Higher capital gains inclusion rate and mutual funds

The impending increase in the capital gains inclusion rate applies to all gains earned by corporations and trusts. However, mutual fund corporations and trusts are likely to be largely unaffected.

“One of the benefits of a mutual fund corporation or a mutual fund trust is they’re generally able to act as a conduit for capital gains, so they’re able to pass those on to their investors,” said Carl Hinzmann, partner with Gowling WLG in Toronto.

As a result, gains are taxed in the investors’ hands.

Hinzmann said the effects of the two-thirds inclusion rate on fundholders would be mitigated by the fact that many mutual funds and ETFs are held in registered accounts, which are either tax-exempt or allow tax-deferred savings.

“And beyond that, you have individuals who have the $250,000 a year exemption,” he said.

Hinzmann cautioned that real estate investment trusts (REITs) are also mutual fund trusts. While they too flow gains to unitholders, “the difference with REITs is there are probably more units held outside of registered plans and in the hands of individuals [or corporations].”

Draft legislation for the two-thirds capital gains inclusion rate has yet to be tabled, and Hinzmann will be watching for changes to the rules for mutual fund corporations and trusts.

“The way the [existing] rules operate, they require amendments when the inclusion rate changes,” he said. “I would expect, consistent with what they’ve done in the past, that they would change the way those formulas work to keep the same principle alive that’s there today.”

Parliament resumes sitting on April 29.

Stricter rules for mutual fund corporations

The 2024 federal budget also tightened the criteria for qualifying as a mutual fund corporation, though Hinzmann believes the change is unrelated to the capital gains inclusion issue.

Rather, the government is “trying to further backstop an existing position,” Hinzmann said. “People have used mutual fund corporations to try and turn what would otherwise be a non-qualifying investment for registered plans into a qualifying investment.”

Mutual fund corporations are among the investments allowed to be held in registered plans.

The budget proposes to close a loophole where an entity controlled by a corporate group may qualify as a mutual fund corporation even though it is not a widely held investment vehicle. (Being widely held is one of the criteria for a mutual fund corporation.)

For example, an entity may qualify because some of its shares are listed on a designated Canadian stock exchange.

Under the proposal, a corporation will be deemed not to be a mutual fund corporation if a specified person or partnership collectively owns 10% or more of the shares by value, and if the corporation is controlled by or for the benefit of one or more specified persons.

Those rules will not apply to mutual funds incorporated within the previous two years and when the fair market value of shares held by specified persons is below $5 million.

“Although using a mutual fund corporation to defer or avoid income taxes by a corporate group can be challenged by the government based on existing rules in the Income Tax Act, these challenges can be both time-consuming and costly,” the budget said.

The budget proposal, which would apply to taxation years after 2024, “puts a little bit more codification around the principle,” Hinzmann said.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.