Month: December 2007

Merger Mania Creates Tax Headaches

2007 is turning into another record year in Canada for Mergers and Acquisitions. Year to date, Canadian firms have been the subject of 133 buyout transactions valued at $64.1 billion. Private equity activity remains on pace to double in size yet again. Some of the best known companies have been swallowed up by foreign companies or private equity. Such stalwart names as BCE, Alcan, Four Seasons, Shell Canada and most recently Cognos have disappeared from the Canadian publicly traded landscape.

Mutual funds that owned these positions rewarded investors with a big run up in fund values. The downside is that clients can expect to pay a capital gains bill for 2007 as mutual fund companies must distribute the proceeds of these dispositions by the end of the year. What many mutual fund clients may not know is that it doesn’t matter how long they owned a particular fund, they will get their prorated share of the capital gains based on the number of units they own.

Consider this example. Two investors buy the same mutual fund at different times in a year. Investor A buys the fund in January, and enjoys the increase in the fund’s price through the year as the underlying holdings benefit from the takeover activities. Investor B sees the fund performing well so they decide to invest in the fund in November. For the rest of the year, the fund is flat with no increase in share price. At the end of the year, both investors are in the fund when distributions are made. As such, both investors have the same tax consequences, even though investor A was the only one to benefit from the fund’s price increase.
If an investor bought a mutual fund in November 2007, and the fund was holding any of the Canadian firms who were bought out by a foreign company or taken private during the course of the year, they can expect to pay capital gains tax based on the number of units they own, even though they bought the fund after the deals were done.

The distributed gains depend on three things;

  • the mutual fund’s cost base of the individual stock
  • any losses the fund has that can be used to offset gains; and
  • the number of units a client owns at the time the distribution is made.

Capital gains distributions should not be confused with the client’s unique adjusted cost base of the mutual fund itself. The capital gains discussed here are the distributions made by the fund at year end and are either paid to the unit holder in cash or reinvested in the fund, depending on how the client has requested their distributions be paid.

In a Separately Managed Account (SMA) program, each client has their own individual cost base for every individual security so each client will have a different capital gain or loss to report, depending on when they were bought into a mandate. In addition, clients can offset those capital gains with tax loss selling to lessen or even eliminate entirely, the capital gains tax that must be paid.