In December 2012, the Canadian Securities Administrators (CSA) launched a consultation on mutual fund fees, with formal submissions due by April 2013.
This has focused media and public attention both on the cost of investing and on the nature of how such costs are charged. In turn, questions on fee deductibility have been coming in to our Tax & Estate InfoService with increased frequency in the past few months, and are a regular topic of conversation I myself am having with advisors in the field.
Accordingly, it’s an opportune time to revisit the conditions under which investment counsel fees may be deductible, and how fee-based accounts and mutual fund management expense ratios (MERs) compare for tax purposes.
International initiatives in fee disclosure
For some added context on what’s possibly been influencing the CSA, it may be beneficial to look at what a number of jurisdictions are doing regarding investment fund fee structures. Many have reviewed them over the past few years, with varying degrees of change coming or proposed:
- United Kingdom – Effective January 1, 2013, the Prudential Regulation Authority (PRA) requires that advisors set their own charges for their services in agreement with their clients. Specifically, they may no longer receive commissions set by product providers or otherwise embedded in the cost of the product
- Australia – Effective July 1, 2013, Future of Financial Advice (FoFA) reforms will ban commissions that may allow product providers to influence advisor recommendations, such as sales commissions and trailing commissions. Advisors must negotiate fees for advice directly with retail clients and renew their advice agreements every two years if clients are paying ongoing fees
- Europe – In the second quarter of 2013, the European Securities and Markets Authority (ESMA) is expected to publish new guidelines for investment firms. These are designed to ensure the consistent and improved implementation of existing conflicts of interest and conduct of business requirements concerning remuneration
- United States – In 2010, the Securities and Exchange Commission (SEC) proposed Rule 12b-2, which would cap charges for certain distribution activities (including trailing commissions) at 0.25%. Fees above this amount would be allowed, but would have to be explicitly disclosed as an “ongoing sales charge” subject to a cumulative limit calculated with reference to front-end sales charges. The rule has not yet been finalized
On the international stage, clearly there is both direction and momentum toward fee-based advisor compensation. Whether and just how far Canadian regulators may go in this regard, we’ll have to wait and see. In the meanwhile, it’s worthwhile for Canadian advisors to understand the business and tax implications of fee-based billing practices.
Deductibility – The base case
An investor is entitled to deduct investment counsel fees for advice regarding the purchase or sale of specific shares or securities, or for services relating to the administration or management of shares or securities. Furthermore, the fees must be paid to an individual or firm whose principal business is to advise or provide service in such investment matters. As per the Canada Revenue Agency (CRA), “principal business” is satisfied where 50% of either time or gross revenue is spent on the activity. Understandably, the amount of fees must be reasonable in the circumstances.
Fee deductibility does not necessarily extend to all aspects of the business offerings provided by an advisor. Specifically, it does not apply to general financial counselling or planning, nor does it apply when associated with generating tax-exempt income, which includes registered accounts, such as RRSPs, RRIFs and TFSAs.
Fee-based versus MERs: Differing deductibility?
Inevitably the question arises whether a move to a fee-based model – by choice or requirement – will change the tax implications for the investor.
In this regard, a persistent myth exists that deductibility may only be available for fees directly charged to an investor, but not for fees charged internal to a mutual fund. In an article last year (Fundamentals, January 2012), I used a line-by-line comparison to show the effect of earning fully taxable income, such as interest or foreign dividends. The result is the same whether a full MER is charged within the fund or a lower F-series MER in the fund is combined with the advisor charging the difference as a direct fee.
However, where income is not fully taxable, a fee-based account may have an advantage. Take the example of a mutual fund that has only preferred income, such as Canadian dividends, capital gains and unrealized capital gains. An internally charged MER reduces this preferred income, but if some of that fee is directly charged to the investor by the advisor, it can reduce other fully taxable income.*
Aligning advisor and investor interests
Obviously, regulators are operating within their consumer-protection role in exploring investment fee structures, whether that is in pursuit of avoiding conflicts of interest, having greater transparency or encouraging optimal investment choices.
Whatever the impetus, direct-fee-billing practices may become more common as a result, and, in turn, this will affect advisor-investor relationships.
Considering the tax front on its own, investors holding all or most of their investments in registered accounts will have nothing to gain by moving to directly charged fees. For those with significant non-registered investments, however, a move to fee-based could yield a net positive result, even if overall costs remain the same.
* Note: For Quebec provincial taxes, deductions can only be taken against investment income earned. For more details, see our InfoPage titled “Deductibility of investment fees.”