Capital gains mean tax-efficient investing

Reader alert: This is part 2 of a five-part series. • Part 1: Tackling tax-efficient investing • Part 2: Capital gains mean tax-efficient investing • Part 3: Tax-efficient investing and dividends • Part 4: Magic of tax-efficient bond investing • Part 5: Tax-efficient investor behaviour

Capital gains are the most tax-efficient form of investment return because only 50% of capital gains are taxable. In addition, the timing of the payment of tax on capital gains is, to some extent, discretionary. This is because capital gains are taxed only when the related investment is disposed of. One of the principles of tax-efficient investing is to defer the payment of tax on capital gains whenever possible. It is always better to pay tax later rather than earlier. In the meantime, the money can be invested to generate additional returns.

Nevertheless, there are many reasons it may be advisable to dispose of an investment, even if this triggers a taxable capital gain.

For example:

• It is no longer consistent with investment objectives.
• It has reached its full potential.
• Its prospects have changed.
• You need to rebalance the portfolio.

Even in such cases, it is possible to defer the tax if the investment takes the form of an investment fund and the investor switches from one fund to another within a mutual fund corporation.

A mutual fund corporation has several classes of shares, each of which corresponds to a separate fund. The investor can switch from one fund to another simply by switching from one class of shares to another within the corporation. The Income Tax Act (Canada) allows this on a tax-deferred basis. Tax is payable only when the investor redeems shares of a class without reinvesting the proceeds in shares of another class within the same mutual fund corporation.

Capital gains through back door

Caution is necessary if you advise your clients to invest in shares of a mutual fund corporation. A switch is effectively the redemption of shares of one fund and the simultaneous purchase of shares of another fund. The fund whose shares are being redeemed must pay the redemption proceeds to the fund whose shares are being purchased. To do this, it must have sufficient cash. If the issue of new shares to other investors is insufficient to compensate for the redemptions, the fund may need to sell some of its portfolio investments in order to raise the required cash. As a result, it may realize capital gains, which will be distributed to its remaining investors and taxed in their hands. Make sure your clients are not among those investors.

Avoid capital gains distributions

The deferral of tax on capital gains is most complex when the investor owns investment funds. This is because, in addition to being taxed on capital gains realized on the disposal of their units, investors are taxed on the net gains distributed by the fund while they are unitholders. Yet the decisions that trigger capital gains distributions are usually made by the fund’s portfolio advisor.

Investors may avoid paying unnecessary taxes by staying clear of funds prone to capital gains distributions. Knowing the factors that drive distributions will help weed out tax-inefficient funds.

Active versus passive

An important factor is whether the fund’s portfolio is actively or passively managed. A fund portfolio is actively managed when the advisor tries to outperform a benchmark, such as the S&P/TSX Composite Index, which is a broad index of Canadian stocks. A portfolio is passive when it replicates an index. In this case, the portfolio will hold the same stocks, and in the same proportion, as the index. Funds that track an index are known as index funds. Their return should be equal to that of the index less the fund’s fees and expenses.

When a portfolio is passive, there is no reason to sell portfolio investments except when changes are made to the index. Because index funds trade infrequently, they realize and distribute few capital gains. Their return mostly takes the form of unrealized capital gains.

In attempting to outperform the index, actively managed funds usually trade more frequently than their passive counterparts. To the extent that the trades generate capital gains, the latter will be distributed to the fund’s investors.

In an earlier article, I noted taxable investors should base their asset allocation on expected after-tax returns and related volatilities and correlations. If the assets you are considering for the portfolio include both actively managed funds and index funds, the use of after-tax rather than pretax numbers will usually result in a larger allocation to index funds. This reflects the greater tax efficiency of index funds, which is itself a consequence of their low portfolio turnover.

Management style

When the fund portfolio is actively managed, another important factor affecting capital gains distributions is the management style. For instance:

• The growth style involves investing in the stocks of companies that exhibit above-average sales and earnings growth.
• The momentum style involves investing in stocks that exhibit above-average price increases.
• The value style involves investing in stocks that the advisor believes to be undervalued, taking into account factors such as the price-to-book ratio, the price-earnings ratio and the dividend yield.

Some styles trade more frequently than others. The value style assumes the market will ultimately recognize the stock is undervalued, at which time the stock price will rise to its intrinsic value. However, market recognition often takes a long time to occur, if at all. Consequently, funds managed according to the value style tend to trade less frequently than those managed according to the growth and momentum styles. They are therefore less likely to distribute capital gains.

Is the fund experiencing net redemptions?

Although a fund’s capital gains distributions are usually the result of actions taken by the portfolio advisor, they are sometimes driven by the actions of its investors. This is particularly true when redemptions by existing investors exceed the sale of new units. In order to finance the net redemptions, it may be necessary for the fund to sell some of its portfolio investments, possibly triggering capital gains.

The Income Tax Act (Canada) includes the Capital Gains Refund Mechanism (CGRM), which allows the fund to retain the capital gains attributable to the redemption of units without having to pay tax. The CGRM uses a formula to calculate the relevant gains and admittedly is not a perfect mechanism, especially when the fair value of the investments has dropped well below the original cost. Some capital gains may still need to be distributed to the unitholders and will be taxed in their hands.

The portfolio turnover rate and its limitations

Many investors use the portfolio turnover rate as an indicator of a fund’s tax efficiency. Higher portfolio turnover is usually associated with tax inefficiency. The implied assumption is that a fund with a high turnover triggers frequent capital gains, which are distributed to unitholders.

There is some truth in this assumption. However, it would be simplistic to equate a high turnover rate with tax inefficiency. Portfolio turnover may be good because, in some instances, it enables a fund to improve its tax position. Tax-loss harvesting is a case in point.

There is a potential for tax-loss harvesting whenever the current price of an investment is less than its original cost. The sale of the investment triggers a tax loss that may be applied against capital gains realized on the sale of other investments, thereby reducing the net capital gain on which tax is assessed. This trading activity increases the portfolio turnover but improves the portfolio’s tax position rather than hurts it.

The portfolio turnover rate may be used as a screening device, but it isn’t a substitute for a proper analysis of the fund’s circumstances.

Do fund investors pay tax twice on capital gains?

Because they pay tax on the capital gains realized when redeeming their units and on the gains distributed by the fund, many investors are convinced they are taxed twice on the same gains. No double taxation is involved. However, when a fund distributes a capital gain, it accelerates the payment of tax by its investors. The investors must pay, in the year of the distribution, the tax they would otherwise pay in the year they redeem the units. Investors are worse off when they pay taxes earlier rather than later.

A fund usually distributes capital gains in the form of additional units. The issue of new units is immediately followed by a consolidation of the units, such that the total number of units outstanding and the unit price remain the same. There is no transfer of value from the fund to the investors. The sole object of the exercise is to transfer the liability for the tax on realized capital gains from the fund to its investors.

For tax purposes, the adjusted cost base of the investor’s units is increased by the amount of the distribution. When the investor ultimately redeems the units, the capital gains will be reflected in the net asset value of the fund and therefore in the redemption proceeds. The amount of the distribution is thus reflected in both the redemption proceeds and the adjusted cost base and therefore cancels itself out.

Example

Take the example of an investor who owns units of an investment fund with a tax cost of $1,000. At the end of 2010, the market value of the units is $1,500. As far as the investor is concerned, there is an unrealized capital gain of $500.

The fund sold some portfolio investments in 2010. As far as the fund is concerned, the related capital gains have been realized and they are duly distributed at year-end. Our investor’s share of the capital gains distribution is $200, which is taxed in the same year.

At the same time, the amount of the distribution is added to the adjusted cost base of the units, which becomes $1,200, or ($1,000 plus $200).

In 2011, the investor redeems all the units. The fund has made neither profit nor loss in the meantime, and the market value of the units is still $1,500. For tax purposes, the investor’s capital gain is $300, represented by proceeds of $1,500 less the adjusted cost base of $1,200. The investor is taxed on that gain in the same year.

The investor is taxed on the capital gains as follows:

2010: $200 in tax 2011: $300 in tax Total: $500 in tax

If the fund had not made a distribution in 2010, the investor would have realized a capital gain of $500 (proceeds of $1,500 less adjusted cost base of $1,000) at the time of redeeming the units in 2011, and would have been taxed on that amount in 2011. The distribution in 2010 accelerated the payment of tax by the investor on capital gains of $200.

The importance of proper tax records

The adjusted cost base of the units held by the investor is increased by the amount of the capital gains distributions. It is this step-up in the tax cost that prevents the same gain from being taxed twice when the investor ultimately redeems the fund units.

What if the tax records of the investor are deficient? What if the investor fails to add the amount of the capital gains distributions to the adjusted cost base of the units? In these cases, there would indeed be double taxation at the time of redeeming the units. This double taxation would be the result of the absence of proper tax records on the part of the investor. We can only guess at how much tax is overpaid each year for this reason.

Capital gains taxed on redemption

If the fund distributes its capital gains each year, why is there another gain (or possible loss) when investors redeem their fund units?

The capital gains distributed by the fund are the net gains it realizes year by year on the portfolio investments sold during the year. In addition, when investors redeem their units, there will be unrealized gains on the portfolio investments the fund holds at that time. The unrealized gains are reflected in the fund’s net asset value, which is the price that investors receive when they redeem their units. The gains are still unrealized as far as the fund is concerned (because the fund still holds the investments in its portfolio), but they have now been realized by the investors (because the latter have redeemed their units). It is on those gains that investors pay tax when redeeming units of the fund.

As seen in the case study, the capital gains distribution of $200 in 2010 corresponds to net gains realized by the fund on the sale of portfolio investments in 2010. On the other hand, the capital gain of $300 realized by the investor in 2011 on the redemption of units corresponds to net unrealized gains on the fund’s portfolio of investments at the time of the redemption.

André Fok Kam, CA, MBA is a consultant to the financial services industry. He authored the Tax-efficient Fund Investing Course offered by the IFSE Institute. He is a member of the Independent Review Committee of the Standard Life Mutual Funds.