assistant vice president of tax and estate planning, with Mackenzie Financial Corp. of Toronto.
Pooling of expenses
For example, unitholders of Mackenzie Ivy Foreign Equity Class, a corporate-class fund, do not receive foreign dividends, which are fully taxable, as a component of their units’ distributions. But the structure also can be effective for Canadian equity funds, he adds, due to the ability to pool expenses and income among all funds in the corporate-class family. Mackenzie, which has 40 corporate-class funds, remains committed to those products and will be enhancing its lineup this autumn.
The corporate-class structure is primarily of benefit to high net-worth clients with financial assets held outside registered plans such as RRSPs or tax-free savings accounts. The value of assets held in corporate-class funds stands at $140 billion, according to Toronto-based Investor Economics Inc., compared with $1.3 trillion held in conventional mutual funds.
DiPietro says the tax efficiencies of the corporate-class structure can appeal to clients who are small-business owners who channel excess cash into operating or holding companies, which normally are subject to high corporate taxes. He says the product also is attractive to parents and grandparents holding units of mutual funds in informal in-trust accounts for children. Typically, the taxes on any interest or dividends paid by a conventional fund are taxable in the hands of the contributor to these accounts, while realized capital gains are attributed to the child (who normally doesn’t pay taxes). Corporate-class funds can minimize the taxes on any interest or dividends.
Corporate-class funds also are useful for systematic withdrawal strategies, in which unitholders sell off their units on a regular basis to create an income stream. For example, retirees with assets held outside an RRSP can enjoy tax efficiency on income earned within the corporate-class funds, while regular withdrawals from the overall structure would be taxed as capital gains or return of capital, which are tax-advantaged.
“The decision to end tax-deferred switching reduces benefits to investors,” says Hallett, “but doesn’t eliminate [those benefits] entirely or invalidate the product.”
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