Ideal candidates for mutual fund corporations

Tax managed strategy 21

A mutual fund corporation is a single, taxable entity consisting of several classes of shares, with each class representing a different mutual fund. This allows mutual fund corporations to offer tax benefits to investors who hold non-registered funds.

As an investor, you can buy into the overall corporate structure by purchasing shares of one or more classes (funds). Since a corporation computes its net income and net capital gains as a single entity, it can offset the income and capital gains of one fund with the expenses and capital losses of another, providing more flexibility in reducing potential taxable distributions.

A corporation can’t flow through ordinary income (i.e., interest or foreign income). Net income or capital gains from a corporate class fund may be paid out to investors as tax-efficient distributions like an ordinary Canadian dividend or a capital gains dividend (which is taxed at 50% as a taxable capital gain).

Investors may find these tax advantages attractive in various situations

Non-registered investors

Investing in a corporate class fund could be a great choice for your non-registered investments. For registered funds, registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs), and tax-free savings accounts (TFSAs) already provide tax-deferred growth. Investing in non-registered funds could provide greater potential to accelerate the growth rate of your portfolio by earning tax-efficient distributions.

Seniors

Actively managing your taxable income in retirement can have a significant impact on both the tax you pay and whether you qualify for certain government income-tested benefits. If you’re collecting Old Age Security (OAS), for example, this benefit can be clawed back if you have too much taxable income. Using a corporate class fund that usually distributes capital gains or return of capital in a non-registered portfolio can help reduce the amount of income reported on your tax return, therefore, potentially reducing OAS clawback.

Trusts for minors

Often, a parent or grandparent will set up a trust account to hold investments on behalf of their minor child or grandchild. One benefit of this is the potential to split income with the minor. The Income Tax Act (Canada) attribution rules cause any income (interest, ordinary Canadian dividends, and foreign income) to be taxed to the parent or grandparent. However, capital gains are taxed to the minor, who’s normally in a lower tax bracket, resulting in little or no taxes being paid. To maximize the benefits of income splitting, you should try to generate capital gains versus other income. Therefore, if you don’t invest in a fund that distributes ordinary Canadian dividend income, all the return would be capital gains or return of capital, which won’t be attributable to you.

Incorporated business owners

Many business owners have built up significant after-tax profits in their corporation, and rather than withdrawing those funds and investing them personally, they’re being invested by the corporation. Since corporate tax rates on passive income are generally higher than the top marginal rates for individuals, reducing the amount of investment income the corporation reports is very beneficial. Using corporate class funds for corporate investments can help keep taxable distributions to a minimum, and since they can only be ordinary Canadian dividends, capital gains dividends, or return of capital, this can reduce the amount of investment income that’s subject to the high passive income tax rates.

Also, keep in mind that passive income earned in a corporation can lower the corporation’s small business deduction (SBD). This reduction begins when a corporation (or group of associated corporations) earns $50,000 of passive income in a year, and is fully eliminated when passive income reaches $150,000. Investing in low-taxable, distribution corporate class funds can help reduce the impact on a corporation’s SBD.

Investors looking for income

Many corporate funds also have a Series T option, which can give the income-oriented investor a regular stream of tax-efficient cash flow from monthly distributions.¹ All or a significant portion of the distribution is likely to be considered tax-free return of capital (ROC). This essentially defers triggering capital gains from monthly withdrawals. However, there may still be taxable distributions of ordinary Canadian dividends or capital gains dividends, as mentioned earlier.

Each time the corporate fund distributes ROC, the adjusted cost base of the investment decreases. When the adjusted cost base reaches zero, all further ROC distributions are taxable as capital gains, which is still tax efficient since only 50% of capital gains are taxable.

U.S. estate tax

If you’re a Canadian resident but not a U.S. citizen, you may still be subject to U.S. estate tax on your U.S. situs property if the value of your worldwide estate at the time of your death is above a certain threshold. U.S. situs property includes, but isn’t limited to, U.S. real estate (e.g., a vacation home in Florida), as well as U.S. securities (e.g., shares of Apple Inc.). U.S. securities are considered U.S. situs property regardless of whether they’re held in a Canadian brokerage account, even if they’re held in a registered account such as an RRSP or TFSA. However, an investment in shares of a Canadian mutual fund corporation (or an investment in units of a Canadian mutual fund trust, exchange-traded fund, or segregated fund contract) aren’t considered to be U.S. situs property, even where a fund invests in U.S. securities, thereby limiting your potential exposure to U.S. estate tax. To learn more about U.S. estate tax, read “U.S. estate tax exposure for Canadian residents (who are not U.S. citizens).”

Ideal candidates

Non-registered investors who:

  • want the potential to accelerate their portfolios’ rate of growth by saving taxes
  • want to actively manage their taxable income in retirement, or for their corporation or trust

Take action

Talk to your advisor if you’re considering a mutual fund corporation structure to help reduce taxes and find corporate funds that fit your investment objectives and risk tolerance.

1 To learn how the Series T option can be used to provide tax-efficient income now and be a tax-effective way to donate to charity in the future, see “Using Series T for income now and charitable donations later."

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Tax, Retirement & Estate Planning Services Team

Tax, Retirement & Estate Planning Services Team

Manulife Investment Management

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