Capitalizing on corporate mutual funds

Mutual Fund Corporations have been around for some time now but they really exploded on the scene about 15 years ago. Their popularity was sparked by astute advisors and clients looking for ways to reduce income taxes on investments. As a refresher, a mutual fund corporation is a single entity which establishes multiple share classes within it. Each share class, often referred to as a “corporate fund” or “corporate class fund”, would represent a different mutual fund. Class A, for example, may be a Canadian balanced fund, Class B, a U.S. equity fund, Class C an international equity fund and so on.

Corporate Funds offer your clients benefits that cannot be ignored. Clients can switch between various classes within the corporation without triggering an immediate capital gain or capital loss as is the case when client switch between mutual fund trusts. The other significant benefit is that such a structure allows the corporation to consolidate all income and expenses across all share classes, thus providing greater flexibility in reducing the potential for taxable distributions.

In the event a taxable distribution is paid on a corporate fund, it will either be an ordinary dividend or capital gains dividend (which is taxed as a capital gain), both of which are taxed favourably in Canada. Combining these benefits within a client’s portfolio means taxes can be minimized thus enhancing the value of the client’s portfolio.

That being said, when does it make sense to consider corporate funds for your client’s portfolios? The most obvious situation is for client’s with non-registered portfolios, since RRSPs , RRIFs and TFSA’s already provide clients with a tax deferral or exemption for investment income but more specifically, be sure to consider recommending a corporate fund if you have clients with any one of the following profiles.

1. Active Clients – By this, I’m not referring to clients with gym memberships or busy schedules. I’m referring to clients who create more turnover in their portfolios than you would otherwise prefer. Each time the client sells an investment, taxes may be triggered, thus leaving the client with less money to reinvest. By investing this client in corporate funds, the client is free to switch between the various mutual funds within the corporate structure without limitation and without impeding taxes on his or her wealth.

2. Seniors – Clients who are collecting Old Age Security will need to repay a portion of these benefits if their net income in the year exceeds $66,733 (for 2010). The repayment rate is equal to 15% on each dollar over this threshold up to a maximum. One of the culprits triggering the OAS clawback is taxable investment income from non-registered portfolios (usually resulting from taxable distributions or the selling or switching of investments) reported on a client’s tax return. Corporate funds reduce the amount of taxable income reported on a senior’s tax return. So, not only do you help reduce income taxes for your senior client, but you also help them protect their valuable OAS benefit.

3. In Trust For (ITF) Accounts – Typically, parents or grandparents who wish to set aside money for their minor children or grandchildren do so by way of an ITF account. However, to be tax effective, the ITF investments should be focused on generating capital gains, rather than interest or dividends. The reason is to sidestep attribution rules in the Income Tax Act. These rules will ‘attribute’ and tax any interest and dividends back to the parent or grandparent who contributed the money to the ITF. That’s not an ideal situation. Capital gains, on the other hand, are generally not subject to the attribution rules and therefore they may be safely taxed in the hands of the minor child. This is the preferred result since the child is likely in a very low tax bracket (or has no income at all) and thus little, if any, taxes will be paid. Corporate mutual funds make great sense for your ITF accounts since taxable distributions are minimized and capital gains is generally the focus. This mitigates the possibility of the attribution rules applying.

4. Income Seekers – Corporate funds are also an ideal investment for client’s looking to create a regular, tax efficient cash flow stream in retirement. Most corporate funds will allow you the choice of a T series option for a particular corporate fund. This allows the fund to pay out a regular stream of cash flow to your client in the form of return of capital (ROC). This allows you to separate the capital from the growth in the investment, and as the name suggests, is a return of your own capital. Although ROC payments are not taxable when received, they will drive down your client’s cost base on the particular investments, meaning a higher capital gain is deferred into the future. The result though in the meantime, is that your client receives tax efficient cash flow using corporate funds that will have little to no taxable distributions. In addition, the client’s investment portfolio can continue to grow, as all the shares remain intact when ROC is paid.

5. Philanthropic Clients – Clients who plan to donate to charity can use corporate funds in tandem with T series to provide tax-efficient cash flow in retirement while establishing an effective charitable giving strategy. As mentioned above, the payment of ROC drives down the ACB over time, and could possibly bring the ACB to zero. These investments would then make the perfect fit for an in-kind charitable donation to a registered charity or donor advised mutual fund. The benefit is this strategy will utilize special rules in the Income Tax Act to eliminate the capital gains tax liability on the in-kind donation. The client would also receive the donation tax credit applicable to charitable donations. Hence, the benefits here are three-fold; your client is able to minimize tax on the accumulation of capital, the T series provides tax efficient cash flow, and the charitable donation satisfies philanthropic aspirations while maximizing the amount available to charity through the reduction of tax.

6. Incorporated Business Owners – Successful business owners often accumulate after-tax profits in their corporations which are then invested. Unfortunately, corporate tax rates on ‘passive’ investment income is pretty high across all provinces and territories. In fact, the rates are usually higher than the top marginal tax rates applicable to individuals. As a result, subject to investment objectives, corporate assets should be invested with a focus on minimizing exposure to high corporate tax rates. This means minimizing taxable distributions and focusing on capital gains. This can be achieved by utilizing corporate funds for your client’s corporate investment assets.

As you can see, when compared to mutual fund trusts, corporate funds are ideal for non-registered accounts. It may be time to review your client’s non-registered accounts to see if corporate mutual funds can be used to help minimize your client’s income tax liability.

Frank Di Pietro

Tax & Estate

Frank Di Pietro, CFA, CFP, is assistant vice-president of tax and estate planning at Mackenzie Investments. He can be reached at fdipietr@mackenzieinvestments.com.