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MUTUAL FUND CORPORATE CLASSES
Latest trend has tax benefits

A recent series of articles in this space spoke about tax smart investing and the trend toward tax-managed funds in the US. One uniquely Canadian trend, which wasn't mentioned in that series, has picked up steam over the past year and is worthy of its own article. Mutual fund corporate class structures have a two-fold tax benefit, which essentially translates into powerful tax deferral potential. It's not a new idea. In fact, it's been in practice for several years, but many mutual fund companies have been crowding this wagon for the past year.

Mutual fund taxation 101

Most mutual funds are set up as trusts. When they realize gains by selling stocks at a profit, earn interest from bonds, and receive dividends from stocks, this income is matched against expenses. Any income remaining after deducting expenses generally has to be paid out to the fund's unitholders. If this income remained in the trust instead of being paid out, the "mutual fund trust" would have to pay tax on the undistributed income. While individuals pay tax on a progressive scale, a trust of this kind pays tax at the top marginal rate. So, less tax will be paid overall if the fund pays out all of its income to be taxed in unitholders' hands.

Corporate classes explained

Corporate class structures are actually set up as mutual fund corporations with multiple share classes - each of which constitutes a different fund. CI Sector Fund Limited, for instance, is such a mutual fund corporation. Under that "umbrella" corporate structure, investors can buy CI Canadian Sector, CI American Sector, CI Global Energy Sector, CI International Value Sector, and many other classes covering a variety areas of the markets. When buying into this structure, you're actually buying different classes of the shares of CI Sector Fund Limited, a mutual fund corporation - which by the way qualifies as foreign content for registered accounts. I know this sounds about as exciting as a conference of stuffy accountants, but stay with me.

Tax-deferred switching

The most apparent benefit of this structure is that it allows investors in one class or sector to switch to another class or sector within the same corporate structure, without the tax laws deeming the transaction a "taxable event". In other words, those who had invested in, and made lots of money on, the CI Global Technology Sector could have taken some profits by switching out some/all of this fund and bought CI Global Energy Sector or any other within CI Sector Fund Limited, without incurring any capital gains taxes. While I'm not an advocate of active mutual fund trading, the ability to rebalance without incurring the tax costs is very valuable.

Minimizing distributions

Tax-deferred switching is just one way that this type of structure can potentially reduce taxes. The other has to do with the capacity to minimize distributions. This is best illustrated with an example. Phillip Morris is a US conglomerate of consumer products companies - including Miller Brewing Company to food manufacturer Kraft Foods. When Phillip Morris prepares its consolidated statement of income, they add up the total revenues and expenses from RJ Reynolds, Kraft Foods, and all of its other subsidiaries. The same thing happens with mutual fund corporate class funds.

Continuing with our CI example, CI Sector Fund Limited will add up the interest, capital gains, and dividends from all of the sector funds or classes within the corporation, before figuring out how much revenue the corporation has, in excess of its expenses. Classes that usually generate little taxable income will absorb the excess income from other classes. Usually, interest and dividend income are used first to offset all of the corporation's management and operating expenses. Capital gains are matched with any expenses left over, then further reduced by taking advantage of certain complex tax provisions to prevent the double taxation of capital gains (i.e. CGRM - capital gains refund mechanism). After all that, there usually is little, if any, taxable income to be distributed. However, whatever is remaining after all that is assigned to the various classes in an effort to distribute income fairly and in a manner that minimizes the impact on investors.

This doesn't just work in theory, it actually works in practice as long as a corporate structure isn't "over populated" with classes of funds that usually generate a large amount of taxable income - like bond funds, money market funds, and stock funds that trade heavily. Having a balance of different asset classes and styles is what makes this work. CI, AGF, and AIM have been running these structures for many years with good success on minimizing the tax impact.

Suitability

This sounds like a structure that caters to active mutual fund traders. Well, it is good for traders but the benefits of this structure are not restricted to investors with a quick trigger finger. Anybody investing outside of tax-deferred savings plans (i.e. RRSPs, RRIFs, etc.) can also benefit from the tax deferral power potential of these corporate class structures. The mutual fund companies currently offering this type of structure are: AGF, AIC, AIM, Bank of Montreal (BMO), CI Funds, Clarington, Dynamic, Franklin Templeton (the newest entrant), Mackenzie, and Synergy.

While there are some additional costs involved (higher administrative costs and small amounts of corporate tax), the tax deferral benefits usually dwarf the extra 20 to 40 basis points of extra operating costs. Remember, first make sure a fund fits your personal investment policy criteria then look at how best to minimize taxes. For the latter goal, this latest trend of funds can be a good fit.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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