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A reader question I received from George in BC in May 2002 was aimed at the potential tax trap of buying into a fund that has built-up an accrued or unrealized capital gain. (I usually answer questions quickly but thought this one deserved its own article.) The fear is that newer investors would buy into something of a tax time bomb. As George put it, “That is great news for long-term holders but how could it influence new investors? It seems to me that new investors could be paying capital gains they did not participate in”.
Treatment of Realized Gains and Losses at the Fund Level
Each year, just like you and me, a fund must tally up its capital gains and losses from selling investments at a profit and loss, respectively.
A net gain occurs when a mutual fund realizes more gains than losses in a year from its trading activities. Generally, the fund must pay out most or all of the net gain to avoid a tax liability at the fund level – which would be at the highest marginal tax rate.
In the case of a net capital loss, a mutual fund (unlike a segregated fund) cannot flow losses through directly to the fund’s investors. Rather, the loss is held inside of the fund and used to offset future net gains.
Unrealized Gains
When a fund has been successful in its stock picking, but has let its winners ride, it gets into a situation described by George. Long-term unitholders would have ridden the fund up and benefited from the tax-friendly ride.
Investors arriving late to the party, however, risk getting the short end of the stick – or a tax bill on past gains to be more specific. Is this real problem or just a misconception?
No Double Taxation
Let me assure readers that paying taxes on gains in which they did not participate is not the equivalent of double-taxation. Rather, it’s a pre-payment of taxes. This statement isn’t exactly going to inspire investors to break out in dance, but it’s worth clarifying.
Suppose XYZ Equity fund has only owned two stocks since inception. It still holds both – one on which there is no gain and one on which there is a 100% gain. Overall, it has an unrealized gain equal to half of its assets. Let’s also suppose that I invest $1,000 in this fund. By the end of that same year, XYZ sells its big winner, triggers a gain equal to half of the asset value, and pays out a distribution accordingly.
I take my share of the distribution – $500 – in cash. Since the distribution is paid in cash, the assets of the fund also fall by exactly the amount of the distribution.
At this point, my units cost me $1,000. They’re now worth only $500 because of the fund’s big distribution. And now, I have $500 in cash – which is the capital gains distribution.
I decide to sell my units at the prevailing price, which equals $500 in total. Since my cost was $1,000 – selling triggers a $500 capital loss.
At the end of the day, I received a distribution based on past gains (in which I did not participate) but because I triggered a capital loss, I have no tax bill and remain in the same position in which I started – with $1,000 in hand.
Obviously triggering the loss by selling sooner rather than later is a smart tax move in this case. However, even if I chose to hang on to sell at some future date, it doesn’t change the fact that this issue is one of timing – not double taxation.
The optimal time to realize gains and losses will be different for each person – allowing each to act accordingly. However, deferring tax as long as possible is generally the way to go.
Management Style
Buying into a fund with big unrealized gains isn’t always going to lead to a premature tax bill. In fact, the investment manager’s sensitivity to tax issues can be critical to the tax efficiency of the fund in question.
Many firms employ a variety of strategies to minimize the tax impact of trading. Judging a firm’s tax sensitivity isn’t easy though one can always look to history as a guide. But as the saying goes, the past may not be indicative of the future.
While AIC makes tax efficiency a central part of their marketing efforts, there are other firms and individuals who are very sensitive to their taxable investors. Generally speaking, any firm that manages money for high net worth individuals will tend to be sensitive to tax issues.
A couple of managers that are illustrative of the tax sensitive contingent in Canada are Mawer Investment Management and John Kellett of RBC. There are others I’m sure, but I’m most familiar with these.
Mawer implements what they call a tax overlay strategy. They employ an ideal blend of tax-sensitivity into their investment process because it is truly a secondary consideration, rather than a dominant factor. The overlay strategy examines ways to minimize the tax impact of the trading activity that naturally results from the firm’s investment process. They call it TEAM – Tax Effective Asset Management. By harvesting capital losses and making use of the capital gains refunding mechanism, they minimize taxes without messing around with the core investment process.
John Kellett runs RBC’s Dividend fund and uses a unique strategy to minimize capital gains from stock selling activity. Provided a sufficiently high yield is available, Kellett will buy bonds at a premium (i.e. a price above maturity value) to accomplish two things. First, bond interest is earmarked to pay fund fees and expenses. Second, the maturity of the premium bonds will result in a capital loss – thereby reducing gains triggered on the fund’s stocks. This result in a more tax efficient structure overall.
More Reading
To learn more about how to spot tax-friendly money managers, visit the “Mutual Fund Research” section of www.sterlingmutuals.com and look for the weekly article dated May 4, 2001.
My next column will expand on how money managers reduce the tax consequences to their unitholders by focusing on the use of capital losses and the capital gains refunding mechanism.