When you are advising mutual fund clients on how to minimize their tax liabilities, the key is how the mutual fund is structured.

Traditionally, mutual funds were set up as trusts. But in the past few years, says Carol Bezaire, assistant vice-president of tax and estate planning with Mackenzie Financial Corp. in Toronto, more and more funds have been set up as corporations, offering a number of tax advantages.

Christine Van Cauwenberghe, director of tax and estate planning, advanced financial planning, at Investors Group Inc. in Winnipeg, says the tax-planning advantages of investing in a mutual fund corporation will be particularly attractive to clients who hold investments outside a registered account — perhaps, individuals who have maxed out their RRSPs — as well as investors who have a long-term investment horizon or those who like to rebalance their portfolios regularly. “The whole point is tax deferral,” she says.

In general, Bezaire explains, taxation on a mutual fund occurs at two levels: the taxation of the investor and the taxation triggered as the portfolio manager changes the asset mix.
In a mutual fund trust, she notes, income generated within the trust in the form of interest, foreign income, dividend income and capital gains is flowed through at the end of each year in distributions, net of expenses, to unitholders.

Investors then pay taxes on these various forms of income at rates applicable to the type of income. For instance, only 50% of capital gains will be taxable and can be used against capital losses. Interest income, however, will be fully taxed. Dividend income from Canadian corporations will be grossed up and eligible for the dividend tax credit.

But buying and selling units in the fund or switching from one mutual fund trust to another will trigger tax liabilities, Bezaire says. There will be a capital gain or loss, depending on the adjusted cost base of units held by the investor in the fund.

A mutual fund corporation, however, is essentially a family of funds within a single taxable corporation. Mackenzie Capital Class, for instance, is organized so each mutual fund is a different class of shares. There are 46 funds or share classes in this corporation, and the shares are convertible from one class to another on a tax-deferred basis.

Taxes may be payable when shares are eventually sold if a capital gain is realized. But by using a rollover provision in the Income Tax Act, Bezaire says, the share conversion between classes is deemed not to be a disposition for tax purposes, so no taxable gain is realized on the switch.

The tax-deferred conversion provision underpinning these funds is only available with respect to the shares of corporations — not the units of trusts. “Taxation becomes a controllable expense,” says Bezaire. “The investor has the flexibility of choosing when to trigger taxes — for example, by crystallizing gains or losses in a lower tax year.”

A mutual fund corporation may be subject to federal and provincial capital taxes on shareholders’ equity and long-term debt, but it is a flow-through entity only with respect to capital gains and dividends from Canadian corporations, Bezaire points out. Mutual fund corporations can use the gains in some funds to offset the losses in others and minimize the taxable distributions to the investors.

Van Cauwenberghe suggests that an investor who wants to redeem a portion of an investment in a mutual fund corporation can also use capital losses in one fund or class of shares to offset gains in another fund, switching shares between funds to minimize the gain on the shares being withdrawn.

However, she emphasizes, capital losses on investments in a mutual fund corporation can only be triggered if the investor leaves the corporation. And, she warns, investors should watch for the “superficial loss” rules that require anyone selling shares in order to make a loss to wait at least 31 days before repurchasing shares in the same corporation. This is not an issue with mutual fund trusts, she notes.

For business-owner clients, investing in a mutual fund corporation can reduce exposure to capital taxes payable in most provinces and at the federal level on money held within a corporation and not used for further business, Bezaire says. In computing these taxes, the corporation may claim a deduction in respect to eligible investments — and that includes shares in a mutual fund corporation, but not units in a trust.

@page_break@Another tax-planning strategy for small-business owners, says Bezaire, involves the capital dividend account, from which the corporation may elect to pay a tax-free dividend to shareholders — potentially a way of supplementing the business owner’s retirement income. If the corporation makes a capital gain on the disposition of eligible capital property — which includes shares in a mutual fund corporation — the non-taxable portion of the capital gain can be added to the corporation’s capital dividend account.

Clients who have investment-holding companies or small businesses, says Bezaire, may want to use a mutual fund corporation to generate capital gains so the non-taxable portion can be paid out to them in retirement on a tax-free basis.

Still, you may have some clients who would be better off in a mutual fund trust. Bezaire gives the example of seniors who need income to supplement a pension and would like to have interest income flowing through regularly. But most clients can save taxes and have more money in their pockets by using a corporate structure, she says. IE