Federal Budget 2016 changes tax rule about corporate class mutual funds

2016 Budget measure: Corporate Class Mutual Funds

Canadian mutual funds can be in the legal form of a trust or a corporation. While most funds are structured as mutual fund trusts, many are also structured as mutual fund corporations (otherwise known as corporate class mutual funds). Corporate class funds offer investors different types of asset exposure in different funds, however each fund is structured as a separate class of shares within the mutual fund corporation. One of the key benefits for investors since the first fund of this type in 1989 is their ability to exchange shares of one class of the mutual fund corporation for shares of another class on a tax deferred basis. Capital gains taxation is deferred until the investor sells the investment for cash, or switches to an investment outside the mutual fund corporation.

In their first budget the new Liberal government made an amendment to the Income Tax Act so that an exchange of shares within the corporate class structure will be considered a disposition for tax purposes at fair market value, thus eliminating the tax deferral and triggering a capital gain if the investment has risen in value at the time of the switch.

Effect:

The goal and effect of this measure can only be stated as to increase tax on Canadian investors for assets held outside one of the government registered plan types. Given that thinking investors will react by not making as many changes within their portfolio as they would have otherwise, this measure is unlikely to actually increase government tax revenue and this is reflected in the budget documents which show only a tiny increase in tax revenues due to this change. This type of effect is very common when the tax rules are tinkered with. Consider a few of the negative effects for investors, all of which act in direct opposition to rational investment decisions:

• it discourages investors from acting on their reasoning or that of their advisor and requires them to first consider the tax cost before changing an investment;
• it adds a tax cost for re-balancing a portfolio to rationally manage investment risk;
• it discourages investors from rationally modifying their portfolio to adapt to their changing circumstances such as retirement, disability or other large potential spending needs;
• it encourages investors to sit on an investment they may now consider less than optimal, which has a changed risk profile or which has had a fundamental change because they may have to pay tax to make a change.

As a side note, the last two items can cause a conflict between what the regulations that govern financial advisors say and what the federal government through the Income Tax Act now discourage, placing advisors and clients in a potentially conflicted position. The bottom line is the change harms Canadian investors and reduces the future wealth of Canada, thus harming our society also.

Now let me explain how I expect this to change my advice to clients: almost not at all. Surprised? While this tax increase is frustrating and even makes me angry, and while income tax planning is an important part of investment and financial planning,  in this case the negative change is less important than the fundamental reasons behind my recommendations. Consider that:

1. capital class mutual funds are still more tax efficient than the regular version of funds because they typically pay out less taxable distributions;
2. when capital class funds pay out income distributions they are in the form of tax efficient capital gains and eligible Canadian dividends;
3. re-balancing is a valuable component of investment management in two important ways – by reducing the overall fluctuation of account value the tendency for investors to make behavioral errors is reduced (I consider this the primary reason to re-balance) and there are credible academic studies that show re-balancing can add about 0.5% per year to account performance.
4. in the sample scenarios below I estimate that after a 50% gain in an investment, a typical re-balancing amount of 5% of the account assets per year is expected to incur a tax cost of a fraction of a percent of the account value per year.

Conclusion: Thus, I will continue to recommend the use of corporate class mutual funds for non-registered accounts and continue to recommend automatic re-balancing services as a risk control measure.  One thing that will change is the administration of funds moving into or out of an account. Whereas in the past I have often used a single fund as the entry and exit points for money being added or withdrawn, I will have to pay more attention to the current percent allocated to each fund to reduce the amount of re-balancing that takes place. You can expect to discuss how this may affect your accounts at our next annual review meeting.