Why corporate-class funds still make sense

Tax-deferred switching ends this year but many other advantages remain.

Matthew Elder 11 November, 2016 | 6:00PM

The corporate-class mutual fund appears to be alive and well. This is despite the 2016 federal budget that eliminated the prime appeal of corporate class: the ability to shift assets among various funds within the entity without immediately realizing taxable capital gains.

Under the outgoing rules, a corporate-class investor could exchange shares of one fund for those of another and not report a capital gain or loss on what essentially was a transaction. Capital gains would eventually have to be reported when shares were redeemed from the corporate-class structure.

Last March's budget, however, made intra-corporate-class transactions reportable as realized capital gains. As a result, half of the gain is subject to tax at the investor's top marginal tax rate in the year a transaction takes place.

While this significant change remains in place -- although the date of effect subsequently was delayed to Jan. 1, 2017 from the originally scheduled Oct. 1, 2016 -- the other often overlooked benefits of the corporate structure provide a reasonably compelling reason to retain existing corporate-class fund investments, or consider purchasing them in the future.

Indeed, the fund industry isn't putting corporate-class marketing on ice -- quite the opposite. Last month Mackenzie Investments announced it was creating corporate-class versions of four of its more popular, existing funds. The company said it was adding to its corporate-class line-up because corporate-class funds still offer the potential for tax-efficient growth and tax-efficient income.

But before the new rule takes effect, corporate-class investors should take advantage of the outgoing rules and rebalance their holdings within the corporate-class structure, says Peter Bowen, vice-president, tax and retirement research at Fidelity Investments Canada.

For example, let's assume you were an investor in Fidelity's corporate-class funds and wanted to decrease your exposure to foreign equities and increase your exposure to Canadian equities. Before the end of 2016 you could move money out of, say, Fidelity International Growth Class and shift it into Fidelity True North Class. You would not have to report taxable capital gains on such a transaction if it were completed before the year-end. Capital gains would have to be realized for tax purposes only when shares are redeemed from under the corporate-class umbrella, or if a capital-gains dividend is paid.

Beginning in 2017, any transactions within a corporate-class family would trigger capital gains or losses. However, a number of tax-advantaged conditions will continue to exist for corporate class investors.

"Corporate-class structures offer the likelihood of reduced taxable distributions compared to conventional (trust-format) mutual funds," says Fidelity's Bowen. "In a mutual-fund corporation, the income and expenses of all the different mutual fund classes are pooled, rather than being managed and reported separately. As a result, corporate-class funds can share income, gains, losses, expenses and loss carry-forwards to reduce taxable distributions generated by the corporation as a whole."

Distributions from corporate-class funds tend to be more tax-efficient than distributions from trust-structured mutual funds, Bowen says. "Corporate-class funds can only distribute Canadian dividends and capital-gains dividends, both of which are taxed more favourably than regular income. They cannot distribute interest or foreign income. This income is retained within the corporation, where it is subject to taxation unless it can be offset by expenses. Accordingly, an important factor in managing corporate class is seeking to ensure that such income does not significantly exceed expenses."

Typically, a mutual-fund corporation will first use expenses that have been paid by all funds within the structure to offset interest and foreign income (which is fully taxable) that have been earned by all funds within its structure. For example, interest earned by a fixed-income fund might be offset by the expenses of a fund that had not earned interest income. As well, capital losses are used to reduce taxable capital gains.

Since interest and foreign income cannot be distributed by a corporation, these amounts are retained and serve to increase a fund's net asset value, or NAV. (By contrast, a mutual-fund trust is required to pay out all types of income that remain after expenses have been paid.) This results in an ongoing tax deferral for this income, as long as there are sufficient expenses. What's more, when corporate-class shares are eventually sold, all of this income will be effectively taxed as capital gains, not as interest or dividends.

As well, capital gains earned from transactions made within the fund do not have to be distributed to shareholders. This can be particularly of interest to seniors who want to keep their income below the clawback threshold for Old Age Security and other income-tested government benefits.

An additional advantage of the corporate-class structure, Bowen says, is through the use of T-SWP funds (or T-series), which can provide tax-efficient cash flow through a return of capital -- where an investor's original investment capital is paid out as a return-of-capital distribution as opposed to dividends, interest or capital gains. This return of capital isn't immediately taxable but instead reduces an investor's adjusted cost base.

Transfers between different series of a corporate-class fund can continue to be made on a tax-deferred basis, since such transactions normally are done for the purpose of reducing management fees or moving to a monthly-pay T-series.

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Matthew Elder

Matthew Elder