With the end of tax-free switching in corporate class funds, Total Return Index ETFs offer an alternative.Getty Images/iStockphoto
The countdown to Oct. 1 is on for Canadian investors that are currently holding corporate class mutual funds in non-registered accounts, who may be under pressure to find new ways to tax-efficiently rebalance their portfolios.
In March, the Federal government took much of the investment industry by surprise when it announced that Canadian investors would no longer be able to "fund switch" within some corporate class mutual funds without incurring a taxable gain. This change takes effect on Oct. 1, which means investors have until then to make any final fund switches within corporate class portfolios tax-free.
If you're unfamiliar with corporate class funds, they can be thought of as an umbrella structure that is legally a corporation. Within that corporation are a multitude of investment funds. These funds can share expenses and in some cases reallocate income distributions across different funds so they are more tax efficient for unitholders.
Previously, as long as an investor bought and sold various funds within that structure, the transactions didn't trigger a taxable event since the funds were viewed to be under one single corporate entity, according to the Income Tax Act. The tax deferral feature of these funds, which enabled tax-free "fund switching," was perhaps their single biggest appeal, along with the fact that taxable distributions were also minimized.
Currently, there are about $120-billion of assets under management (AUM) within corporate class funds, representing approximately 10 per cent of total mutual fund assets in Canada, according to CIBC.
Thankfully, corporate class funds aren't the only game in town when it comes to achieving tax-efficiency in non-registered investment accounts. With about five months left until "fund switching" and resulting capital gains become taxable events, investors do have time to crystallize existing gains and, without tax consequences, explore other tax-efficient strategies.
Total Return Index ETFs, also known as TRI ETFs, can be a cheaper, more tax-efficient alternative to achieving investment exposure, while eliminating taxable distributions.
TRI ETFs work quite differently from your typical mutual fund. Rather than physically owning the securities like in a mutual fund, a TRI ETF is a synthetic structure that provides the end investor with the total return of the index, which is always reflected by the ETF's unit price.
To make this happen, the TRI ETF has a swap agreement in place with one or a number of counterparties – typically, one or more large financial institutions – in which the counterparty delivers the total return of the index (including the value of dividends) to the ETF in exchange for the cash investment from the unitholder. Ultimately, it's the counterparty that assumes the responsibility of ensuring it can deliver the total return of the underlying asset class.
This ETF structure offers a number of advantages to investors with non-registered accounts. Firstly, investors never directly receive distributions since they don't directly own the securities, and as a result, the ultimate tax bill can be deferred to when the investment is sold at a capital gain or loss. This is especially beneficial for fixed income investors, since both interest and dividend income are typically taxed at a higher tax rate than capital gains, and this is certainly the case for more affluent investors in higher tax brackets.
Secondly, for those invested in U.S. equity and other foreign equities, this also means incurring no withholding or estate taxes on such investments. It also means that investors and advisers don't have to undertake the tedious task of filling out T-1135 tax forms, which are required to document foreign income. Finally, returns have the potential for greater compounding on an after-tax basis, since the investor doesn't get taxed until the units are sold.
Currently, Horizons ETFs is the only provider of TRI ETFs in Canada, and offers exposure to wide range of asset classes including Canadian equities, U.S. equities, foreign equities, Canadian and even U.S. bonds.
Along with management fees, taxes have the biggest impact on a portfolio's performance over the long term.
While the era of using corporate class funds as a tax deferral strategy is coming to an end, innovations in the world of ETF investing, like the TRI structure, have made it possible for a new horizon of tax efficiency to begin.
Thane Stenner is founder of StennerZohny Investment Partners+ within Richardson GMP Ltd., as well as director, Wealth Management. Thane is also chairman emeritus of TIGER 21 Canada. He is the bestselling author of True Wealth: an expert guide for high-net-worth individuals (and their advisers). (mailto:thane.stenner@richardsongmp.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates.