Deducting mutual fund investment counsel fees

How tax results can hinge on how fees are paid

There is a longstanding debate whether an investor is better off paying through a mutual fund’s management expense ratio (MER), or by direct fee to an advisor in a fee-based account.

The direct fee is favoured by some advisors and investors as it is more transparent than MERs, and can show the total fees on a portfolio in one place. In turn, the investor can clearly see the after-tax cost of such fees when claiming the deduction on his or her annual income tax return.

Still, the question remains whether a direct fee allows for a larger tax deduction, is neutral, or may be more costly in some cases – all issues being addressed in this bulletin.

Criteria for deductibility

As a tax principle, deductibility generally requires that a particular outlay is related to earning taxable income. The further removed from that core purpose, the less likely the outlay is to qualify.

For investment counsel fees, the financial advisor must be advising on the buying or selling of individual shares or securities, or pooled securities like mutual funds. This may include administration or management services related to those securities. Such advice or services must be the advisor’s principal business.

Non-registered accounts

Comparison using fully taxable income

To illustrate the tax effect, we’ll keep the advisor’s advice and compensation the same, whether payment is by MER or direct fee (“Fee”). Either way, the total cost to the investor will be 2% of the assets under management.

Our investor has $10,000 to place in either an A-series mutual fund with a 2% MER, or a 1% F-series version that leaves room for the advisor to charge a direct fee of 1%. To simplify the arithmetic, we’ll assume our investor is at a 50% marginal tax rate, and that the fund’s only income for the year is a 5% interest return.

In both columns, the MER reduces the initial investment return, thereby reducing the amount of income available for distribution to the investor. Once the direct fee is charged by the advisor to the investor at the second step as shown in the right column, the investor is left with the same taxable income and net income under either method.

As illustrated, there is no difference when the amount of fully taxable income – interest and foreign dividends – is at least as much as the MER of the A-series mutual fund.

Preferred income distributions

Of course, not all investment income is fully taxable. Canadian dividends benefit from the gross-up and tax credit procedure. Capital gains are not taxed until realized, with a 1/2 income inclusion for individuals on the first $250,000 of gains in a year, and a 2/3 inclusion thereafter. (The 1/2 rate is used in the examples in this article.) If the fund has preferred income, does this lead to a preference for either MER or direct fee? The answer is “no”.

A mutual fund is subject to very high tax rates, near or beyond 50% depending on the province where it is headquartered. It would be costly for investors as a whole – and particularly for those below top bracket – if the mutual fund was to pay income tax, especially if applied against preferred income. Accordingly, once MERs are applied against income, a mutual fund will always distribute any remaining income to investors.

Under either method/column in Example 1, this will be an additional distribution of the same amount of preferred income to the investor. Whatever the investor’s tax bracket, the net income will be the same either way.

Registered investments

Recall from earlier that deductibility depends on whether an investment is able to produce taxable income. Accordingly, there is no deductibility when an investor pays a direct fee to an advisor for advice on RRSPs, RRIFs or TFSAs, all of which produce tax-exempt income. This is so even though withdrawals from the first two retirement account types will eventually be fully taxable.

RRSP or RRIF holding mutual fund

When a MER is charged within a mutual fund in a RRSP/RRIF, it reduces the fund’s investment return, just as it does for a mutual fund in a non-registered account. However, if a fund series with a reduced MER is used to allow a direct fee to be charged, the net tax result to the plan annuitant depends on the source used to pay that fee.

All money within a RRSP/RRIF is yet to be taxed, whether in a mutual fund or in the form of cash. A direct fee may be paid by a RRSP/RRIF trust using pre-tax cash held inside the account, effectively achieving the same result as when a MER is charged within a mutual fund. On the other hand, if the RRSP/RRIF annuitant pays a direct fee using non-registered/after-tax money, no deduction is allowed.

To illustrate the distinction, we’ll add a column in Example 2. The left column charges full MER, while the middle and right columns have a reduced MER plus a direct fee, respectively paid from within the RRSP/RRIF or out of non-registered/after-tax money. To show the final after-tax result, the income will be immediately withdrawn by the RRSP/RRIF annuitant. Though the amount available for withdrawal is highest in the right column, once the non-deductible direct fee is paid, the net income is $100 compared to $150 under either of the other two methods.

It should be noted that in order to show the after-tax comparison on the bottom line of Example 2, the non-registered money is actually sourced out of the RRSP/RRIF.

Instead, what if there were no distributions, and the direct fee in the right column was paid using a (non-registered) $100 bill you already had in your pocket? That would preserve $400 of RRSP/RRIF in the right column, which is $100 better than the $300 in the other two columns. More tax-sheltering room must be better, right?!

As appealing as that first appears, it’s an illusion until the tax is reconciled. If you cash out the $400 in the right column, you’re left with $200 after-tax. For the other two columns, your $300 nets to $150 after-tax, to which you can add the $100 bill in your pocket to total up to $250, still $50 better than paying a non-deductible direct fee.

TFSA holding mutual fund

As mentioned above, TFSA income is tax-exempt, so direct fees are not deductible. The net income of a mutual fund inside a TFSA will be the same whether fees are paid by MER, by direct fee from within the TFSA or by direct fee via a non-registered account.

But what about this idea of preserving tax-sheltering room by paying a direct fee from a non-registered source? As we just saw, that didn’t work out with RRSP/RRIFs, owing to the fact that later withdrawals from that type of registered account are taxable. By contrast, when a direct fee is paid from outside a TFSA, the preserved tax-sheltering room will ultimately be delivered through to the planholder as a tax-free TFSA withdrawal.

An alternative way to illustrate this is to assume that the TFSA itself is the cash source for the direct fee, as shown in Example 3. By any of the three column/methods, the net increase for the TFSA is $300. In the first two columns, all the money remains within the TFSA, but in the right column the planholder makes a $100 withdrawal to pay the direct fee, giving the planholder a $100 re-contribution credit the following January 1^st.

Related considerations

Financial planning

Financial planning addresses a person’s overall financial needs, including budgeting, saving strategies, credit/debt education, and tax and estate planning. To provide context and foundation for investment recommendations, financial advisors may engage in financial planning discussions and prepare formal plans.

As important as these services are in providing the personal context for investment advice, they are not directly related to earning income, and therefore any fees charged for financial planning are not deductible.

Tax preparation

Personal income tax return preparation fees are generally not deductible, regardless who is preparing the return. But if part of the preparation fee relates to calculating and reporting the details of business income and/or investment income, that portion may be deductible. For those whose income is derived principally through business income and non-registered investments, this could arguably amount to almost the full preparation fee.

It’s helpful if the fee’s components are itemized—or better yet, if the preparer renders a separate invoice for the business and investment-related fees.

Not applicable to segregated funds

Segregated funds are sometimes described as the insurance industry’s version of mutual funds. Despite the similarities to mutual funds, segregated funds are legally structured as annuity contracts (a form of life insurance) whose value fluctuates with a pool of investments that the insurer ‘segregates’ from its other assets.

The current position of the Canada Revenue Agency (CRA) is that a segregated fund is not a share or security, and therefore no deduction is allowed for investment advice related to the purchase or sale of segregated funds.

Reasonableness

There is a general requirement under the Income Tax Act that in order to claim a deduction, the outlay or expense must be reasonable in the circumstances. Reasonableness could be an issue if:

- A combined fee is levied for financial planning, tax preparation and investment counseling, allowing the client to choose how to allocate that among the services
- A single investment counsel fee is charged, covering RRSP/RRIF, TFSA and non-registered accounts, allowing the investor to determine how much is related to each account type
- Investment fees are pooled for multiple family members and charged disproportionately to one of them
- A higher fee is charged on non-registered assets compared to registered assets, even though the advice and/or service is otherwise indistinguishable

In all these situations, the investor’s deduction claim could be questioned as to reasonableness, bearing in mind that the legal onus lies with the taxpayer to prove entitlement to a tax benefit, not upon the CRA to disprove it.

Investment fees paid from outside RRSP, RRIF or TFSA – CRA position deferred to 2019

At issue

A common feature among RRSPs, RRIFs and TFSAs is that investments accumulate on a tax-sheltered basis. In principle, any reduction in the amount in the respective account reduces the benefit of that tax sheltering. Where investment management fees are paid from an external source, more money remains invested in the particular account.

However, whether an investor is inevitably better-off should take into consideration the source of those external funds. Whereas RRSP and RRIF accounts are pre-tax, a TFSA is after-tax. Arguably, using after-tax money from a cash account for a pre-tax RRSP/RRIF fees may not be the best result for an investor. The benefit is clearer with TFSAs, as both it and a cash account hold after-tax funds. Investors should consider their own tax position before coming to a conclusion.

Apart from the investor’s decision, the Canada Revenue Agency (CRA) has been mulling over the issue. According to its most recent communication, their updated and more stringent position will not apply until 2019, and hopefully we’ll have more clarity on that position early in the coming new year.

Income Tax Act s. 207.01(1) (b)(i)

These “advantage rules” were enacted in 2007 with the introduction of TFSAs, and were extended to RRSPs and RRIFs in 2011.

The definition of “advantage” applies to an increase in the value of a registered plan because of an action or transaction of a non-arm’s length party to the plan. If someone at arm’s length party would not have taken the action, and if the purpose is to benefit from the plan’s tax-exempt status, then a 100% tax applies to the amount of the determined advantage.

2016-0670801C6 – 2016 CTF Q5. Investment management fees for RRSPs, RRIFs and TFSAs

The CRA has a long-standing administrative policy that it does not consider it to be an over-contribution if a planholder uses outside funds to pay registered plan expenses. At the 2006 Canadian Tax Foundation Conference, the CRA was asked whether it holds a similar deferential view on the application of the (relatively new) advantage rules.

In response, CRA stated that an increase in value of the registered plan indirectly results from investment fees being paid by a party outside of the plan. This would likely be an advantage, and the planholder could personally be subject to advantage tax of 100% of the amount of fees paid.

The agency then advised that it was continuing its review of fees and fee rebates and would share the results in an Income Tax Folio expected to be published in early 2017. Its revised position would apply to fee payments after January 1, 2018.

2017-0722391E5 – Investment management fees

In September 2017, the CRA announced that it was considering a number of submissions from various stakeholders, and would be deferring the proposed implementation date by one year to January 1, 2019.

It made no mention of an updated target date for publication of the relevant Tax Folio, nor did it give any indication that it might be reconsidering its position.

Practice points

Expect publication of the Income Tax Folio on the advantage rules in 2018. As the CRA’s original advisory acknowledged that time would be needed for the investment industry to make applicable system changes, presumably CRA is still targeting for a date early in the year.
There will be no negative tax consequences for the payment of investment fees for registered accounts from any source any earlier than 2019.
Apart from the CRA/tax rules, individual investors should consider their own tax situation before deciding the appropriate source for the payment of investment fees.

Per CRA, no fee deductibility for advice on entering into or redeeming segregated funds

At issue

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 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. Of particular interest are guarantees of future account value or income flow, though the insurer will charge a fee inside the contract for this.

But how are fees charged outside the segregated fund by a financial advisor treated for tax purposes? Specifically, does advice related to segregated funds mirror the tax-deductibility accorded to advice on buying and selling mutual funds?

Income Tax Act (ITA) Canada paragraph 20(1)(bb) – Fees paid to investment counsel

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. Enumerated under ITA s. 20(1) are deductions permitted in computing income from business or property, with investments falling within the latter category.

Pursuant to ITA 20(1)(bb)(ii)(A), a deduction may be taken for “advice as to the advisability of purchasing or selling a specific share or security of the taxpayer” where fees are paid to a person whose principal business is advising in that respect. Mutual funds pool investors’ capital to invest in shares or securities, and thus qualify under this section.

2014 CALU Conference, Question 5 – Segregated Fund Counselling Fees – May 6, 2014

At the 2014 Conference of Advanced Life Underwriters (CALU) roundtable, representatives of the Canada Revenue Agency (CRA) considered whether a deduction should be allowed for advice related to the purchase or sale of segregated funds. The key part of the response is as follows:

“Paragraph 20(1)(bb) of the Act applies in the context of shares or securities of a taxpayer. A segregated fund policy is a contract of insurance and, in our view, is not a share or security of the taxpayer. Consequently, it is our position that paragraph 20(1)(bb) of the Act does not apply to fees paid by a taxpayer in respect of the advisability of the acquisition or disposition of segregated fund policies, or for the administration or management thereof as the requirements of that paragraph are not met.” [Emphasis added here.]

In the conference report, the CALU editors indicated that Department of Finance officials had expressed some sympathy to a broader interpretation, and that industry stakeholders would continue to correspond with CRA in the hopes of the agency taking a more expansive view of segregated funds.

2014-0542581E5 (E) – Segregated fund counselling fees – August 24, 2016

In an email dated August 6, 2014 (sent 3 months after the CALU conference above), the CRA was asked to reconsider its position that a segregated fund policy is not a security. In its response, CRA redacts the addressee’s name, though it appears to be directed to CALU.

After acknowledging that there are arguments for and against the proposition based on the plain text of the terms, the analysis turns to the context in which the words are used. Specifically, paragraph 20(1)(bb) is an exception to the general limitation on deductibility delineated in paragraph 18(1). The position put forward is that as the exception is narrowly drafted, its interpretation should be similarly narrow.

The author then harkens back to predecessor provisions of the ITA and the definition of the term “security”, both pre-dating the existence of segregated funds. From that perspective, an expansion of that definition could have unintended consequences elsewhere in the ITA.

In the author’s opinion, the inclusion of segregated fund in the definition of security is not supported by the law, so a legislative amendment would be necessary to achieve this result. The letter then acknowledges that the issue has already been brought to the attention of the Department of Finance, presumably by the letter recipient.

Practice points

CRA does not consider counselling fees deductible when paid to an advisor who advises on entering into or redeeming segregated funds.
For clarity, the subject matter of this discussion is the charging of fees directly by an advisor to an investor/client. Any fees charged within a segregated fund cannot be claimed as a deduction by an investor.
Note as well that segregated funds have both insurance and investment elements that may make them well suited to a particular individual, with deductibility being a secondary consideration or non-issue.
Depending on the reception at the Department of Finance, this may not be the end of this issue, though it is ultimately up to legislators whether to make changes to the law.