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New Rules for Corporate Class Mutual Funds and How They Affect You

New Deadline on Changes to Taxation on Corporate ClassAt the beginning of the year, we hosted round table discussions to help you set your planning agenda for 2016. We discussed income tax changes being implemented by the federal Department of Finance and the potential impact on investment planning.

With the change in tax rules, it is more important than ever to think strategically about the type of income you will earn on your investments and to then position your portfolio accordingly. Initially, the government intended to change the tax treatment of corporate class mutual funds effective September 30, 2016. They have since extended the deadline to January 1, 2017 – a welcome reprieve in a year of many changes in the financial sector. 

Tax Treatment of Income Earned on Your Investments

You are aware that interest, dividends, and capital gains all receive different tax treatments. Interest earned in non-registered accounts is treated the same as employment income. For example, if your combined federal and provincial marginal tax rate is 37.90%, you pay 37.90% tax on all interest earned.

Capital gains are treated differently. A capital gain happens when you sell or transfer capital property, such as stocks, mutual funds or real estate at a price higher than you paid. For example, if you bought $10,000 of units of Investment Fund A and sold those units two years later for $15,000, you have a capital gain of $5,000. Although there are a few exceptions, in most cases this gain is taxable, but you only have to declare for tax purposes only 50% of the actual gain. In this case, you pay tax on the $2,500, not the entire $5,000. The result is you pay less tax on capital gains than on interest.

In the chart below, you can see that if you are a Manitoba resident and your taxable income in 2016 will be between $67,000 and $90,563, it will be more tax efficient if you earn capital gains (18.95% marginal tax) rather than eligible Canadian dividends (20.53% marginal tax).

 

Manitoba Personal Income Tax Brackets and Tax Rates

For investors who use mutual funds, one way to reduce the tax burden is to invest non-registered money in investment funds that are held within a corporate class structure. Mutual funds can be organized as trusts or corporations.

Historically, corporate class mutual funds have had two main benefits:

  1. Less investment income to be reported annually as taxable income. This is because corporate class funds usually reinvest their interest and dividend income or use this income to pay fund expenses.
  2. No capital gain or loss triggered as a result of switches between different fund classes within the corporation. For example, if you have money invested in class A units of Corporate Fund X, at this time you can switch some or all of that money to class B units of Corporate Fund X without triggering a taxable gain or loss.

If you would like more information about capital gains and how they are calculated, visit CRA’s website: http://www.cra-arc.gc.ca/capitalgains/

Changes to Tax Treatment of Corporate Class Mutual Funds

The federal government has decided switching between different classes within the same mutual fund corporation will now be considered a taxable event. If you have a gain in class A fund, and you want to rebalance your portfolio by moving some of this money to class B, you will have to declare that capital gain.

Originally, this change was to take effect in October 2016. The federal government has moved the date to January 1, 2017. The old rules still apply for the remainder of this year.

There will only be two exceptions to this new rule. If the change in class happens because the fund itself restructures and converts all class A shares to class B, there is no tax implication for the investor. Also, if you move from the same class of fund but into a different series, there is no tax implication. The difference between one series and the next is usually the fee structure. The government won’t penalize investors for trying to have the exact same funds at a lower fee.

According to the Globe and Mail, “Approximately $120 billion of industry assets under management (AUM) are in corporate class funds, representing 10% of total mutual fund assets in Canada.” Therefore, many people will be affected by this change.

Review Your Non-Registered Investments with Your Advisor Before December 31, 2016

While corporate class funds still offer the advantage of using interest or dividends to offset fund expenses, you won’t be able to rebalance your portfolio free of tax implications come 2017. It will be critical for you and your advisor to review your non-registered investment funds so you can make appropriate changes before the new legislation comes into effect. In light of this change, you will need to think more strategically about how to construct your non-registered portfolio and how to manage it tax efficiently.

We’ve been working hard over the past few months to evaluate the great number of changes that investment firms have been making in their offerings. In studying these trends we’ve been able to confirm strategies that will enable you to position well for the years ahead. If you have non-registered investments, please contact us to schedule an appointment before the end of the year.

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