It just got more expensive to switch between corporate-class mutual funds.
The government has eliminated the ability to switch tax-free between investment funds held inside the same mutual fund corporation.
“An exchange of shares of a mutual fund corporation (or investment corporation) that results in the investor switching funds will be considered, for tax purposes, to be a disposition at fair market value,” the government states in the 2016 Budget.
The new rules apply to dispositions after September 2016 — the budget did not provide a more specific date.
Under the old rules, there was no taxable disposition for investors who moved between different funds within one mutual fund corporation.
“It artificially protected the investor from that disposition when they were rebalancing the portfolio,” says Nancy Graham, portfolio manager at PWL Capital.
She says the move puts these funds on a level playing field with mutual fund trusts and other investments. The government says this is one of the reasons it’s taking away the tax treatment.
“This deferral benefit is available to taxable investors in ‘switch funds’ is not available to taxpayers investing in mutual fund trusts or investing on their own account directly in securities,” it notes.
Mutual fund corporations are typically held in non-registered accounts, because their structure provides similar tax-deferral benefits to holding the investment in a registered one, says Doug Carroll, vice-president of tax and estate planning at Invesco.
Advisors should ensure that affected clients rebalance as needed before the September deadline. Graham says that will help defer the need to rebalance later and trigger a disposition.
Beyond giving investors time, there are no apparent ways to use the months until the deadline to avoid the tax consequences of switching funds within a mutual fund corporation. “I don’t think it can be manipulated; it just gives you a little bit of time before you’re subject to these rules,” says Carroll.
The new rule doesn’t apply to investors who are switching to a low- or no-fee version of a fund series they already hold. If the investment portfolio is substantially the same, that action won’t be taxed.
“It’s a positive thing that these aren’t affected,” says Graham. “It isn’t a substantial change to what the investor is owning.”
Many investors may want to switch between classes as they become more aware of the fees they’re paying through CRM2, she adds.
Investing inside a business
“With this new rule, if a business corporation used a mutual fund corporation investment, then the idea would have been to defer capital gains recognition,” explains Carroll.
Now, switching funds will trigger both passive corporate income tax and refundable tax. The only way to recover the refundable tax is to pay dividends to shareholders. This could cause business owners to pay dividends sooner than they would have wanted to, says Carroll, in order to retrieve the money trapped in the refundable dividend tax account.
Despite the elimination of this tax benefit, mutual fund corporations still have redeeming qualities, he adds.
“You’d expect to see lower distributions coming out of a mutual fund corporation as opposed to holding individual mutual fund trusts. That continues to be available,” Carroll says. For instance, losses in some funds can be used to offset gains in other funds, so only the net amount is taxable.
Also, interest and foreign income are taxed to the mutual fund corporation itself, not to the individual investor. When the fund corporation’s expenses can be applied to those income amounts — the interest and foreign income — the investor gets the benefit of the income being eventually treated as a capital gain when they have growth in their net asset value in the fund, he adds.
“I do think that those other benefits still mean that the mutual fund corporation structure works for those people who are using them in other ways — just not as well as before this announcement.”