Be aware of mutual fund tax rules

Nobody likes paying taxes, even though we all recognize they’re necessary to finance the public services we take for granted.

What is especially annoying, however, is paying taxes on money you haven’t actually received. Yet that’s exactly what happens to many investors who hold mutual funds in non-registered accounts (outside an RRSP, RRIF, etc.).

Why this happens
There are two ways in which you can end up in this unhappy situation:

    1. You switch assets from one mutual fund to another. 
    2. You receive a distribution in the form of additional units.

1.Changing funds
Even if the switch takes place within the same company, the Canada Customs and Revenue Agency (CCRA) takes the position that you have sold your shares and tax becomes payable on any capital gain you may have earned.

Some companies have devised a creative way around this problem to allow you to move money around without triggering a tax liability. They have set up umbrella funds – a kind of super-fund that is divided into several ‘classes’ or ‘sectors.’

A super-fund might offer a Canadian equity class, a U.S. equity cls, an international equity class, a bond class, a money market class and perhaps several others. In terms of investment objectives and other defining characteristics, these classes function the same as other funds in their categories.

Money moved between classes is not liable to tax because the assets remain inside the umbrella fund. Capital gains will only be triggered when you make withdrawals from the super-fund itself.

Companies offering these umbrella funds include CI, AGF, AIM, Mackenzie, Synergy and Clarington.
2.Additional units
Mutual fund distributions can take four forms: capital gains, dividends, interest (other income) and ‘return of capital.’ All but return of capital are taxable, even if you don’t take them as cash. Dividends and capital gains are taxed at preferential rates; interest is fully taxed.

Of course, you can ask that any distributions be paid directly to you, in which case you’ll receive a cheque from the company. But the net asset value (NAV) of your fund units will decline by a corresponding amount, so you really haven’t added to your total worth.

An example
Suppose your fund units are valued at $10 and the company declares a year-end distribution of $1 a share. On the day the distribution is payable, the NAV of your units will drop to $9 and you’re on the hook to pay tax on the $1 that was paid out.

Most mutual funds are set up as trusts. This means they are required by law to pay out any net capital gains, dividends and interest to investors at least once a year. This may give rise to a situation in which your fund actually loses money in a given year, but you’re still on the hook for taxes. This actually happened in several cases in 2000.

Tax shock
The AGF Aggressive Growth Fund was one of those that produced a nasty tax shock for its unit-holders. The fund dropped 14.2 per cent during the year. But unit-holders received a distribution of $6.81 a unit, all of it taxable. This was a result of profit taking by manager Richard Driehaus, who was locking in gains in a falling market.

Avoidance strategies
There are two ways to avoid this situation:

  • Invest in funds that use a buy-and-hold investment philosophy. The less trading the managers do, the lower the amount of taxable capital gains that have to be distributed at year-end. One fund company that prides itself on this type of approach is AIC.

  • Make inquiries in November about the prospects for a year-end distribution. Many fund companies now put out advisories in advance to allow people to do some tax planning. Usually these are directed to financial advisers but the information is public and you can obtain it if you ask.

If a fund you’re holding is looking at a large taxable distribution, you can avoid it by selling your units before the distribution date. This can be done by switching into a money market fund temporarily, a move that would also let you avoid paying deferred sales charges.

The downside is that if you make this move outside an umbrella fund, you will trigger a taxable capital gain on your profits to date (or a capital loss if your units have declined in value). Be sure to take this into account in your planning.

Of course, you cannot avoid paying taxes on your profits forever. But with a little planning and foresight, you can delay the day of reckoning for several years.