fees-pen-reports

[Editor’s note: This is an updated version of an article that originally appeared in 2009.]

In light of recent global market volatility and its impact on clients’ portfolios, advisors are naturally investigating avenues to help investors mitigate losses while positioning their portfolios to benefit when the markets recover. One such avenue involves seeking out opportunities to help clients reduce the amount of tax they pay on their investment income. Consequently, the topic of the deductibility of investment management fees has become a popular, though not universally understood point of discussion among industry professionals. This column aims to help clear up some of the issues on the matter.

Investors in mutual funds and wrap investment programs pay fees for investment advice and management services. The fees in either of these investment arrangements may be deducted for income tax purposes as a carrying charge. However, there are a number of important qualifications that must be kept in mind when considering each individual case. Exactly what kinds of investment management fees are deductible? Is there any advantage to claiming these fees through a wrap account rather than a mutual fund? If such fees are allowable deductions, are there any exceptions?

Let’s look at these questions in order.

Fees can be deducted if they qualify on the following points:

  • They have been paid for advice connected to the buying or selling of a specific investment
  • They cover the cost of administering or managing an investment owned by the person making the claim
  • They are not a commission
  • They relate to advice on investments made in non-registered accounts. The CRA will deny a deduction of fees related to registered accounts including RRSPs, RRIFs, RESPs and TFSAs. An investor cannot circumvent this rule by charging fees related to a registered account to a non-registered account. For the remainder of this article, when referring to investment management fees I mean deductible investment management fees related to a non-registered account.

Investment management fees are paid in different ways and the tax implications show up differently too. Investors in mutual funds do not pay fees directly; they pay a management expense ratio (or MER) that’s built in so the fee is implicit. MERs are not disclosed separately on income tax slips or returns as mutual funds deduct the fees and report distributions net of fees.

Investors in wrap accounts or separately managed accounts (for which annual or quarterly fees are charged for management of a portfolio) will pay fees directly so they are explicit. The amounts are deducted separately on income tax returns. For example, the investor reports gross income from his or her investment accounts and deducts investment management fees separately as a carrying charge.

Different payment methods, same results

No matter how these qualifying investment management fees are paid—meaning whether the fee is implicit or explicit in the investor’s tax picture—the net results are the same. What follows is an example of the tax and investment consequences for an individual at a 45% tax rate who pays investment fees indirectly or directly. The first column assumes an investor is paying fees inside a mutual fund (indirectly). The second assumes the investor has a separately managed account and the payment is outside a fund (directly). The bottom line in both cases is identical. The investor ends up keeping the same amount of principal and after-tax income and paying the same amount of tax.

Indirect Direct
Initial investment 100,000 100,000
Realized income 10,000 10,000
Less: MER @ 2.3% (2,530)
Net Asset Value (NAV) 107,470 110,000
Distribution (7,470)* (10,000)
Remaining investment 100,000 100,000 (A)
Income 7,470 10,000
Management fee @ 2.3% (2,530)
Net income before tax 7,470 7,470
Personal tax @ 45% (3,362) (3,362)
Net income after tax 4,108 4,108 (B)

What the investor keeps

Remaining investment 100,000 100,000 (A)
Net income after tax 4,108 4,108 (B)
Investment and cash in hand 104,108 104,108

* Funds generally distribute all income to avoid paying tax at the fund level.

Be reasonable

As with any deduction, the CRA requires that investment management fees be reasonable in order to qualify for a deduction. So what’s reasonable? Generally, fees that are based on a sensible percentage of the fair market value of the underlying investments are considered acceptable and the deduction will be allowed by the CRA. The amount of time spent and type of work done by the person providing the advice or service should also be taken into consideration in determining whether a fee is reasonable. Arm’s length terms and conditions should apply to fees, although this is not a concern when the investor has no family or corporate relationship with the investment manager.

Exceptions to the rule

As mentioned above, commissions are specifically excluded from the definition of investment fees. This is logical since commission fees are not for investment advisory services but for a transaction. It is worth noting, however, that commissions increase the adjusted cost base (or ACB) of an investment at purchase and reduce the proceeds when the investment is sold. Commissions, therefore, work to reduce the potential capital gain (or increase a loss) on an investment, and, in turn, the resulting tax payable. Capital gains (and losses) are reported in the year in which an investment is sold or realized; investors should remember to adjust the gain (or loss) for the commissions paid. The capital gain (and loss) inclusion rate is 50%, so in effect only 50% of the commission fee is deductible.

The definition of investment management does not include financial planning services. Where a portion of the annual fee relates to financial planning, that portion will not qualify as a deduction. Similarly, when an investor pays an all-in fee, some of it likely will relate to commissions; again that portion is not deductible. The CRA has not provided guidance on fee allocation, so this is not an easy task. Ultimately, the investor and his or her tax preparer need to determine how much of the total fee is deductible.

It should also be noted that investment fees, whether paid inside or outside of a fund, are subject to GST/HST. For separately managed accounts, the rate of GST/HST that is payable on investment fees depends on the province in which the investor resides.

However for investors of mutual funds, the rate of GST/HST applied on the investment management fees embedded in the MER is typically a blended rate and depends on the proportion of a mutual fund’s investors residing in a particular province and the GST/HST rate of that province. For example, if a mutual fund has 50% of its investors in Alberta (where the GST rate is 5%) and 50% of its investors in Ontario (where the HST rate is 13%), the blended HST rate would be 9%.

For now, having an understanding of the basics of investment management fee deductibility will help you provide your clients with meaningful answers regarding the tax efficiency of their investments. It should also help you navigate the ongoing debate regarding the tax advantages and disadvantages of certain investment arrangements in relation to others.

Michelle Munro is director, tax planning, for Fidelity Investments Canada ULC.
Originally published on Advisor.ca