Last time, we looked at why and when investment fees are deductible.

This article will look at how the method by which such fees are charged affects tax treatment.

It is sometimes suggested that a direct fee charged to an investor is deductible, while an MER is not. Technically, the statement is correct. On filing his/her tax return, an investor can claim a deduction for a directly charged fee on Line 221, “Carrying charges and interest expense,” but she cannot claim an management expense ratio (MER) fee on Line 221.

While an MER is not deducted by the conscious action of the investor, it is nonetheless accounted for at an earlier stage of the investment reporting process. In many situations, the net tax result is the same through either the MER or direct fee route, while in others, a direct fee may be more or less favourable, depending on the mechanics of how it is paid.

Non-registered mutual fund trust with taxable income distribution

We begin our numerical examples by looking at the effect of charges being paid through an MER or by direct fee where the investment is a mutual fund trust that flows taxable income through to an investor. (We’ll look at a mutual fund corporation in a later example). While an advisor using a fee-based account may recommend a different asset mix (e.g., stocks, bonds and ETFs, in addition to mutual funds), for comparison we’ll use the same investment on both sides of
our example.

For all the examples, we will assume an A-series fund with a 2% MER, versus an F-series with a 1% MER that leaves room for the advisor to charge a 1% direct fee.

This first scenario tests whether there is a bottom line difference between MER and direct fee, where the generated income is taxable in the current year.

A mutual fund trust that does not distribute income is itself subject to tax at the highest marginal rate. As many investors will be in lower tax brackets, mutual fund trusts therefore distribute realized income to be taxed in the hands of unitholders annually. We will assume a return of 5% in the form of interest. We will also assume a high tax bracket investor, using a 50% marginal tax rate (see Table 1).

As Table 1 shows, there is no difference when interest income is earned and the net amount distributed from the mutual fund. For investors with their non-registered balanced funds in the form of mutual fund trusts, this is pretty much reality. Fully taxable income types (interest and foreign dividends) are the first charges against MERs, commonly exceeding (though not guaranteed) the amount of the MER.

Even when a non-registered portfolio is made up of a variety of mutual funds, this scenario explains many annually realized returns. However, as preferred income is generated, the pendulum begins to swing toward tax efficiencies that can be gained through directly charged fees.

Table 1: Non-registered mutual fund trust with taxable current income

$10,000 invested, 5% return MER Fee
Interest income $500 $500
Less: MER ($200) ($100)
Distributed income $300 $400
Less: Investment counsel fee $0 ($100)
Taxable income reported $300 $300
Less: Taxes ($150) ($150)
Net income $150 $150

Note: For ease of display, beginning asset value is used to calculate the MER and fee scenarios, whereas the actual calculation uses average annual assets under administration. For our purposes, there is no relevant or material difference in the result.

Preferred income distributions

It may be tempting to extend the foregoing scenario by substituting capital gains as the income type, resulting in only half of the distributed income being taxable. This would favour the direct fee option because there is a larger distribution of (one-half taxable) capital gains on the fee side.

However, making the comparison in this manner would be misleading. It effectively charges the full A-series MER against capital gains, while charging only half against the F-series MER on the direct fee side, with the remaining fee being fully deductible. As mentioned above, a balanced mutual fund would most likely have more than sufficient interest and foreign dividends to match against the full A-series MER. Any excess would be distributed, added to which would be the fund’s realized capital gains. Though the exact dollar figures may differ, the investor would be in the same position through either route.

Even in the case of an equity mutual fund, foreign dividends would first be charged against the MER in the fund. It is also not uncommon to have some interest income from cash holdings. There is no guarantee that these would completely offset the MER, but mutual fund managers will be conscious of the implications, and presumably will seek to best serve investor interests.

Next time, we’ll look at the tax treatment of MERs versus direct fees for corporate-class funds.

Read Part 1 of this series here, Part 3 here and Part 4 here.