Historically, mutual funds in Canada have been set up as a trust structure. However we are now seeing more and more corporate class structures which can provide tax advantages for certain investors.
Under a trust structure any income remaining after deducting expenses is usually paid to the fund’s unit holders. If this income was not paid out, taxes would be payable by the fund itself, usually at a higher rate than if taxed in the hands of an individual.
In contrast a corporate class structure will have several classes of shares with multiple series of each share class. A corporate class share is the equivalent to a mutual fund unit and a corporate class series is equivalent to a mutual fund class. This structure provides several tax advantages for investors. An often cited feature is that investors can switch between various classes of funds within the corporate structure without incurring taxes on deemed dispositions. These taxes are deferred until the overall investment with the corporation is sold.
Some corporate share classes include a return of capital which is not taxable when received but reduces the fund’s cost base and defers a higher capital gain into the future. Interest income, as well as foreign income, is converted to lower taxed capital gains and the fund manager is able allocate expenses across the various classes of shares in order to minimize distributions. There are some instances where corporate class shares can be useful for clients with non-registered assets and some examples have been set out below.
Corporate class T series shares can be an option for clients looking for a regular, tax efficient income stream. These shares will target an annual payout rate which includes a return of capital as well as capital gains income. Return of Capital payments are not taxable when received but reduce the fund’s cost base and defer a higher capital gain into the future. Until the corporate class shares are redeemed, clients receive tax efficient cash flows while reducing taxable distributions. When the shares are redeemed they effectively defer and convert high tax interest payments into capital gains which are taxed at a lower personal rate.
The benefit of the return of capital distributions can also be of interest to high income seniors collecting Old Age Security (OAS). Once current income crosses the OAS maximum income threshold, a portion of a senior’s benefits will have to be paid back. Switches in open account mutual funds set up under a trust structure may trigger taxable distributions and cause clients to be subject to the OAS claw back. The same switches under a corporate fund structure or regular receipt of return of capital distributions would not trigger the same increase in taxable income and thereby preserve government benefits for these seniors.
Small business owners may find that the reinvestment of surplus corporate profits becomes a problem because the tax rate on passive corporate investment income is often higher than the top marginal personal tax rate. As corporate class funds focus on capital gains income and minimize taxable distributions, an incorporated small business can lower the tax rate on the earnings realized on their surplus profits.
Individuals with long term plans to make charitable donations can also benefit from the return of capital feature which over a sufficiently long time horizon can bring the cost of the corporate class shares to zero. Over the years the individual receives a tax efficient cash flow. Years later the individual can donate their shares in kind to a charity and receive a donation tax credit as well as eliminate their tax liability on the shares which is passed on and effectively extinguished within the charity.
Corporate class shares have been available in Canada for some time but have not drawn much scrutiny from some clients as they can appear to be complicated. Because of their favourable tax treatment, the trend to these types of funds is expected to grow so it can be worthwhile for advisors and clients to keep informed of developments in this field.