Latest
trend has tax benefits
A recent
series of articles in this space spoke about tax smart investing and the trend
toward tax-managed funds in the US. One uniquely Canadian trend, which wasn’t
mentioned in that series, has picked up steam over the past year and is worthy
of its own article. Mutual fund corporate class structures have a two-fold tax
benefit, which essentially translates into powerful tax deferral potential.
It’s not a new idea. In fact, it’s been in practice for several years, but many
mutual fund companies have been crowding this wagon for the past year.
Most mutual
funds are set up as trusts. When they realize gains by selling stocks at a
profit, earn interest from bonds, and receive dividends from stocks, this
income is matched against expenses. Any income remaining after deducting
expenses generally has to be paid out to the fund’s unitholders. If this income
remained in the trust instead of being paid out, the “mutual fund trust” would
have to pay tax on the undistributed income. While individuals pay tax on a
progressive scale, a trust of this kind pays tax at the top marginal rate. So,
less tax will be paid overall if the fund pays out all of its income to be
taxed in unitholders’ hands.
Corporate
class structures are actually set up as mutual fund corporations with multiple
share classes – each of which constitutes a different fund. CI Sector Fund
Limited, for instance, is such a mutual fund corporation. Under that “umbrella”
corporate structure, investors can buy CI Canadian Sector, CI American Sector,
CI Global Energy Sector, CI International Value Sector, and many other classes
covering a variety areas of the markets. When buying into this structure,
you’re actually buying different classes of the shares of CI Sector Fund
Limited, a mutual fund corporation – which by the way qualifies as foreign
content for registered accounts. I know this sounds about as exciting as a
conference of stuffy accountants, but stay with me.
The most
apparent benefit of this structure is that it allows investors in one class or
sector to switch to another class or sector within the same corporate
structure, without the tax laws deeming the transaction a “taxable event”. In
other words, those who had invested in, and made lots of money on, the CI
Global Technology Sector could have taken some profits by switching out
some/all of this fund and bought CI Global Energy Sector or any other within CI
Sector Fund Limited, without incurring any capital gains taxes. While I’m not
an advocate of active mutual fund trading, the ability to rebalance without
incurring the tax costs is very valuable.
Tax-deferred
switching is just one way that this type of structure can potentially reduce
taxes. The other has to do with the capacity to minimize distributions. This is
best illustrated with an example. Phillip Morris is a US conglomerate of
consumer products companies – including brewer Miller Brewing Company to food
manufacturer Kraft Foods. When Phillip Morris prepares its consolidated
statement of income, they add up the total revenues and expenses from Miller
Brewing, Kraft Foods, and all of its other subsidiaries. The same thing happens
with mutual fund corporate class funds.
Continuing
with our CI example, CI Sector Fund Limited will add up the interest, capital
gains, and dividends from all of the sector funds or classes within the
corporation, before figuring out how much revenue the corporation has, in
excess of its expenses. Classes that usually generate little taxable income
will absorb the excess income from other classes. Usually, interest and
dividend income are used first to offset all of the corporation’s management
and operating expenses. Capital gains are matched with any expenses left over,
then further reduced by taking advantage of certain complex tax provisions to
prevent the double taxation of capital gains (i.e. CGRM - capital gains refund
mechanism). After all that, there usually is little, if any, taxable income to
be distributed. However, whatever is remaining after all that is assigned to
the various classes in an effort to distribute income fairly and in a manner
that minimizes the impact on investors.
This doesn’t
just work in theory, it actually works in practice as long as a corporate
structure isn’t “over populated” with classes of funds that usually generate a
large amount of taxable income – like bond funds, money market funds, and stock
funds that trade heavily. Having a balance of different asset classes and
styles is what makes this work. CI, AGF, and AIM have been running these
structures for many years with good success on minimizing the tax impact.
This sounds
like a structure that caters to active mutual fund traders. Well, it is good
for traders but the benefits of this structure are not restricted to investors
with a quick trigger finger. Anybody investing outside of tax-deferred savings
plans (i.e. RRSPs, RRIFs, etc.) can also benefit from the tax deferral power
potential of these corporate class structures. The mutual fund companies
currently offering this type of structure are:
AGF, AIC, AIM, Bank of Montreal (BMO), CI Funds, Clarington, Dynamic,
Franklin Templeton (the newest entrant), Mackenzie, and Synergy.
While there
are some additional costs involved (higher administrative costs and small
amounts of corporate tax), the tax deferral benefits usually dwarf the extra 20
to 40 basis points of extra operating costs. Remember, first make sure a fund
fits your personal investment policy criteria then look at how best to minimize
taxes. For the latter goal, this latest trend of funds can be a good fit.
Dan Hallett, B.Comm.,
CFP is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached
at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.