Reader alert: This is part 2 of a five-part series.
• Part 1: Tackling tax-efficient investing
• Part 2: Capital gains mean tax-efficient investing
• Part 3: Tax-efficient investing and dividends
• Part 4: Magic of tax-efficient bond investing
• Part 5: Tax-efficient investor behaviour
Capital gains are the most tax-efficient form of investment return because only 50% of capital gains are taxable. In addition, the timing of the payment of tax on capital gains is, to some extent, discretionary. This is because capital gains are taxed only when the related investment is disposed of. One of the principles of tax-efficient investing is to defer the payment of tax on capital gains whenever possible. It is always better to pay tax later rather than earlier. In the meantime, the money can be invested to generate additional returns.
Nevertheless, there are many reasons it may be advisable to dispose of an investment, even if this triggers a taxable capital gain.
- It is no longer consistent with investment objectives.
- It has reached its full potential.
- Its prospects have changed.
- You need to rebalance the portfolio.
Even in such cases, it is possible to defer the tax if the investment takes the form of an investment fund and the investor switches from one fund to another within a mutual fund corporation.
A mutual fund corporation has several classes of shares, each of which corresponds to a separate fund. The investor can switch from one fund to another simply by switching from one class of shares to another within the corporation. The Income Tax Act (Canada) allows this on a tax-deferred basis. Tax is payable only when the investor redeems shares of a class without reinvesting the proceeds in shares of another class within the same mutual fund corporation.
Capital gains through back door
Caution is necessary if you advise your clients to invest in shares of a mutual fund corporation. A switch is effectively the redemption of shares of one fund and the simultaneous purchase of shares of another fund. The fund whose shares are being redeemed must pay the redemption proceeds to the fund whose shares are being purchased. To do this, it must have sufficient cash. If the issue of new shares to other investors is insufficient to compensate for the redemptions, the fund may need to sell some of its portfolio investments in order to raise the required cash. As a result, it may realize capital gains, which will be distributed to its remaining investors and taxed in their hands. Make sure your clients are not among those investors.
Avoid capital gains distributions
The deferral of tax on capital gains is most complex when the investor owns investment funds. This is because, in addition to being taxed on capital gains realized on the disposal of their units, investors are taxed on the net gains distributed by the fund while they are unitholders. Yet the decisions that trigger capital gains distributions are usually made by the fund’s portfolio advisor.
Investors may avoid paying unnecessary taxes by staying clear of funds prone to capital gains distributions. Knowing the factors that drive distributions will help weed out tax-inefficient funds.
As is often the case, there is tension between active and passive managment. Click through below for more…