Mutual fund – Page 2 – Doug Carroll

Transferring capital losses between spouses

Advantageous use of the superficial loss rules

Our tax system is based on each individual as a distinct taxpayer as opposed to taxing a pooled unit such as a couple or a family.

Even so, there is a built-in acknowledgement of these personal relationships in many ways; for example, the ability to transfer capital property between spouses at adjusted cost base (ACB). This defers recognition of any existing unrealized capital gains and associated taxes until there is a disposition by the recipient spouse.

But sometimes it may be preferable not to have that ACB rollover apply. One such occasion is when one spouse has capital losses and the other has capital gains. By strategically managing the superficial loss rules, the couple can transfer the loss so that it can be used by the spouse with the gain.

Superficial loss rules

A taxpayer’s capital losses in a year must first be applied against that year’s capital gains, with any remaining net capital loss allowed to be carried back up to three years or forward indefinitely. Where identical property is involved, the timing of those gains and losses is critical.

The superficial loss rules deem a capital loss to be nil if an individual purchases identical property 30 days before or after the disposition (a 61-day window) and still holds the property on the 31st day after the disposition. Concurrently, the ACB of the acquired property is increased by the amount of the denied loss, preserving the ability to claim the loss in future.

The rules also apply if certain related parties carry out a purchase, such as a trust of which that taxpayer is a major beneficiary, a controlled corporation or – perhaps most commonly and central for the purposes of this strategy – a spouse.

By strategically managing the series of transactions, the tax results can be split among taxpayers, enabling a couple to use the rules to transfer a capital loss between them.

Steps to transfer the loss

The strategy is most easily explained through an example. Let’s assume Eve has 300 XYZ Ltd. shares in in her non-registered account with an ACB of $30,000 and a fair market value (FMV) of $20,000. Her spouse Adam already has a realized capital gain of $10,000 this year. To maintain focus on the transfer of the capital loss, we’ll assume no market movements.

Step 1 – Eve sells her 300 XYZ shares on the exchange on day 0.

Step 2 – Within 30 days before or after Eve’s sale, Adam purchases 300 XYZ shares on the exchange.

Step 3 – No earlier than the 31st day after Eve’s sale, Adam sells his XYZ shares on the exchange.

As Adam’s purchase is within the 61-day window, Eve’s $10,000 loss is deemed to be nil. Adam would have spent $20,000 to acquire the XYZ shares, to which is added the $10,000 denied loss, giving him an ACB of $30,000. When Adam sells, he will incur a $10,000 capital loss.

For this to work, Adam must use his own funds for the purchase, or he could obtain (and service) a prescribed-rate spousal loan from Eve if the funds are in her hands. As well, bear in mind that if this is part of a broader series of transactions, the Canada Revenue Agency may seek to invoke the general anti-avoidance rule, or “GAAR.”

It is also possible to transfer the capital loss by transferring property between the spouses directly, for example, shares of a closely held corporation. In that case, the spouses must take the further step to elect out of the automatic ACB rollover that would otherwise apply. A detailed example of this procedure is included in our InfoPage titled “Capital loss planning.”

Mutual funds – Form matters

If the property in question is a mutual fund, remember that investment mandates are often available in trust and corporate forms. The two forms are not treated as identical property under the superficial loss rules.

This could work to a taxpayer’s benefit in trying to reduce his/her own capital gains. Let’s say that a mutual fund trust holding had lost value, but the taxpayer is confident that it is positioned well for the future. The holding could be sold and the corporate version acquired. The superficial loss rules will not apply, so the capital loss will be immediately usable by that taxpayer.

However, for the spousal capital loss transfer to succeed, the spouses actually want the superficial loss rules to apply. Hearkening back to our example, If Eve sells a mutual fund trust and Adam acquires a mutual fund corporation, Eve will have a capital loss that she has no present use for. For the capital loss to transfer, Adam must be sure to buy the same mutual fund trust as Eve held.

As a final note, be aware that a mutual fund company’s frequent trading rules could affect the timing of transactions and possibly their cost. It would be well-advised to vet the intended transactions with a tax professional to be sure that they carry out as intended.

Mutual fund distributions – Year-end accounting and tax reconciliation

Mutual funds allow investors to purchase and hold a basket of securities in a convenient single security form. To deliver this streamlined structure, however, there are some fairly complex activities operating in the background.

One very important event when these activities come to the foreground is in the annual distribution of income generated on the securities held in a mutual fund. These distributions occur at year-end, and can be particularly confusing for an investor who has seen a decline in the net asset value (NAV) of the fund.

Why distributions?

Whether in the form of a trust or corporation, a mutual fund is a taxable entity, and a highly taxed one at that. Income earned in the fund is taxable, though the fund is entitled to apply expenses against that income. Those expenses are the management expense ratios (MERs) charged to the fund by the investment management company.

Any remaining income will be subject to tax rates in the same range as the top-bracket tax rates an investor would face personally. Of course a significant proportion of investors will not be in the top bracket – or won’t be currently taxable at all in the case of registered investment accounts. Rather than subject all the investors to a high tax rate, the mutual fund will distribute excess income to investors. In turn, the recipients will be taxed on the income at their respective marginal tax rates, or, in the case of registered accounts, be entitled to deferred taxation.

A distribution of income means that the assets held by the mutual fund decline. We can illustrate this with the following example, with the assumption that there are 1,000 mutual fund units.

Mutual fund Pre-distribution Post-distribution

Fair market value of securities $10,000 $10,000

Cash from realized income $400 $0

Total fair market value $10,400 $10,000

Net asset value per unit $10.40 $10.00
(1,000 units)

At first glance, an investor might think that something has been lost, but we need to look further at the investor side of the arrangement. Assuming an investor held 100 of these mutual fund units, here is that other side:

Investor Pre-distribution Post-distribution

Fair market value of mutual fund $1,040 $1,000

Cash in hand $0 $40

Total $1,040 $1,040

Net asset value per unit $10.40 $10.00
(100 units)

Cash versus reinvested units

Quite often, an investor will have chosen to have distributions reinvested in the mutual fund. In that case, the $40 distribution would purchase 0.4 more units. The investor would own 100.4 units x $10.00 = $1,040. Accordingly, whether the distribution is paid in cash or reinvested, the net position of the investor is the same.

In the case of a registered account, there would be no taxable event to prompt the investor’s attention, and so this may go effectively unnoticed.

With a non-registered account, the form may appear to matter, but that is just an illusion arising from focusing on the mutual fund value alone. A cash distribution will be subject to tax, leading to a net-of-tax amount in the hands of the investor. Comparatively, a reinvested distribution does not provide cash to the investor, but tax still has to be paid on the distributed income. The investor will need to pay that tax out of other assets, netting to the same position as the taxable cash payment.

Form of an income distribution

The key area where there is a divergence between registered and non-registered accounts is in the type of income that is distributed.

For a registered account, the type of income is irrelevant. Only withdrawals are taxable from a registered account, not the interim activities within it. And when those withdrawals occur, they are fully taxable, irrespective of the types of income that had contributed to the growth of the account.

On the other hand, the type of income matters a great deal for fund distributions to a non-registered account. Interest and foreign income are fully taxable, Canadian dividends are entitled to a gross up and tax credit, and only half of capital gains is taxable. Consequently, while net wealth is the same whether under a cash distribution or reinvestment, the net-of-tax result of the distribution will depend on the type of income at issue.

Distributions in a time of decline

In years where the NAV of a fund has fallen, it may appear that there has been a breakdown in the logic and accounting of distributions. What is important to keep in mind is that it is possible that the capital value of the assets declined during the year, despite that income was earned and paid from the securities.

Furthermore, for tax purposes, the reduced paper value of the investment should not be confused to have been an actual loss. An actual capital loss or gain will only come about on a disposition (actual or deemed), and will be calculated based on the change from the investor’s adjusted cost base, not simply based on an interim calendar-year value.

In-trust accounts: Achieving tax efficiency with children’s savings

Known as in-trust, in-trust-for, or simply ITF, parents may often hold investment accounts earmarked for a minor child’s needs. While historically these trust accounts have been most commonly associated with education planning, they need not be constrained to that purpose alone. In particular, there are tax benefits that may be gained.

However, to take effective advantage in this broader sense, greater formality is necessary. By carefully documenting and monitoring the arrangement, a family will be better able to calculate the tax benefits and obtain more certainty that those benefits will indeed be realized.

An informal trust?

Parents may view an ITF as an informal way to isolate savings, but there must truly be a trust relationship in order for the tax benefits to be realized. To paraphrase Yoda of Star Wars fame, a trust either “is or is not,” so the use of the term “informal trust” is something of a misnomer. Thus, it must be clear what the property is, who will benefit from that property, and that there is a discernible intention to transfer ownership of that property into this new relationship.

The principal benefit to be gained is to have as much of the income as possible taxed in the child’s low tax bracket. Absent the trust, all income will generally be taxed in the parent’s hands. With the trust in place

interest and dividends will still be attributed back and taxed to the parent,
income-on-income (so-called second-generation income) will be taxed to the child, and
realized capital gains will be taxed to the child.

Follow the money

It is important to understand that a taxpayer must be able to prove entitlement to a tax benefit, not for the Canada Revenue Agency (CRA) to disprove it. Logistically, this presents some challenges when an ITF is employed.

In the classic ITF, all income is initially reported as that of the parent, being that it is that person’s Social Insurance Number that is on file with the investment company. In order to transfer taxation into the child’s hands, a note will have to be attached with the parent’s annual income tax return. In turn, a tax return should be filed on behalf of the child. Often there will be no tax due from the child given the basic personal exemption, but it is a good idea to nonetheless file the return to demonstrate you are in compliance with CRA filing rules.

Likewise, good recordkeeping is critical to being able to distinguish the types of income generated, in order to allocate the tax liability to the correct party. This can be especially complicated if the investment account is a combination of parent-sourced funds and the child’s own money, the latter being included because investment companies will not generally enter into contracts with minors. To the extent that these are commingled, it may become difficult – if not impossible as rebalancing and second-generation income come into play – to know what is whose, recalling once more that the onus is on the taxpayer vis-à-vis the CRA.

It may be preferable to use at least two accounts, both of which will be ITFs in form, though in substance their source funds differ. The first account will be the child’s own money; for example, from the Canada Child Tax Benefit, the Universal Child Care Benefit or an inheritance. The ITF format is an administrative convenience, and all income of whatever sort is to be taxed to the child.

The second account will be the true trust arrangement whereby the parent-sourced funds are gifted from the parent to be invested for the child. The above-mentioned tax-filing procedure would apply to this account. Ideally, each year the second-generation income would be shuttled over to the first account, thereafter completely clear of being attributed back to the parent..

A role for corporate class

This is a situation where corporate class mutual funds may offer some value. Such funds do not distribute interest and foreign income, two of the income types that are subject to immediate attribution. Of the two types of income that are distributed, Canadian-eligible dividends will still be attributable (at first generation) to a parent under an ITF, but capital gains distributions will be taxed to the child.