There are several tax-planning opportunities associated with mutual funds. To understand how your clients can take advantage of them, however, it is important to understand how mutual funds are structured and how they distribute taxable income and gains.
A mutual fund can be structured as a trust, with investors called “unitholders,” or as a corporation, with investors called “shareholders.” Regardless of structure, income earned and gains realized in a mutual fund are subject to tax annually. In general, it is more tax efficient for a fund to flow out taxable income to investors than to pay tax itself at typically high rates.
If the income were taxed in the fund rather than being flowed out, investors “may end up paying more – it would be reflected in a lower net asset value [NAV],” says Wilmot George, vice president of tax, retirement and estate planning with Toronto-based CI Investments Inc.
A mutual fund trust can flow out interest, Canadian dividends, capital gains and foreign income to its unitholders, with distributions retaining their tax nature in the hands of the unitholders. A mutual fund corporation, on the other hand, can flow out only Canadian dividends and capital gains. Interest and foreign income must be taxed first in the corporation and then flowed out as Canadian dividends.
Here are three key tax-planning considerations:
1. Yearend distributions
A client may be able to achieve a tax deferral by delaying the purchase of a mutual fund until after an anticipated taxable distribution, such as those that occur near yearend.
If an investor elects to purchase units in a mutual fund just before a distribution, he or she will receive a pro-rata share of those distributions and be taxed on them, “even though the value of those distributions may have been reflected in the cost that [the investor] paid for those units,” says Debbie Pearl-Weinberg, executive director, tax and estate planning, with Canadian Imperial Bank of Commerce’s financial planning and advice group in Toronto, and chairwoman of the Investment Funds Institute of Canada’s taxation working group.
Purchasing a mutual fund immediately after a distribution should be viewed as “more of a tax deferral as opposed to a significant tax savings,” George says. That’s because delaying a purchase until after a distribution will result in an investor purchasing the mutual fund at a lower NAV, and thus a lower adjusted cost base (ACB). That will mean a larger potential capital gain when the mutual fund is eventually sold than would be the case had the mutual fund been purchased before the distribution.
There’s also the potential opportunity cost associated with delaying a purchase should the fund rise in value. John Soutsos, a financial advisor with Mississauga, Ont.-based IPC Securities Corp., says that as yearend approaches, he has to balance the relative merits of delaying a purchase against the potential opportunity risk associated with remaining out of the market. “The last 45 days of the calendar year start to become tricky,” Soutsos says.
However, it can be difficult for investors to know if a mutual fund will make a distribution and how much it will be, although some mutual fund companies may provide advance guidance.
“If you can [time a purchase] with ease, and it makes sense, fine,” George says. “But, for a lot of investors, jumping through hoops to avoid a distribution just doesn’t make a lot of sense.”
2. Return of capital funds
When a mutual fund makes distributions in excess of income, dividends and capital gains, the excess portion is considered a return of a part of the investor’s capital, or ROC, and is not taxable to the investor. Some funds must pay regular distributions, with any difference between the fund’s taxable distribution and the set distribution amount made up via ROC.
ROC funds can work for retirees looking for a steady income stream.
Since ROC distributions are not considered taxable income, they may also help a retiree minimize the clawback of income-tested government benefits, such as Old Age Security.
Again, tax experts caution that the tax benefit associated with ROC is one of deferral, rather than true savings. A return of the investor’s capital reduces the ACB, meaning when the fund is eventually sold, a larger capital-gains tax liability may arise. In fact, if, after many years of ROC distributions, the ACB is ground down to zero, all distributions that would have been ROC before would then be considered capital gains.
Aurèle Courcelles, assistant vice president, tax and estate planning, at Investors Group Inc. in Winnipeg, suggests that a charitably inclined client might consider donating an ROC fund in his or her will. If your client makes an in-kind donation of an ROC fund with a low or zero ACB in a will, the estate will receive a charitable donation tax receipt for the value of the fund, but the related capital-gain inclusion rate will be zero.
“You can benefit from the tax-free cash flow [from the ROC fund] during your lifetime, and at death, if you intend to make a charitable donation, and give away the asset with the biggest capital gain on it,” Courcelles says.
3. Corporate class funds
While a mutual fund trust is an entity in its own right, a mutual fund corporation typically consists of different classes, with each class representing its own distinct fund. While the performance of each class is contingent on the performance of the fund’s underlying assets, the income and gains generated across all the different classes can be offset against the expenses and losses across the entire corporation, providing an opportunity to reduce an investor’s taxable distributions.
In the past, it was possible for a client to switch between classes without triggering a taxable event, providing them with an opportunity to defer taxation until they ultimately withdrew money from the corporation. In the 2016 federal budget, however, the government eliminated that tax-deferral opportunity.
Despite the change in tax law, corporate class funds “continue to be an efficient way to grow money,” George says. “They’re designed to generate capital gains over time, and specifically, unrealized capital gains that will be realized sometime down the line.”