With the advent of CRM2, many advisors have considered switching to a fee-based model, in part so investors can deduct advisor fees. But when are advisor fees tax-deductible? And are there real financial benefits to this deductibility? This article provides the answers.

ADVISOR FEE DEDUCTIBILITY RULES

The rules for deductibility of Investment Counsel Fees can found in section 20 (1) (bb) of the Income Tax Act (italic emphasis ours):

20. (1) (…) in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted (…) (bb) an amount, other than a commission, that

(i) is paid by the taxpayer in the year to a person or partnership the principal business of which

  • (A) is advising others as to the advisability of purchasing or selling specific shares or securities,
  • or

  • (B) includes the provision of services in respect of the administration or management of shares or securities, and

(ii) is paid for

  • (A) advice as to the advisability of purchasing or selling a specific share or security of the taxpayer,
  • or

  • (B) services in respect of the administration or management of shares or securities of the taxpayer;

Basically, the Income Tax Act allows a taxpayer to deduct fees paid for advice on buying or selling a specific share or security of the taxpayer, or for the administration or the management of the shares or securities of the taxpayer. The amounts deducted need to be reasonable. A reasonable fee would be a fee charged normally in an arm’s-length relationship.

Read: Investment fees: what’s deductible?

Quebec-specific rules

Advisor fees are deductible against any other type of income at the federal level. However, Quebec has its own rules: advisor fees are only deductible against investment income (interest, Canadian dividends, foreign income, and taxable capital gains). In Quebec, if there is not enough income generated by the investments to use the deduction, the unused portion of the deduction can be accumulated and carried forward indefinitely as long as there is investment income earned in a future year.

Other advice

Fees paid for other types of advice, such as financial planning, are not within the provisions of paragraph 20(1) (bb), and are not deductible.

Commissions

Commissions are specifically excluded from the definition of investment counsel fees. So commissions paid to stockbrokers to process transactions, or front- and back-end mutual fund commissions, are generally not deductible. All is not lost, however, as commission fees increase the ACB of an investment at purchase or sale, thus reducing capital gains or increasing capital losses when the investment is eventually sold.

Read: Case study: Incorporated client, higher taxes

Registered accounts

Although not specified in paragraph 20 (1) (bb), fees charged by the trustee of a registered plan directly to the annuitant are not deductible, as the shares or securities held in the plan belong to the trust, not the annuitant. This means that no fees are deductible if paid on registered accounts (i.e., RRSP, RRIF, TFSA, RESP, RDSP).

Shares or securities

Paragraph 20 (1) (bb) mentions that the advice has to be relative to a share or a security owned by the taxpayer – so stocks, bonds, mutual funds, corporate class mutual funds and ETFs.

But are segregated funds considered securities? It seems not. At the CALU 2014 CRA Roundtable, CRA stated that, for the purpose of paragraph 20(1) (bb), a segregated fund policy is an insurance contract and not a share or security. Consequently, CRA says, fees for acquiring, disposing, administering or managing segregated fund policies are not deductible.

The taxpayer must pay

To be deductible, the taxpayer needs to pay the advisor fee. Also, the fee needs to be paid for advice or service pertaining to shares or securities that the taxpayer holds directly. That means mutual fund MERs are normally non-deductible at the investor level.

And, if the advisor fee is charged directly to the investors (not as part of an MER) in a non-embedded (F-class) mutual fund, the fee would be deductible against income for the investor, if other criteria are met – namely, the fee is paid in respect of advice regarding the purchase of eligible securities (including mutual fund units or shares) owned directly by the investor. However, mutual fund portfolio management fees themselves, even if charged directly to the investor by the mutual fund company, are not normally deductible at the investor level. Why? Again, par. 20 (1) (bb) specifies that the shares or securities must be held directly by the investor for deductibility to be possible. The CRA has supported this position in several technical interpretations.

Read: How to answer common fee questions

Do investors truly benefit?

Is there a true tax advantage when an investor can deduct advisor service fees directly? And does owning a security directly, as opposed to owning mutual funds, provide a distinct tax advantage?

To answer those questions, consider the following situations.

  1. In the chart below, the first column illustrates when someone holds a traditional embedded mutual fund, with bundled management and advisor fees that are paid directly by the fund. The MER of the fund is 2.3%, and no fee is deductible by the investor on his or her personal tax return.
  2. The second column illustrates when holds a non-embedded mutual fund, where the management and advisor fees are separated and the advisor fee is paid directly by the investor. The fund’s MER is lower (1.3%), reflecting the fact that the investor directly pays an advisor fee of 1%, allowing him to deduct the advisor service fee directly on his income tax return.
  3. The third column illustrates when someone invests with a full-service broker and directly owns the securities. His full service broker charges 2.3% in advisory, administration and management of securities fees. Since the investor owns all securities personally, he will be able to deduct the full 2.3%.

For the sake of comparison, it is assumed all three investors own balanced portfolios that are sold after one year, generating capital gains on disposition.

Embedded Mutual Fund Non-Embedded Mutual Fund Direct Ownership of Securities
Initial investment $ 100,000 $ 100,000 $ 100,000
Capital gains (6%) $ 6,000 $ 6,000 $ 6,000
Interest income (4%) $ 4,000 $ 4,000 $ 4,000
Minus MER @ 2.3% (1.3% for non-embedded) ($ 2,300) ($ 1,300) ($  0)
Generated capital gains $ 6,000 $ 6,000 $ 6,000
Taxable capital gains $ 3,000 $ 3,000 $ 3,000
Interest distributed after paying MER $ 1,700 $ 2, 700 $ 4,000
Total taxable income before deduction $4,700 $5,700 $7,000
Deduction of advisor fee @ 1% (2.3% for direct ownership): ($ 1,000) ($ 2,300)
Total taxable income $ 4,700 $ 4,700 $ 4,700
Tax paid @ 45 % ($ 2,115) ($ 2,115) ($ 2,115)
Net income after MER, advisor fee deduction and taxes $ 5,585 $ 6,585 $ 7,885
Minus advisor fees paid out of pocket by investor ($ 1,000) ($ 2,300)
Net cash flow generated $ 5,585 $ 5,585 $ 5,585

When investing in a mutual fund, whether the advisor fee is deducted from income generated within the fund structure (as is the case with embedded mutual funds), or whether the fee is deducted at the investor level personally, the net after-tax result is the same.

Even with a full-service broker, the after-tax effect is identical. That is, owning securities directly does not confer an after-tax advantage.

Francois Bernier is Mackenzie Investments’ Director, Tax & Estate Planning. He can be reached at: fbernier@mackenzieinvestments.com.
Originally published on Advisor.ca
See all commentsRecent Comments

GERALDC.CURTIS.6

On closer look, the calculation IS a little oversimplified in that it assumes that there is always enough interest (fully taxable income) distributed from the fund or portfolio annually to equate to the deductible portion of the MER (i.e. the part paid directly to the rep), While this may be true in many cases most of the time, in these days of super-low interest rates, or in the case of a pure equity portfolio with no income distributions except capital gains and/or dividends, there may, indeed, be some small advantage to paying the 1% or so portion of the MER directly in a fee-based arrangement. So, it really depends on the fund and what kinds of income are distributed in any given year, but, in any case, the advantage is not as great as some would claim. Of course, none of this matters in a registered plan (RRSPs or TFSAs) and, apparently, seg funds don’t qualify as “securities” anyway, so it’s a moot point there.

Friday, August 21 @ 2:36 pm //////

GEORGE.WRIGHT.1

the article assumes that an advisor would charge 2.3% to manage the stock portfolio directly rather than something similar to the 1% (s)he was charging in a mutual fund portfolio, which seems high.

Friday, August 21 @ 8:26 am //////

DE THOMASIS

Re deduct-ability of fees
It was a great article-thank you
But…one point was not mentioned.
As advisers, we are expected to offer full services in order to justify our fees (re taxes, estate, budgeting, etc)
If we do that and we charge fees separately (not embedded) how will CRA look at that re advice given for other planning services other than investments?
I can see them prorating the fees and giving only a partial deduction.

Wednesday, March 11 @ 12:53 pm //////

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