2 ways for mutual funds to handle higher capital gains inclusion rate

The fund industry “was largely expecting this type of election based on the last time inclusion rates changed,” said Grace Pereira, partner with BLG LLP in Toronto. “People were hoping [the government] would give similar flexibility in terms of how to treat the transitional year as they did before.”

Now, “what everybody is asking is, Should we do the detailed calculation versus the election?” said Joseph Micallef, tax partner and national tax leader, financial services, with KPMG Canada in Toronto.

The detailed calculation involves determining the exact underlying capital gains incurred before June 25 (Period 1) and after (Period 2), then disclosing and flowing out the gains to fund holders with attribution to each period, according to the backgrounder accompanying the notice of ways and means tabled on June 10.

Gains in Period 1 are subject to the 50% capital gains inclusion rate, and the gains in Period 2 are subject to the two-thirds inclusion rate if a fund holder is an individual and has more than $250,000 in total capital gains for the year. (Fund holders that are corporations or trusts cannot benefit from the threshold.)

The election, meanwhile, will deem a mutual fund’s underlying capital gain to have been realized proportionately before and after June 25, based on the number of days in each period divided by the number of days in the taxation year.

As 2024 is a leap year, June 24 is the 176th day of the year and represents 48% of the 366-day calendar year. Therefore, a mutual fund with a calendar tax year with a $1,000 capital gain on Dec. 31 would be deemed to have realized $480 of the gain in Period 1, and $520 in Period 2, for the purposes of distributing the gains to fund holders.

The $480 gain would be subject to the 50% inclusion rate, and the $520 gain would be subject to the two-thirds inclusion rate if the fund holder is an individual and has more than $250,000 in total capital gains for the year.

Mutual funds that choose neither option will be deemed to have realized the capital gains after June 24, making them entirely subject to the two-thirds inclusion rate.

Funds are allowed to choose the option that’s more favourable to fund holders, but choosing to perform the detailed calculations will require a cost/benefit analysis, Micallef said.

Micallef said KPMG is recommending that mutual funds targeted at the retail public, which are more likely to be held in registered accounts and/or by individuals who will be below the $250,000 threshold, consider taking the election.

“We suggested [the election] would appeal to the majority of these types of funds, and therefore would be a lot more cost effective and easier to address, particularly since [having two periods] is a one-time event,” Micallef said.

Mutual funds marketed to institutional, high-net-worth and accredited investors may wish to run the detailed calculation, since fund holders are more likely to be above the threshold.

“However, if you believe that the majority of your investors [hold the fund] in tax-exempt accounts, which is not uncommon, then perhaps [the detailed calculation] is not that relevant,” Micallef said. “So, you should really do that analysis to make that determination.”

The detailed calculation will require a lot of work, he said, “and there is going to be some professional judgment on some intra-period calculations.” Micallef added that some calculations will not be possible until draft legislation addresses them.

“Of course, as with most things in the investment fund space, a lot will turn on operational issues and what is actually practically possible,” Pereira said. She noted that funds of funds, for example, will need to wait for calculations to come in from their underlying funds before making their own calculations.

Nonetheless, “I believe administrators are already trying to build systems to be able to give their clients [and] the funds the information to choose the best result,” she said.

Mutual funds have time to decide between the methods, as the election is due along with the fund’s tax return. For mutual fund trusts with a Dec. 31 year-end, the deadline is March 31, for example.

“It’s not like they make an election today and they’re bound to it,” Micallef said. Further, no form to make the calculation is available, and “it’s likely we won’t see that for quite a while.”

Pereira said she’s watching for all relevant forms: “Having that information sooner rather than later would be great, because it’s not easy to move these big behemoths in terms of operationalizing the systems.”

Micallef suggested fund manufacturers use this time to identify which funds in their lineups are more likely to be held in tax-exempt accounts and by smaller retail clients.

Manufacturers can also review which funds have large capital loss carryforwards (for which the election may make more sense) or large unrealized capital gains with low redemptions (for which the detailed analysis may be prudent).

Other types of investment funds will have similar decisions to make.

“The tax treatment of mortgage investment corporations, and of shareholders receiving capital gains dividends from mortgage investment corporations, would be similar to that of mutual fund corporations,” the backgrounder said.

As for segregated funds, “the related segregated fund trust would be required to disclose the deemed capital gains that relate to dispositions of property that occurred in each period but would have the option to make the proportional election that is also available to commercial trusts,” the backgrounder said.

The government has indicated that draft legislation for changes to the capital gains inclusion rate will be tabled at the end of July.