Last time, we talked about how charging a management expense ratio (MER) fee, versus a direct fee, can affect fee deductibility for mutual fund trusts. This article will look at deductibility for corporate-class funds, or mutual fund corporations.

Two characteristics of mutual fund corporations

Mutual fund corporations house a number of funds within one structure, with each fund being a class of share of the corporation. These funds can be effective for investing non-registered money, due to two main characteristics:

  1. Capital gains and losses of the funds within a mutual fund corporation are pooled or consolidated for annual tax reporting. Compared to discretely held securities, a mutual fund corporation is less likely to realize capital gains distributions. The annual calculation includes unused capital losses that have been carried forward from prior years. Correspondingly, if the currently calculated net figure is negative, that will be added to the loss carryforward balance to be used in future years. Overall, this characteristic helps defer (but not eliminate) capital gains recognition for the investor, which is beneficial due to the time value of money.
  2. Interest and foreign income are taxable to the mutual fund corporation. These are the first charges against the MER. For investors in funds generating this underlying income, there will be a rise in the net asset value of their holdings, eventually contributing to a capital gain (or reduced capital loss) on a disposition. If such income had been earned directly by a taxpayer, it would have been fully taxable.

In a given year, an investor in a mutual fund corporation can often experience an increase in net asset value (i.e., an unrealized capital gain), with few or no distributions. This changes the game somewhat for our comparison of MER and direct fees. The revised example below uses the same assumptions as in last month’s article, except that the income type is assumed to be an unrealized capital gain arising through the use of a mutual fund corporation.

Table 1: Using a mutual fund corporation in a non-registered account (50% tax rate)

$10,000 invested, 5% return MER Direct fee
Unrealized capital gains $500 $500
Less: MER ($200) ($100)
Unrealized capital gain $300 $400
No distribution
Less: Investment counsel fee N/A ($100)
Taxable income reported $0 ($100)
Reduced taxes, added back $0 $50
Net income $0 ($50)

Note: Though the unique characteristics of a mutual fund corporation are emphasized in this illustration, a mutual fund trust may also experience appreciation through unrealized capital gains, generally due to price appreciation of its securities and the netting of capital gains and losses. The net calculation for a mutual fund trust is within the fund alone, whereas a mutual fund corporation performs this calculation across its entire array of fund holdings.

The key figure here is the $50 in reduced taxes. Put another way, paying a direct fee leads to current-year tax savings, based on full deductibility. In most provinces, the fee is deductible against other income in the year (shown as negative $100 under “Taxable income reported”), though in Quebec the provincial component of the tax deduction will be delayed until the year in which the associated income becomes taxable. Meanwhile, a greater amount of the investment is left invested (deferred taxation), and will ultimately be treated as a capital gain (preferred taxation).

On the face of it, there would appear to be an obvious benefit now to using direct fees, but we still need to tread carefully before coming to a conclusion.

In contrast to the scenario from our last article, there is no distribution of cash to the investor in Table 1. External cash is being used to pay the direct fee. In effect, the $50 tax savings has been purchased by adding $100 to the fee-based program. To maintain the integrity of the comparison, an equal amount needs to be added to the MER side (or in some other way accounted for, as we’ll discuss) each year to keep the two options on an even footing.

Unfortunately, the impact of introducing the direct fee from external cash cannot be illustrated with the limited view of Table 1, which simply looks at current year taxation. Instead, to illustrate the effect on a current year basis, the investments could be disposed at the end of the year.

Table 2: Mutual fund corporation, non-registered, on disposition (50% tax rate)

$10,000 invested, 5% return MER Direct fee
ACB – End $10,000 $10,000
FMV – End $10,300 $10,400
Terminal capital gain $300 $400
Terminal tax owing ($75) ($100)
After tax value, before reconciliation $10,225 $10,300
Fees paid out of external cash N/A ($100)
Reduced taxes, added back N/A $50
After external cash reconciled $10,225 $10,250

Table 2 continues from Table 1, showing the net impact after disposition of the investment immediately after the income distribution. This has the additional benefit of clearly quantifying the capital gain.

There is a $25 increased investment return (from $225 to $250) once all income is realized, which is a little more than an 11% improvement for having used a direct fee. This can be directly derived by multiplying the invested amount, in this case $10,000, by the formula:

fee x marginal tax rate x capital gain rate

If the investor’s marginal tax rate is 40%, the bottom line difference will be 0.2%, or $20.

Three alternatives for fee payment

As mentioned, the use of external cash for the fee requires a balancing exercise on the MER side in order to maintain a fair comparison. However, the use of external cash is not the only way to pay the direct fee. There are three practical ways a fee may be charged:

  1. Introduce new/external cash, reconciling this on the MER side (as outlined above).
  2. Use an annual systematic withdrawal plan (SWP), calculated to net to the required cash for the fee. The withdrawal will be mostly return of capital (ROC), with some realization of capital gains. Assuming growth in capital value over time, the ROC proportion will generally decline from year to year. The ROC component reduces the ACB for future/terminal capital gain/loss calculation.
  3. Elect an annual T-series distribution (T-SWP) from the mutual fund, assuming such an option is available for the particular fund. If there is no realized income in a given year, the entire distribution will be ROC. As with a SWP, under a T-SWP the ROC component reduces the ACB for future/terminal capital gains calculation.

The two latter modes benefit from the logical simplicity that the MER side remains untouched, since the fee is being funded entirely from cash already within the respective investment. Table 3 (see page 20) shows that the calculations under the second and third modes yield the same bottom-line result originally shown in Table 2.

Compounding the savings?

While, as stated, the single-year snapshot allows for immediate quantification of the unrealized capital gain, it also potentially discounts the compounding potential of that aspect of capital gains treatment. If the funds were left to grow over the course of say, 10 years, how much more benefit could be expected to accrue to the fee side?

As it turns out, extra returns in later years are relatively modest. Most of the benefit arises in the first year, with following years’ additional returns coming from the first year’s reinvested tax savings and slightly larger unrealized capital gain.

However, on the MER side, the quid pro quo addition of external cash (equal to what was added to the fee side) keeps the fee side from running away. On cashing out the two investments after 10 years (including payment of all taxes, deduction of original principal and extraction of all added external cash), the investor has $3,032 on the fee side or $2,655 on the MER side, a difference of $377, or 14.2%. On an annually compounded basis, that’s less than 1.4% per year.

Similarly to Table 3, this 10-year example can also be tested using a SWP or T-SWP. The dollar values vary slightly across the three methods (in large part due to the need to use weighted-average MERs), but the variance is not material and the percentage differences remain effectively the same.

That being said, the benefit in the first year is real. Likewise, new deposits into the investment will similarly experience this benefit. Indeed, reinvestment of the tax savings is, in truth, a new deposit. Similarly, by not disposing of the investment at year-end, the investor is effectively keeping invested the unrealized component that would otherwise be subject to capital gains taxation.

Keep in mind, however, that the benefit does not compound on itself over time, as the time series emphasizes.

Table 3: SWP and T-SWP for fee payment, non-registered (50% tax rate)

$10,000 invested, 5% return SWP T-SWP
ACB – Begin $10,000 $10,000
FMV – Before fee paid $10,400 $10,400
ROC portion (by formula) 96.2% 100.0%
ROC amount $97 $100
Non-ROC % 3.8% 0.0%
Non-ROC amount $3 $0
Total redemption $101 $100
ACB – End $9,903 $9,900
FMV – End $10,299 $10,300
Terminal gain $396 $400
Terminal tax ($99) ($100)
Net before tax savings $10,200 $10,200
Tax savings $50 $50
Terminal value $10,250 $10,250

Note: Figures are rounded and may appear to show discrepancies. The terminal value is exactly the same either way—the same as when using external cash as illustrated in Table 2.

Read Part 1 of this series herePart 2 here and Part 4 here.

Doug Carroll, JD, LLM (Tax), CFP, TEP, is Practice Lead — Tax, Estate & Financial Planning at Meridian.

Originally published in Advisor's Edge Report

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