Among the many proposals presented in last Monday’s 2021 federal budget is a measure intended to lighten the tax burden and, by extension, improve investment returns for investors in pooled funds and other funds that do not benefit from rules that favour mutual funds and segregated funds.
The issue is that pooled funds often are registered investments under the federal Income Tax Act, but do not qualify as mutual trusts or corporations because they have fewer than 150 unitholders. These pooled funds are set up for large institutional investors and certain employees, plus other qualified individuals to offer scalable low-cost retirement saving vehicles.
In order to accept contributions from registered pension plans (RPP), registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs) and deferred profit-sharing plans (DPSPs), the pooled fund is permitted to only invest in qualified investments. If the pooled fund holds any investments that are not qualified investments as defined under the Act, they are subject to a penalty tax of 1% per month on the non-qualified investments’ acquisition value at the end of each month. This penalty tax impacts the investor’s overall yield.
While the list of what constitutes a qualified investment under the Income Tax Act is extensive and complex, the main barrier is that pooled funds are permitted to only hold investments that are listed on a designated stock exchange. The list of designated stock exchanges is limited to 47, whereas there are over 100 exchanges worldwide – and more than double that number when you consider those exchanges that include subsidiaries located outside the country where the main exchange is located. In addition, the names of certain designated stock exchanges under the Act no longer exist as a result of previous mergers.
“This restricted list of exchanges creates significant limitations on the investment universe for pooled funds, not to mention regulatory inconsistencies requiring the fund managers to make investment for the fund under best execution standards.” says Joseph Micallef, FCPA, FCA, partner and National Tax Leader, Financial Services and Asset Management with KPMG in Canada. “In a nutshell, these rules exclude Canadian retirement-savers from many growth opportunities, as well as creating potentially higher execution costs.
Mutual fund trusts and corporations, as well as insurance-company segregated funds, are exempt from this penalty. They also do not need to only hold investments which are listed as a qualified investment under the Act.
The budget proposes the penalty be prorated based on the proportion of units of these funds that are held within a registered plan, as opposed to those that are held in non-registered (i.e., “taxable” accounts). For example, if only 20% of a fund’s units are held within RPPs, RRSPs, RRIFs and DPSPs, and the other 80% in taxable accounts, the monthly penalty tax would be reduced from 1% to 0.2% (or 20% of 1%).
The Portfolio Management Association of Canada (PMAC) has been lobbying the federal government to adopt a “look-through” provision for these pooled funds, which would put them on an equal footing with more retail-oriented mutual and segregated funds. As pooled-fund investors are mostly institutions – many of which are pension plans that in turn hold retirement-saving assets for thousands of individual Canadians – a “look-through” mechanism essentially would look at the number of beneficiaries under these institutional plans in order to satisfy the widely held test necessary to qualify as a mutual fund trust. This concept is not novel, as other jurisdictions, such as Australia, have applied it. In the end, this would reduce pooled funds’ investment restrictions, thus ultimately benefitting Canadians saving for retirement.
“The investment restrictions and penalty regime under the registered investment rules certainly have affected pooled funds’ overall yields, which has had an impact on many average Canadians’ retirement savings,” Micallef says.
Moreover, he says, unlike mutual funds, “These funds are handcuffed in terms of the limitations on the types of securities they are allowed to own. These rules are decades old, and were created at a time when there were far fewer exchanges worldwide, and the number of investable financial products were not as diverse. From a tax-policy perspective, there are a number of justifications why the rules exist for registered plans in order to prevent certain abuses. However, these rules don’t seem to fit in the context of legitimate and commercially offered pooled funds.”
Despite the proposed pro-rating of the penalty tax, Micallef says this still does not really solve the issues for pooled funds – namely, the need to level the playing field so that they are treated under the Act similarly to mutual funds and segregated funds.
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