Surprise distribution creates

Advisors with client money in corporate class mutual funds have learned the hard way why they are called tax efficient, rather than tax proof. A surprise distribution from Franklin Templeton’s corporate class funds on January 10 has caused an uproar, after leaving clients with an unforeseen tax-bill. Franklin Templeton says the move was necessary to prevent unethical investor behaviour.

Dennis Tew, senior vice-president and chief financial officer at Franklin Templeton, says it was the first time the company has issued a distribution on their corporate class funds since they began offering them in 2000. Not all, but most of their 34 corporate classes issued a distribution.

Before his company decided to go through with it, Tew says he called around to other fund companies and learned its industry practice to not give advance warning on corporate class distributions.

Because corporate class funds are specifically designed to allow investors to move their money around without triggering a taxable capital gain, investors may see few barriers to exiting a given fund, if they know a distribution is coming up.

Tew says the company was concerned that if a distribution were announced on corporate class, investors might pull their money out the fund to avoid the tax hit, and leaving those left in the funds with an even larger distribution. The decision was therefore made to give no notice, which Tew says created a “level playing field.”

“People in trust [structured] funds have to make a decision to redeem and trigger their capital gain and size that up against the distribution they are going to receive. In the corporate class world, because they can switch between classes tax-free, the incentive to keep them in isn’t there,” Tew says. “They can switch out of certain classes to avoid the distribution. It harms some investors to the benefit to others. Other fund companies such as CI Investments have paid corporate class distributions in the past and have not given prior notice. If we do have any distributions on the corporate class in the future, I’m confident we won’t be telling anybody which funds we will be distributing.”

Tew admits that the firm would rather not have a distribution on their corporate class since its tax efficiency is one of its main advantages. But it was unavoidable this year due to the amount of taxable gains that been realized.

“A lot of our investment managers triggered some long-term gains this year in some portfolio rebalancing and generated a lot of capital gains that were a bit unique to this year,” he says. “Our managers tend to be ‘buy-and-hold’ and with the market peaks earlier this year, they were realizing and triggering gains, which is what you want them to do.

“Unfortunately, a lot of these are very long-term holdings that did cause a capital gain that couldn’t otherwise be sheltered this year.”

Tew says Franklin Templeton has distributed literature to their staff to help explain to advisors why the distribution was necessary. The company also has some strategies advisors can use to optimize their client’s tax planning. Part of the benefit for having the distribution in early January is that advisors will have nearly 12 months notice to plan for the 2008 tax year.

“It is an unfortunate reality that you have to do this, but there is very little option for us. Rather than pay a distribution we could have paid tax on the company, that would have had a negative impact on more people than those who would have benefited from it,” Tew says.

As Tew mentioned, Franklin Templeton has not set any industry precedent by keeping mum on the distribution. For instance, CI Investments has similar protocol for how it will disclose corporate class distributions.

CI will not pay a distribution on any of their CI corporate class funds for 2007. But if it is necessary to do so in the future, the company says it will give advance notice to investors so they may receive a distribution from their corporate class funds and will provide a range of how much of distribution this could be. CI will not specify which individual share classes might issue the distribution.

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Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com