Understanding mutual fund trusts and corporations

Transcription

1 Understanding mutual fund trusts and corporations Originally most funds were formed as mutual fund corporations (MFC). As the industry evolved, mutual fund trusts (MFT) became more common as they were better suited for passing income along to investors. Recently there s been a renewed interest in MFCs as they can be structured to have multiple share classes. Each share class can then represent a different investment strategy such as Canadian equities, European bonds or even money market investments to name a few. This can provide investors with tax advantages over the more traditional MFC. The following provides an overview for investors who hold mutual fund trusts and/or mutual fund corporations in non-registered accounts. Mutual fund trusts versus corporations Switching funds Generally if you sell an investment in one fund to purchase units of another, any capital gain (loss) is immediately taxable. However, because of a special rule in the Income Tax Act, if you switch between classes of the same mutual fund corporation, you will not have to pay tax. This is because you will not have triggered a disposition, and therefore will not realize an immediate capital gain or loss. The adjusted cost base (ACB) of the investment in the mutual fund corporation remains unchanged, and tax on any gain is deferred until you sell out of the mutual fund corporation structure. Fund versus class AIM Trimark Investments uses the term Fund to denote a mutual fund trust and Class to indicate that a mutual fund is held within a mutual fund corporation. An investor of a mutual fund trust is referred to as a unitholder, while the investor of a mutual fund corporation is referred to as a shareholder. Capital tax planning In computing taxable paid-up capital for capital tax purposes, where applicable, corporations may claim an investment allowance as a deduction from paid-up capital. This deduction is granted to minimize double-taxation that can result from including the qualified investments in the paid-up capital of the lending corporation as well as the borrowing corporation. Investments in shares of mutual fund corporations are generally considered to be eligible for the investment allowance for federal and provincial capital taxes.

2 Taxation of mutual funds non-registered investments Non-registered mutual fund investments are taxed two ways on distributions received from the fund and on redemptions (i.e. when you sell units/shares of your fund investment). Distributions from the funds When you invest in mutual funds, your money is pooled with money from other investors and invested in securities on your behalf by the fund managers. What is taxable income? In a mutual fund, taxable income consists of: net income plus net taxable capital gains Canadian and foreign dividends plus interest less management fees less administration expenses taxable capital gains less allowable capital losses less taxable capital gains (that remain untaxed due to the capital gains refund) In both mutual fund corporations and trusts, taxable capital gains arise when the fund managers sell securities in the fund s investment portfolio at a gain. If any securities are sold at a loss, the losses are deducted from the gains before the distribution is calculated. Also, a portion of the taxable capital gains may not have to be distributed, but may remain in the fund on a non-taxable basis. These gains are considered to have been distributed already on redemptions of fund units throughout the year, and therefore have already been taxed. The fund calculates a capital gains refund to determine the level of capital gains that can remain in the fund untaxed and therefore do not require distribution. Foreign content planning Mutual fund corporations are mainly of interest to investors with taxable nonregistered accounts. However, you may still benefit if you hold mutual fund corporations inside a registered plans (such as an RRSP or RRIF). This is because switches between classes of shares in a mutual fund corporation do not change the cost amount (or book value) for calculating the foreign content limitation of 30%. For information on mutual funds held in registered plans please refer to our Tax & Estate InfoPages, Registered Retirement Savings Plans and Registered Retirement Income Funds. Full flow-through of taxable income Mutual fund trusts are generally considered to be flow-through entities for tax purposes. This is because they allow the taxable income earned inside the entity to be treated (for tax purposes) as if you had earned it directly. In other words, it s as though you held the securities directly instead of through the fund. This flow-through of taxable income is done through a distribution of income, (interest, Canadian 2

3 dividends, foreign income 1 ) and/or capital gains from the fund to investors. These are made on an annual or sometimes more frequent basis. The flowthrough generally results in a more favourable tax treatment of the income for investors. If income is not distributed at least annually, the fund is taxed on the income at the highest marginal rate of tax in effect, treating all investors as if they are taxable at the highest rate. Taxable income that is distributed to investors is taxed at their own, often lower, marginal tax rates. Limited flow-through Mutual fund corporations only provide a limited flow-through because only Canadian dividends and capital gains can be passed on directly to investors. Interest and foreign income earned inside a mutual fund corporation are taxed first inside the mutual fund corporation. Mutual fund corporations generally pay two types of dividends: ordinary dividends and capital gains dividends. Occasionally mutual fund corporations may also pay a return of capital. Capital gains dividends are deemed to be capital gains realized by the shareholder. If you have mutual fund investments in non-registered accounts, you are entitled to the gross-up and dividend tax credit on Canadian dividends. Mutual fund corporations can also distribute capital gains dividends, which are different from Canadian dividends. These dividends are deemed to be capital gains realized by the shareholders receiving them and are subject to the general taxation rules relating to capital gains. Why are distributions lower in mutual fund corporations? Distributions from mutual fund corporations can often be lower than they would be in a mutual fund trust. This is because of the ability to share losses among the different classes of a mutual fund corporation. In the corporate structure, only one corporate tax return is filed for the entire mutual fund corporation. This is despite the fact that there may be multiple classes of shares representing multiple investment strategies within the corporation. Why does the price of a fund fall after a distribution? Income and capital gains earned by the fund are added to the fund throughout the year and are reflected in the fund s daily unit/share price. When a distribution is made, the income received and capital gains realized are calculated and then divided by the number of units/shares in the mutual fund. You receive a portion of this income from the distribution in proportion 1 If foreign investment income is distributed from a mutual fund trust, any foreign tax associated with it will also be allocated. 3

4 to the number of units/shares you own. The resulting price will be lowered by the amount of the distribution. How are distributions reported? Each mutual fund trust that has any distributions in the year reports the types and amounts to Canadian-resident investors on a T3 slip. This records the amount of distributions including interest, foreign income, capital gains and Canadian dividends received by each investor. Residents of Quebec will also receive the Relevé 16 in addition to the T3. Shareholders of mutual fund corporations will receive a T5 slip, which records both taxable Canadian dividends and capital gains dividends received by each investor. Residents of Quebec will also receive the Relevé 3 in addition to the T5. Non-resident investors will receive an NR4 slip instead of a T3/T5, showing the distribution amount, as well as any non-resident tax withheld, if applicable. How do reinvested distributions affect my account? The reinvested distributions are deemed to have been received by the investor in cash, and are immediately given back to the fund as a purchase of new units/ shares. The dollar amount of the new units/shares purchased is deemed equal to the dollar amount of your distributions. This purchase of these new units/shares increases the total adjusted cost base (ACB) of your total investment (although not necessarily the average ACB per unit/share). The result is a lower capital gain when you redeem your total investment holdings at a later date. This ensures you are not taxed again on the amount of the distribution. An example of this appears in the sample ACB calculation on page 6. If the distribution is not reinvested, the ACB will remain unchanged. After the distribution is paid out, the market value of the account will decrease, resulting in a lower capital gain upon sale of the investment. Redemption of mutual funds How am I taxed when I redeem my investment? Mutual funds are generally considered to be capital property for tax purposes. This means that you may realize a capital gain (loss) when you dispose of, or redeem, your mutual fund. Outlays and expenses relating to the redemption or disposition of your units/shares may be deducted from the capital gain. These include redemption fees or deferred sales charges (DSC or back-end loads ) and transfer fees. Fifty per cent of your capital gain (loss) becomes Several types of transactions or events are considered a sale for tax purposes. For example: Transfer from one mutual fund trust to another mutual fund trust Transfer out of a mutual fund corporation Change of registration to anyone other than your spouse Transfer from a non-registered account to a registered account Upon ceasing to be a resident of Canada Upon death 4

5 your taxable capital gain (or allowable capital loss). Taxable capital gains are included in your income for the year. Allowable capital losses cannot be deducted from income; they may only be deducted from taxable capital gains (including capital gains distributions). If you do not have enough capital gains to offset the capital losses in the current year, the capital losses may be carried back three years and applied against any capital gains realized in those years. They may also be carried forward indefinitely to be used against future capital gains. One caveat: beware of the superficial loss rule that could deny your capital loss. This occurs if you or your spouse (or a controlled corporation) (re)acquires the identical property within 30 days of the sale. Instead, the denied loss is added to the ACB of the identical property. Please make sure to keep track of this amount for tax reporting. How do I calculate the ACB of my investment? The ACB is the amount you paid for the units/shares of your mutual fund. It is made up of: the amounts you paid to purchase your units/shares in cash plus any upfront sales commissions ( front-end loads ) plus any distributions you received from the fund and reinvested in more fund units/shares plus any denied losses under the superficial loss rule. If you redeemed all of your units/shares in a fund, you would use the total ACB calculated. If you redeemed only some of your units/shares, multiply the number of units/shares redeemed by the ACB per unit to determine the ACB of the portion redeemed. A sample ACB calculation is shown on page 6. ACBs and sales charges The ACB of a mutual fund investment is equal to the original cost of the units/shares plus any front-end sales charges and reinvested distributions. An increase in the ACB will reduce the capital gains upon disposition. Deferred sales charges (DSC) paid on the withdrawal will not affect the ACB. However, the DSC may be deducted as an outlay or expense in computing the capital gain / loss on disposition and reported on Schedule 3 of your income tax return Capital gains (or losses). 5

6 Sample calculation: Average cost per unit/share Mutual fund investment Cost No. of units Average cost per unit share A B A B January 2, 2001 Opening balance $ 80, , $ December 31, 2001 Reinvested distribution (@ $20.50) 2, , , December 31, 2002 Reinvested distribution (@ $21.35) 2, , , March 15, 2003 Purchase (@ $22.00) 11, , , November 17, 2003 Partial redemption (@ $25.00*) (16,700.00) (1, ) , , December 10, 2003 Reinvested distribution (@ $24.60) 2, ACB December 31, 2003 $ 81, , $ * Ignored for ACB calculation see below The average cost per unit/share is equal to the total cost of the investment divided by the total number of units/shares (e.g., $78,530/4, = $16.70). After each transaction, the total cost, the total number of units/shares and the average cost per unit/share are recalculated. Each new purchase or distribution reinvestment may cause the average cost per unit/share to increase or decrease depending on the price at which the transaction occurs. Each unit/share redeemed has a cost equal to the average unit/share cost for the investment immediately before the redemption. Therefore, in the example above, the total cost of the investment is reduced by the cost of the units sold, not their market value. A redemption will not cause the average cost per unit/share to change, but it will generally affect the total cost of the investment. Calculation of capital gain In the previous example, a partial redemption of 1,000 units at $25.00 per unit was made on November 17, The capital gain would be calculated as follows: Proceeds at $25.00 per unit ($25.00 x 1,000) $ 25, Adjusted cost base at $16.70 per unit ($16.70 x 1,000) (16,700.00) Redemption fees (deferred sales charge) assumed (125.00) Capital gain $ 8,

7 Can I use the cost and capital gains calculations on my annual statement of account? The average cost per unit/share indicated on your AIM Trimark annual statement of account is provided to assist you in calculating your capital gain (loss). For some accounts, it may not properly reflect all transactions. Additionally, it may not reflect the correct ACB if the account has been subject to a deemed disposition for tax purposes or if the same fund is held in multiple accounts. Under the identical property rule, if you had the identical fund(s) in more than one non-registered account, you are required to calculate your ACB across all accounts. We have also calculated the capital gain (loss) on redemptions that occurred in the account during the year based on information that is available to us. As mentioned above, it may not properly take into account any deemed dispositions. We are not always able to guarantee the accuracy of the information on these statements. As a result, we urge you to verify the calculations with your own records and to recalculate your average costs and gains (losses) on redemption for your income tax return. How are my redemptions reported to me? To the CRA? Each year, you receive an annual statement of account summarizing all the transactions in your account. This account statement shows all of the redemptions and transfers that are required to be reported on your income tax return. To increase efficiencies, the CRA allows us to use the annual statement of account for tax information purposes, rather than issuing you an additional T5008 form. The T5008 will still be filed with the CRA. It summarizes all of the redemption and transfer-out transactions you have undertaken during the year and which have appeared on your annual statement of account. It is not necessary to file your annual statement of account with the tax return only to report the redemptions that have occurred. What is the exempt capital gains balance? How is it used? The February 1994 federal budget eliminated the $100,000 general lifetime capital gains deduction and introduced the capital gains election. An exempt capital gains balance (ECGB) is an account you would have created for each of the flow-through entities for which you made a capital gains election in

8 Mutual funds trusts are flow-through entities, so an ECGB will have been created for each fund on which you made an election. In most cases, the ECGB created was equal to the elected capital gain you reported on your election and represented your accrued gains to February 22, 1994 on each investment. A separate ECGB was created for each fund for which you made a capital gains election and each balance must be drawn down separately. The ECGB for one fund may not be used to offset capital gains on another fund. Once you have used up the ECGB for a fund, any further capital gains realized on that fund will be taxable. If a fund is completely redeemed and an ECGB still remains, the remaining balance is automatically added to the ACB, thereby reducing your taxable capital gain (or increasing your capital loss). Any remaining ECGB on any fund will expire on December 31, At this point, the remaining ECGB is once again added to the ACB of your fund. How do I report my income if I bought or sold my mutual fund holdings in U.S. dollars? All amounts must be reported on your Canadian income tax return in Canadian dollars. To make reporting your U.S. dollar holdings easier, all T3/T5 Slips are issued in Canadian dollars, even if the fund was bought in U.S. currency. However, your annual statement of account for your U.S. holdings shows all transactions in U.S. dollars only. To report any capital gains (losses) in Canadian dollars, you will have to convert the U.S. dollar amount of the proceeds of disposition, adjusted cost base and DSC fees (if any) to Canadian dollars. You can obtain the exchange rate in effect at the time of your transaction(s) by consulting the Bank of Canada website at bankofcanada.ca. 8

9 Getting advice If you are holding mutual funds in a non-registered account you may want to consider whether you are better off with a mutual fund trust, or a mutual fund corporation. The rules are complicated. Your advisor can help you obtain your own independent financial, legal and/or tax advice and assistance. The information provided is general in nature and is provided with the understanding that it may not be relied upon as, nor considered to be, the rendering of tax, legal, accounting or professional advice. Readers should consult with their own accountants and/or lawyers for advice on the specific circumstances before taking any action. Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing. Copies are available from your financial advisor or from AIM Trimark Investments. AIM, the chevron logo and all associated trademarks are trademarks of A I M Management Group Inc., used under licence. * Knowing Pays, TRIMARK and all associated trademarks are trademarks of AIM Funds Management Inc. Designed and paid for by AIM Trimark Investments. AIM Funds Management Inc., 2004 TBMFTRE(11/04) AIM Trimark Investments is one of Canada s largest investment management companies with over $39.8 billion** in assets under management. A subsidiary of U.K.-based AMVESCAP PLC, which is among the world s largest independent investment managers, AIM Trimark employs more than 900 people in its Calgary, Montreal, Toronto and Vancouver offices. AMVESCAP is dedicated to helping people worldwide build their financial security, offering a broad array of investment solutions and services to individuals and institutional investors in 100 countries. Its securities trade on the London, New York and Toronto stock exchanges. AIM Trimark and its associated companies under the AMVESCAP umbrella draw on the talents and expertise of more than 650 investment professionals in 18 countries to manage over $457 billion** in assets worldwide. **As at September 30, Yonge Street, Suite 900, Toronto, Ontario M2N 6X7 Telephone: or Facsimile: or inquiries@aimtrimark.com