Tag: Fees

Deduction denied – Tax treatment of investment counseling on segregated funds

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:

  1. it must relate to advisability of purchasing or selling, and
  2. 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.

Fee-based accounts on the horizon? – Regulatory initiatives and tax implications

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.”

Money for nothing? – Of commissions, fees and advice

I was humming that classic Dire Straits tune “Money for Nothing” as I traveled the moving sidewalk at the airport last month.  My flight was headed south of the border that day, and not having allowed enough time to make it to my own financial institution that morning, I instead employed the money changer’s booth on the departures level. 

On a day when the loonie sat a full penny above parity, it cost me $238.52 Canadian to receive $200.00 of the US variety.  Do your own arithmetic, but in ballpark terms that’s roughly a 20% premium.  I said as much as I scraped my jaw off the counter, and took little solace when the clerk suggested that it’s not all commission, but rather is attributable as well to fees. 

As the colleague hosting at my destination suggested (between chuckles), maybe I should just view it as a service that facilitated my ability to travel with confidence.  While there is certainly an intellectual appeal to that perspective, on an emotional level I had just paid money to obtain money, and no euphemism was going to convince me otherwise.

Money for money?

I was reminded of this during a meeting last week with a group of advisors who were exploring alternatives to their existing client model.  In the context of the continued sideways market, they were concerned whether their current approach still aligned with investor needs.  In particular, with the growth of exchange-traded funds in the market, the media has been abuzz with discussions about the cost of obtaining investment advice. 

Thus our purpose was to look at the tax implications of a spectrum of arrangements from MERs on mutual funds, to fee-based accounts using F-class mutual funds and/or ETFs, and on through to purely transactional based commission structures.  

Suffice it to say for current purposes, tax efficiencies may certainly be gained by both advisor and client by choosing an appropriate model, and the interests of each need not necessarily conflict in arriving at an optimal choice.  As with the issue of the overall cost of advice, one size does not fit all.

Money for advice

In fact, the consensus within the group was that while the tax aspect is relevant, it must not distract from or overshadow the core purpose of delivering valuable investment advice.  In that regard, though absolute cost is obviously important, the measurement of its value is in how well it is catered to the client’s situation and how well the client understands that connection.

In many fields, advice relates to physical products like cars or building materials, or tangible services like dental work or travel planning.  By comparison, financial advice is much more open to being perceived in that fungible money-for-money sense if communications are not carefully managed.  That can be a tall order for an advisor to deliver on, regardless how the cost of that advice is calculated.

As for my business trip, in the end most of it was managed on plastic, leaving me with cash for family gifts.  That was my colleague’s suggestion – Good advice indeed.