Segregated funds are sometimes described as the insurance industry’s version of mutual funds. This is convenient as a rough reference point, as outwardly their value tracks against an underlying pool of investment assets segregated from the offering insurer’s other assets.
In truth, however, they are a form of annuity, a type of insurance contract. This is not mere technical phrasing; a host of rights, obligations, protections and restrictions flow from this characterization.
And as became starkly apparent during the Canada Revenue Agency (CRA) roundtable at the 2014 meeting of the Conference for Advanced Life Underwriting (CALU), this can include significant tax implications.
Tax and investment advice
As a general tax principle, an amount may (note the emphasis) be deductible in computing income where that outlay is related to the generation of income. More specifically in the case of investment counselling fees, a deduction may be available if it fits within s.20(1)(bb) of the Income Tax Act (ITA).
Fees paid to investment counsel
20. (1) … in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted …
(bb) an amount, other than a commission, that
(i) is paid by the taxpayer in the year to a person or partnership the principal business of which
(A) is advising others as to the advisability of purchasing or selling specific shares or securities, or
(B) includes the provision of services in respect of the administration or management of shares or securities, and
(ii) is paid for
(A) advice as to the advisability of purchasing or selling a specific share or security of the taxpayer, or
(B) services in respect of the administration or management of shares or securities of the taxpayer;
Notably, “a commission” (eg., a classic brokerage fee for a trade) cannot be deducted under this provision, though such a charge is factored into the adjusted cost base used in calculating any eventual capital gain/loss. In CRA’s view, a charge that is computed by reference to the fair market value of a portfolio (ie., the generic sense of a commission) may nonetheless be deductible if it otherwise fits within s.20(1)(bb).
To paraphrase the section with respect to advice and securities, there are two main components to the test:
- it must relate to advisability of purchasing or selling, and
- the advisor’s principal business must be to provide such advice.
Critical in this determination is the scope of the definition of “securities”.
CRA roundtable at CALU 2014
The CRA was asked about its views on the deductibility of investment counselling fees on segregated funds. The question was phrased as follows:
“Can the CRA confirm that investors acquiring segregated funds may deduct fees in respect of the advisability of the entering into or redeeming out of, or the administration or management of, segregated funds under paragraph 20(1)(bb)?”
The question followed from a detailed preamble providing a variety of instances where courts have broadly interpreted the term “securities”. Courts have been called upon to do so as the term is not directly defined within the ITA.
While acknowledging the judicial review of “securities” for other purposes of the ITA, in its response the CRA noted that there is nothing on point with respect to this particular section. The agency held firm in its position that a “segregated fund policy is a contract of insurance and, in our view, is not a share or security of the taxpayer.” Accordingly, in the opinion of the CRA, no deduction could be claimed under ITA s.20(1)(bb) where the advice relates to segregated funds.
The future?
While it always bears noting that the CRA’s views are not binding on courts, they clearly show the agency’s auditing perspective. Given that challenging an audit could be a costly and time-consuming process — not to mention the uncertainty — the audit decision may be the de facto result for many taxpayers.
And the complications don’t end there. While this CRA response deals with a deduction claim on a directly charged fee, what does it mean for such fees that are embedded within a segregated fund’s management expense ratio? Do those have to be annually netted out of the investment return in order to reverse-out the imputed deduction taken at the fund level?
As a final thought, one cannot generally deduct interest under ITA s.20(1)(c) where money is borrowed to purchase a life insurance policy, but s.20(2.2)(c) allows an exception for segregated funds. Though in a different context, how does CRA’s administrative prohibition reconcile with this legislated exception?
In the CALU conference report, the editors indicate that Department of Finance officials (those who draft legislation at the behest of Parliament) have expressed some sympathy to a broader interpretation, and that industry stakeholders continue to correspond with CRA in the hopes of the agency taking a more expansive view of segregated funds.