Coping with HST

The price of investing has gone up. On July 1, the harmonized sales tax (HST) took effect in Ontario and British Columbia . As of that date, almost every Canadian, not just residents of those provinces, started paying more to own mutual funds and ETFs. That’s because HST now applies to the fees charged by funds domiciled in those two jurisdictions. That includes all the Canadian-based ETFs and most mutual fund companies.

The new tax will be reflected in each fund’s management expense ratio (MER). However, investors won’t know exactly how much more they are paying for many months. That’s because MERs are historical numbers. The figure that you see now is actually the MER for a fund’s last fiscal year, which in most cases ended Dec. 31, 2009. The MERs for 2010 won’t be published until sometime in the spring of 2011, when year-end financial results are released. And even those numbers won’t be a true indication of the increased cost because they will only reflect six months’ worth of HST.

To make matters even more confusing, the mutual fund industry, which fought the imposition of HST to the bitter end, has not settled on a uniform way of dealing with the new cost. Some companies are using a “blended” HST/GST rate which is applied to all their funds, nationwide. This effectively means that residents in non-HST provinces such as Alberta , Manitoba , and Saskatchewan are paying more than they should while people in live in Ontario , B.C., and other HST jurisdictions are paying less. In effect, residents of non-HST provinces are subsidizing those who live in HST jurisdictions.

A few companies are absorbing the HST, at least temporarily. Hartford Investments is in this small group. But the most significant development is the decision by some mutual fund firms to launch a new class of funds for purchase by residents of non-HST provinces. These special units will have a lower MER than those sold in the rest of Canada, which will translate into a slightly higher return.

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The first to act was Brandes Investment Partners which announced on July 8 that it has launched new class AN and class FN units for four of its funds: Brandes Global Equity Fund, Brandes International Equity Fund, Brandes Sionna Canadian Equity Fund , and Brandes Sionna Canadian B alan ced Fund. The new classes are identical to the existing class A and class F units but can only be purchased by investors residing in provinces that do not participate in the HST. The 5 per cent GST will apply (HST rates vary from 12 per cent to 15 per cent depending on the province) . The new units are already available for purchase or switching so anyone living in an eligible province who owns units in any of the four funds should switch to the AN or FN class. Your broker or dealer can arrange this.

The press release announcing the new units does not offer any estimate of how much investors will save but it probably will be significant. The 2009 MER of Brandes Global Equity A units was 2.57 per cent. Backing out the 5 per cent GST leaves us with a base cost of 2.45 per cent. Applying Ontario ‘s 13 per cent HST, this suggests the new MER will be about 2.77 per cent. The AN units should come in about 20 basis points cheaper (two-tenths of a percent), which will go straight to the investor’s bottom line.

The lower the original MER, the less the savings offered by the new units. For example, the F units of Brandes Global Equity (those sold for fee-based accounts) had a 2009 MER of 1.52 per cent. Using the same set of assumptions as above, we arrive at an HST-included MER of 1.63 per cent. This means the FN units will offer a saving of about 11 basis points compared to the regular F units.

A few days after the Brandes announcement, Toronto-based Edgepoint Funds said it will also launch a series of non-HST funds in response to what the company calls “the questionable decision” by Ontario and B.C. to implement the tax. Using unusually strong language, Edgepoint said in a July 12 press release that ” the thought of jamming this unfortunate new tax on unsuspecting investors is simply unjust”.

The press release went on: ” We believe this approach is the appropriate course of action for an investment-led company that puts the interests of its unitholders first in all decisions…Currently, management fees and most operating expenses of mutual funds are only subject to the 5 per cent GST. Mutual fund investors who reside in HST-participating provinces must now pay additional sales taxes as a result of the changes. These taxes will negatively impact management expense ratios (MER) and ultimately investor returns.”

Edgepoint said that it expects the new units to be available in early August, as soon as regulatory approval is received.

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Late in July, Dynamic became the first major fund company to announce its intention to offer a new series for some (but not all) of its funds for investors in non-HST provinces. Dynamic is currently using a blended tax rate on fees and operating expenses for all its funds.

“Our goal is to ensure fairness for all investors,” said David Goodman, president and CEO of DundeeWealth. “For those investors who are not subject to HST, we are identifying where it will be possible to create a new series on certain funds without incurring operating expenses that exceed the tax savings we are trying to pass down.”

Note the use of the term “certain funds”. This clearly signals that non-HST units will not be made available for all Dynamic funds. In practical terms, it is likely only larger funds with a significant investor base in non-HST provinces will make the cut.

The Bottom Line: HST confusion is going to reign in the fund industry for the next several months. Some companies will offer special units, some won’t. But if any other biggies follow Dynamic, the pressure on the hold-outs will build. It’s not inconceivable that savvy investors in non-HST provinces will begin insisting on only using units that have stripped out the new tax.

All this is going to cost the fund industry a lot of money and will create still more investor confusion as the number of unit choices for a single fund continues to grow. The situation also again underscores the absurdity of Canada ‘s fragmented financial regulatory and taxation system. Ottawa should never have allowed the HST to have such a disrupting effect on fund industry. The federal government can still fix things. Over to you, Mr. Flaherty.

Photo © Michael Riccio

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