Boom, trust and echo II

Here’s a question to see how closely you’ve been reading my column. How many of you remember Ashley, the prototypical echo boomer profiled in December 2010?

Ashley was the daughter of an existing client, who had just recently finished an MBA, and was establishing her career at a Calgary oil services consultancy. Then, in her late 20s, she wanted to buy a condominium and that column discussed the alternative savings vehicles – a tax-free savings account versus a registered retirement savings plan – that would get her to her goal of a $25,000 down payment most tax efficiently.

It seemed an ideal opportunity for the parents’ advisor to engage and offer useful advice that could form the basis of a lasting relationship with the child.

Already on the right track

This month, we’re going to look at the next stage of that relationship building as the advisor encourages Ashley to become a more tax-efficient investor. We’re going to cheat a bit and leap ahead a few years in Ashley’s life. She’s still single, but she’s had a few promotions and purchased that condo.

Ashley has also turned into something of a savings machine, maximizing her annual RRSP (thanks in part to her employer’s matching program) and TFSA contributions. She’s even been able to repay the withdrawal she made to cover her down payment.

Ashley’s condo is small and financially quite manageable. She has no children so there are no costs on that front. And while she’d love to travel, she’s limited by the four weeks of annual vacation allowed by her job. In short, she is in the envious position where her income consistently exceeds expenses, and while she could use the excess to pay down her mortgage faster, interest rates are so low that she figures, reasonably, that she would get a better return if she invested those excess funds.

The question is: How to do it? Ashley’s plan is simply to invest her excess cash in several equity mutual funds to supplement her registered savings, review on a quarterly basis and rebalance as necessary. Because she has decades to go before retirement, she realizes that this non-registered investment account will have to be re-balanced several times over the coming years. It may be adjusted to focus on particular sectors or regions, different asset classes, variable time horizons, and, inevitably to shift to less risky investments like balanced funds as she gets older.

Understanding mutual fund structures

At the outset, though, there are big gaps in her investment knowledge, starting with the fact that she knows little about mutual fund structures and the varying tax differences they provide. Like many investors, Ashley has a general awareness of the traditional mutual fund trust structure. What she doesn’t know however is that the alternative, mutual fund corporations, offer tax advantages for people who want to invest in mutual funds through non-registered accounts. Here is a clear opportunity for you to provide knowledge and advice that could help Ashley grow her capital in the most tax-efficient way.

The mutual fund corporate structure was originally designed to meet the growing demand from investors for a non-registered product that allows for maximum compound growth potential by deferring the capital gains taxes triggered by switching between funds.

The differences between mutual fund trusts and corporations are straightforward. In a traditional trust structure, investors are unit holders who purchase units of individual mutual fund trusts. Any income or capital gains they receive on their units are called “distributions” and are reported on individuals’ T3 slips. Investors in mutual fund corporations are shareholders who are buying shares of a corporation that is comprised of multiple classes, which provides the potential for reduced distributions. They receive dividends or capital gain dividends on their shares which are reported on their T5 slips.

Generally, you can tell by the name whether a mutual fund is set up as a trust or a corporation. Usually, a share of a mutual fund corporation will have the word “class” in the name.

Many mutual fund companies using a corporate structure have a diverse range of regional, sector, and asset class offerings. Class funds may hold the same types of investments as their traditional mutual fund trust revisions, directly or indirectly.

The capital gain deferral

For Ashley, who’s building her non-registered account, it’s important to know about the tax benefits of a corporate mutual fund structure. Investors in these corporate structures can move from one class fund to another in the same corporate structure without immediately triggering a capital gain.

To put it a little more technically, these shifts from one class to another within the same corporate structure are not taxable transactions. The Canada Revenue Agency doesn’t consider that a redemption has taken place in this instance, so capital gains are deferred until the investor redeems out of the corporate structure.

When a change is made from one class fund to another class fund within the same corporate structure, the cost of the shares in the new class that’s being acquired is equal to the adjusted cost base of the shares in the old class. In other words, the cost of the shares will be carried through.

Assume, for example, that Ashley invests $1,000 in Class A, giving her an adjusted cost base of $1,000. But Class A later appreciates to $1,500 and she decides to switch that $1,500 from Class A to Class B. The adjusted cost base of Class A now becomes nil, while the adjusted costs base of Class B is $1,000.

Ashley would face a different situation making a switch between mutual fund trusts. At the time she makes the switch, a redemption of units subject to capital gains (or losses) would have taken place. So, for example, if Ashley invested $1,000 in mutual fund A, she would have an adjusted cost base of $1,000. If her investment then appreciated to $1,500 and she then switched the money to fund B, two things would happen. She’d face a realized capital gain of $500 on the disposition of fund A, and her adjusted cost base on fund B would now be $1,500.

Tax deferral equals faster growth

A basic principle of tax-efficient investing is that investments grow faster the longer taxes are deferred. In this respect then, mutual fund corporations have an obvious advantage over mutual fund trusts. When an investor like Ashley switches between class funds, she’s actually exchanging one class of shares in a corporation for another class of shares within the same corporate structure; hence no capital gain is triggered at that time.

Another advantage of a mutual fund corporation is that income and expenses for all its fund classes can be pooled, unlike mutual fund trusts where income and expenses for individual funds must be managed and reported separately. For this reason, class funds are able to share income, gains, losses, expenses and loss carry forwards that can reduce taxable distributions generated by the corporation. And if taxable distributions are reduced, the tax on the growth of the assets can be delayed, resulting in potentially better compound growth.

From boomer to echo

There are many Ashleys out there, the children of existing clients who are now old enough and financially able to require your advice to make tax-efficient investments. They’re thirsty for investment knowledge, and when you provide them with insights such as the important differences between mutual fund trusts and corporations, you’re equipping them to make smart choices. That’s not a bad way to build a second generation advisor, client relationship.