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On July 29, the Department of Finance released draft legislation to implement the 2016 federal budget changes.

One such change was to the taxation of corporate-class funds. Budget 2016 told us that exchanging units of one corporate-class fund for another would no longer be tax-deferred, and that the change would take effect Oct. 1, 2016.

But Finance has given us a break: July’s draft legislation says the changes to corporate-class taxation won’t come into force until Jan. 1, 2017.

Background

For almost 30 years, Canadian investors holding corporate-class funds have been able to rebalance their portfolios while deferring the realization of capital gains until they withdrew funds from the corporation.

Under the new legislation, a corporate-class investor who exchanges, or otherwise disposes of, shares of one corporate-class fund for shares of another will be considered to have disposed of those shares at fair market value – triggering a taxable event.

Finance included two exceptions to the new legislation, and tax-deferred switching will continue to be allowed in the following circumstances:

1. If the exchange of shares is the result of the mutual fund corporation undergoing a capital reorganization or amalgamation, provided all shares of a particular class are exchanged.

Such reorganizations are typically initiated by the fund manufacturer, rather than an individual investor. The rationale for this exception is so that in such transactions, shareholder investors are not unfairly impacted from a tax standpoint.

2. If the shares exchanged are from the same share class but are from a different series (e.g., T-series, A-series).

This exception exists so as not to penalize investors who simply want to access lower fees, for instance. The underlying investments remain the same, but the series is distinguished by different fees or other share attributes. To qualify for this exception, the different series of the share class must be recognized as a single investment fund under Canadian securities laws.

Read: Don’t panic about corporate-class funds

Planning and discussion points

What planning should wealth advisors consider, discuss and carry out with clients who hold corporate-class funds prior to Jan. 1, 2017?

  1. Identify all clients who hold corporate-class funds in non-registered accounts. Are the funds held outright or in a fund-of-fund solution? Consider what, if any, difference from a client perspective would occur if funds or underlying funds were rebalanced post-2016. If the funds are held outright, the client will report the disposition. If the client owns a fund of fund solution, the rebalancing occurs at the fund level and may or may not trigger a capital gain dividend in the hands of the client.
  2. Identify all clients whose corporate-class funds have accrued capital gains or losses over a certain threshold. Combine those numbers with 2016 net realized capital gains or losses and capital gains dividends received.
    • Where a client has significant accrued capital gains, see if it makes sense to proactively time the realization of capital gains after 2016. That might make sense if the client will have room in their respective tax bracket next year, or knows that her income may be lower than usual next year (e.g., she’s changing jobs). If she immediately reinvests the funds, she may benefit down the road from a higher ACB.
    • Consider if there’d be a tax advantage in implementing tax-loss selling. Realized capital losses can be carried back against taxable capital gains reported in the last three years, applied to current year capital gains or capital gains dividends received, or carried forward and applied against future taxable capital gains.
  3. Consider the client’s target asset mix/Investment Policy Statement (IPS) and compare to the fair market value breakdown of existing holdings. Would it make sense to carry out a final rebalancing on a tax-deferred basis by mid-December 2016?
  4. What, if any, changes to a client’s IPS should be considered on a longer-term basis? Previously, changes to an IPS could be made on a tax-deferred basis to align with life events. If a client is going to be retiring in the near future, or perhaps is looking to buy a house in the next few years, consider changing the IPS now and completing any necessary rebalancing prior to mid-December. (Read: Rebalancing act: Estimating the value added through portfolio rebalancing)
  5. Consider how you might alter the client’s threshold for rebalancing (while aligning with his or her IPS) on a go-forward basis. If a certain investment mandate is off by 8%, and the client’s threshold to rebalance is 5%, does the client want to trigger a taxable event post-2016? Or, would they benefit from increasing their rebalancing threshold to, say, 10%?  Increasing thresholds simply impacts the timing of capital gains; capital gains reported may be larger but occur less frequently. For certain investors, such as individuals and graduated rate estates, who may have lower marginal tax rates, a greater tax liability may result from increased thresholds. Triggering capital gains regularly at lower marginal tax rates may be preferable.

Read: Clarity is key to investment policy statements

While the aforementioned planning and discussion points may frustrate some, reacting to Finance’s proposed tax legislation offers the opportunity to reach out to clients and demonstrate your value in being proactive.

Corporate-class still valid?

Corporate class remains a tax-efficient investment solution for Canadian investors who hold non-registered investments. Continuing benefits include:

  • a low dividend payout policy;
  • the ability to aggregate income and expenses across mandates within the same corporate-class structure;
  • tax-efficient distributions in the form of Canadian eligible dividends and capital gain dividends; and
  • the ability to generate and access cash flow through T-class fund offerings.

Read: Consider T-Series for tax-efficient cash flow

Michelle Connolly, CPA, CA, CFP, TEP, is vice-president, Tax, Retirement and Estate Planning at CI Investments. MConnolly@ci.com
Originally published on Advisor.ca
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