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Investors can build wealth faster with the corporate version of mutual funds

by Wayne Cheveldayoff, 2004-06-03

Many fund companies offer two versions of the same equity mutual fund — the traditional trust version and the increasingly available corporation version.

For mutual fund holdings outside of RRSPs and other registered plans, the corporate version offers investors greater flexibility in managing a portfolio as well as the opportunity to save on income taxes and build wealth faster.

This favourable situation results from the different structure surrounding the fund in the corporate version.

Mutual funds traditionally have been organized as trusts. Investors own units in a trust and all interest, dividends and net capital gains resulting from trading (by the portfolio manager) within the mutual fund flow to the unitholders. These distributions are subject to income tax.

When an investor sells units of a mutual fund trust (outside of an RRSP, RRIF, or RESP), the sale, even if it is only to switch to another fund, is regarded under the Income Tax Act as a disposition. If the sale price is higher than the adjusted cost base (often the original purchase price), the difference is a capital gain. As with all capital gains, half must be reported as income for the year incurred.

Hence, when investors switch from one fund to another in managing their portfolios, the resulting trigger of income taxes acts as a drag on the accumulation of wealth.

In order to alleviate this situation for investors, some of the mutual fund companies during the 1990s developed a corporate structure for mutual funds.

An important feature of the corporate structure is that it allows investors to switch among any mutual fund that is within the corporation without triggering a taxable disposition. Investors can change asset allocations or try to time the market without losing capital to income taxes.

According to Tina Di Vito, vice-president and national manager of tax planning at BMO Nesbitt Burns, this occurs because “the corporation is organized so that each mutual fund is a different class of shares and the shares are convertible from one class to another on a tax-free basis.”

One consequence of organizing mutual funds in this way is that shares can only pay out a dividend. As a result, this structure is usually not used for bond or balanced funds, which earn large amounts of interest and would trigger income taxes to be paid by the corporation.

At the same time, however, the corporate structure allows capital losses in one fund to offset capital gains in another fund with a benefit to investors because there would be less in the way of mutual fund gains distributed and subject to tax.

While several mutual fund companies have what they call “corporate class” or “capital class” versions of their funds, Mackenzie Financial has introduced some innovations lately that may make these even more attractive to investors.

First, Mackenzie has developed corporate funds that give returns similar to money market or bond funds. Any returns distributed from these funds, known as Mackenzie Sentinel Managed Yield Capital Class (money market) and Mackenzie Sentinel Managed Return Capital Class (bonds), are effectively “capital gains dividends,” which are taxed as capital gains.

The advantage is two-fold: (1) investors outside of registered plans can maintain an appropriate asset allocation with bond, money market and equity holdings within the corporate structure and switch between them without triggering a taxable disposition; and (2) any annual interest earnings (net of fees) from these holdings will be in the form of capital gains dividends and taxed more favourably at only half the rate that would apply to interest.

In these several way, the corporate strucutre definitely allows investors greater flexibility to properly managing their non-registered mutual fund holdings and also to build wealth faster in a tax-favoured environment.

Second, Mackenzie, which has 46 funds within its corporate structure, has found a way to change the designation of corporate class funds held within RRSPs and RRIFs from foreign to Canadian content. (The rules state that foreign funds can make up only 30 per cent of an RRSP.)

This means, according to a Mackenzie publication entitled Capital Class Funds, that “all of the Capital Class Funds – U.S. equity funds, global equity funds, sector and specialty funds – are no longer considered foreign property and can be held in your RRSP as Canadian content.”

Other mutual fund companies may be in the process of, or may have already implemented, similar changes. So investors interested in these features should check with an investment advisor.

Of course, the benefits of corporate class funds come at a cost, although it is relatively minor.

A quick check of the Ivy Canadian fund on Mackenzie’s website (www.mackenziefinancial.com) showed it has a management expense ratio (MER) of 2.7 per cent for its corporate class version and 2.5% for its regular trust version. The Ivy Foreign Equity fund’s MER is 2.7 per cent and 2.53 per cent, respectively.

The higher MERs, according to Marnie Jezewski, capital class product manager, stem from the slightly higher administrative cost associated with the corporate structure and the fact that the capital class versions are at present much smaller than the trust versions.

“We believe that the industry trend is towards corporate structures and as the size of these funds grow, so will the operating efficiencies,” she stated.

In the meantime, used properly, the corporate structure can generate tax savings that easily exceed the slightly higher MERs and this is an area that should definitely be explored by investors with funds outside of registered plans.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff