My financial adviser is recommending corporate class funds as a more tax-efficient investment. What are the pros and cons of this type of fund?
Any investment that can reduce your taxes is worth a look. However, like most investments, corporate class funds aren't for everyone, despite the promise of being tax-efficient.
There are two types of mutual funds: a trust, which is a single fund with a sole investment goal; and a corporation, which is a collection of funds, known as classes, each with its own investment mandate.
The investment community describes a mutual fund corporation as a house with different rooms. The purpose of a corporate class fund is to allow investors to move money from room to room, or from one corporate class fund to another – without incurring an immediate tax hit.
The tax isn't avoided. Instead, it is deferred until it's withdrawn from the corporation (or removed from the house).
Corporate class funds are ideal for non-registered investments and longer-term investors, says Dennis Tew, chief financial officer at Franklin Templeton Investments Corp.
Similar to an investment such as registered retirement savings plan, investors with corporate class funds can benefit from having the money grow (one hopes) and compound over time, before it's taxed upon withdrawal. Investors also have control over when to pull out the money and pay tax on it.
Mr. Tew says corporate class funds cater to people who like to move their money around every few years, as well as younger people who have longer investment time horizons.
"The longer you hold it, the more you benefit, obviously, with any kind of tax deferral," he says.
Franklin points to an example of two investors, each with $100,000 to invest over 20 years, and both with a marginal income tax rate of 46.4 per cent (based on a resident of Ontario in 2013). Let's call them Jack and Diane.
Jack and Diane are doing the best they can, bringing in good incomes at that top tax bracket. They also like to rebalance their portfolio every four years.
Diane has the corporate class funds, while Jack has funds outside this structure. Based on an annual 6-per-cent compound average rate of return, Diane's funds didn't incur capital gains taxes, which allowed her tax-deferred investment to grow to $320,714. Meantime, Jack's investment, which was subject to taxes when switches were made, grew to just $263,159.
It's an oversimplified example, but shows Diane's investment is more tax-efficient.
Of course, some investors would argue that if Jack and Diane skipped mutual funds and invested in stocks or exchange-traded funds instead, their performance may have been better. They would also point out that the management expense ratios for corporate class funds are often higher than regular trusts, and that both well surpass fees for ETFs.
Some investors also question the concept of investing money with the main goal of deferring taxes.
"You should make a decision to invest for the investment reason, not the tax reason," says Adrian Mastracci, portfolio manager and financial adviser at Vancouver-based KCM Wealth Management.
He also argues there are fewer investment options with the corporate class funds as compared with other investments.
The Investment Funds Institute of Canada says there are about $924-billion in mutual fund assets under management in Canada today, approximately $80-billion of which are in corporate class structures.
IFIC says about $20-billion of those corporate class funds were impacted by recent changes in the federal budget that prevent investment funds from converting fully taxable ordinary income to capital gains by purchasing or selling capital properties under a derivative forward agreement. The so-called "character conversion measure" has caused a number of fund companies to halt sales to affected funds, to prevent a dilution of the tax benefits.
The industry says the proposed changes don't directly impact the corporate class structure.