The federal budget tabled on March 22, 2016 announced changes to the tax treatment of fund switches within mutual fund corporations. Despite the change, this structure continues to offer investors significant tax efficiencies for non-registered portfolios and corporate accounts.
Background
Canadian mutual funds can take the legal form of a trust or a corporation. While most funds are structured as mutual fund trusts, some are structured as mutual fund corporations. The latter are also known as corporate class funds, as each fund is a distinct class of share of the corporation.
To rebalance holdings within a mutual fund corporation, investors are able to exchange shares of one class of the mutual fund corporation for shares of another class.
By making use of an Income Tax Act (Canada) provision applicable to convertible corporate securities, this exchange is deemed not to be a disposition for income tax purposes.
The change
Budget 2016 proposes to amend the Income Tax Act so that an exchange of shares within a mutual fund corporation will be considered to be a disposition at fair market value for tax purposes.
This measure will apply to dispositions of shares that occur after September 2016.
The measure will not apply to switches between series of shares within the same class where the shares received in exchange differ only in respect of management fees or expenses to be borne.
While tax measures of this nature are usually made effective on Budget Day, it would appear that the government is content that investor-taxpayers would not be able to manipulate or circumvent the change. Accordingly, investors will have a few more months to rebalance before facing dispositions.
Continuing benefits
Apart from tax-deferred switching, mutual fund corporations have a number of tax-beneficial features that remain available.
Netting of gains and losses
Capital gains and capital losses are shared across all funds within a mutual fund corporation. This feature can lead to lower expected distributions compared with holding a series of mutual fund trusts.
- Gains that would otherwise be distributed from a class fund can be offset by losses elsewhere within the mutual fund corporation
- If a capital gain is distributed, the investor is subject to tax on that gain
- If there is no distribution, there is instead an increased net asset value, being as this is an unrealized capital gain
- That gain will be realized when the class fund is disposed, which now includes switches between funds within the mutual fund corporation
If a mutual fund corporation has more capital losses than gains in a year, the excess can be carried forward indefinitely to apply against capital gains in future years. As of March 31, 2015, Invesco Corporate Class Inc. had assets under administration of $7.01 billion, and a $1.46-billion capital loss carryforward.
The use of the loss carry forwards depends on activity within the corporate class funds. There is no assurance that this level of loss carry forwards will be maintained, nor can a timeframe be predicted in which these losses may be exhausted.
Managing high-tax income within the corporation
For mutual fund trusts, interest and foreign income are distributed to investors (net of associated expenses), to be fully taxable at the investor’s marginal tax rate.
A mutual fund corporation is taxable on all income earned by its funds. Management and operational expenses are deductible for the corporation.
- There is no distribution of interest or foreign income from mutual fund corporations
- Instead, the investor experiences an increased net asset value, roughly equal to the income earned, net of applied expenses
- That gain will be realized when a class fund is disposed, which now includes switches between funds within the mutual fund corporation
Flow-through of preferred income
Canadian dividends and realized capital gains are initially taxable to the mutual fund corporation. Special refunding mechanisms allow these two income types to be distributed to investors in their preferred form.
- Canadian dividends maintain their preferred character on distribution, allowing investors to claim the dividend tax credit, netting to a lower effective tax rate compared with other fully taxable income types
- As with capital gains realized by investor actions (now including switches), only half of distributed capital gains are taxable
As stated above, assuming the budget is passed as tabled, the measure will only apply to dispositions of shares that occur after September 2016.