Corporate-class funds offer tax benefits

Section 85 of the ITA permits a taxpayer to transfer eligible capital property, and that property’s adjusted cost base (ACB), into a corporation in exchange for shares and to defer taxes on the capital gain until the shares are sold — as long as the taxpayer and the corporation file a joint election.

With the Horizons restructuring, unitholders traded trust units for shares in a series in the corporate-class fund. If an investor holds the units in a taxable account and doesn’t make the Section 85 election by the time they file their 2019 tax return, the transfer of their ETFs into the corporation will considered be a deemed disposition.

Horizons converted 15 total- return index ETFs and 29 BetaPro ETFs — all of its funds that primarily use derivatives-based structures to achieve tax efficiency — into Horizons ETF Corp. This occurred after the federal government proposed certain changes to the taxation of mutual fund trusts, which include ETFs, in the 2019 federal budget. Those changes to the so-called “allocation to redeemers” methodology increase the likelihood that ETFs using derivatives-based structures, such as the 44 Horizons ETFs, are forced to make taxable distributions.

Horizons has been actively helping unitholders make the joint election. To date, more than 2,000 unitholders have processed their Section 85 election through the company’s dedicated website.

“The reorganization itself is complicated,” Hawkins says, “but Section 85 rollovers are something retail advisors have been using for years [on behalf of clients] with respect to other corporate reorganizations.”

Hawkins says Horizons is assessing whether it will convert any of its other ETFs into corporate-class funds. “We have other ETFs that are actively using futures, as an example, [as part of those ETFs’] investment strategy,” he says. “Managing those products inside a corporate-class [fund] makes a lot more sense from a tax perspective.”

Section 85 rollover elections can be employed in both corporate reorganizations and mutual fund mergers. For example, Toronto-based Mackenzie Investments decided last year to merge some of its funds into a corporate-class structure and helped unitholders make the election.

Separate from the reorganization of its 44 funds, Horizons states it will consider allowing clients to use the special election to transfer a third-party investment fund into its mutual fund corporation.

“We would consider a transfer for similarly indexed products,” wrote Horizons in an email to Investment Executive (IE). Horizons cited an example of an exchange of units in iShares’ S&P/TSX 60 index ETF for shares of Horizons’ S&P/TSX 60 index ETF.

In such a transaction, Horizons would become owner of the third-party fund in consideration for shares of a series in the corporation.

“Horizons, in most cases, will turn around and redeem the third-party ETF immediately in exchange for the underlying securities of that third-party ETF,” the email said. “The competitor ETF’s underlying securities received would become part of the Horizons ETF going forward.”

Tax experts say it’s uncommon for a corporate-class fund to allow such transactions, but that those transactions are permissible under the ITA.

“[Such a transaction] would have to fall within the objectives of the [corporate-class] fund and [take into account] its investment restrictions,” says Jim Witty, vice president of tax, retirement and estate planning with CI Investments Inc. in Toronto.

Says Carol Bezaire, senior vice president of tax, estate and strategic philanthropy with Mackenzie Investments: “It would have to be the same kind of index [as the ETF, and] there would be a lot of [issues to consider]: What kind of index does [the fund] trade on? Does it have a mandate that we want in our corporate structure? So, [the transfer process] would get complicated.”

Toronto-based Purpose Investments Inc. has been allowing Section 85 rollover transactions on a selective basis into an in-kind transfer fund. For example, an investor could exchange shares of a publicly traded company for shares of a Purpose corporate-class fund. If those company shares had a large unrealized gain, that would allow the investor to diversify without triggering an immediate tax event.

“It’s a specific-use case for specific clients,” says Vlad Tasevski, head of product with Purpose, about the in-kind transfer fund. Since 2015, Purpose has had an active patent application with the federal government for a “method of exchanging an asset for shares of an investment fund held in an investment fund corporation.” The patent includes methodology for tracking the ACB of the shares being transferred into the corporate-class fund “during all the time the client is invested in the [corporation].”

Purpose offers almost 25 ETFs and mutual funds in Purpose Fund Corp., as well as individual funds set up as trusts.

CI Investments, which has corporate-class funds in its product lineup, “does not offer in-kind subscriptions at this time,” wrote a spokesperson for the firm in an email to IE.

Corporate-class funds, because of their structure, offer potential tax advantages for investors. One key advantage is that income and foreign dividends generated within one series of the corporation can be offset with expenses and losses incurred in other series, which allows for tax efficiency. In addition, corporations can distribute only capital gains and dividends, which are more tax-efficient than income and foreign dividends.

Bezaire says she expects interest in corporate-class funds to increase, especially for small-business owners. Recent changes to the taxation of private corporations limit access to the small-business deduction tax rate when a small business generates more than $50,000 in passive investment income in a year.

“With corporate-class structures, the passive investment income gets reduced because it [generates] fewer taxable distributions,” Bezaire says.