How a tax-friendly RBC fund became a tax headache for unitholders

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When Bernie Bellan opened his wife's T3 tax slip recently, he had to do a double take: In box 21 was an unexpected capital gain of $21,923.93 courtesy of the RBC Managed Payout Solution – Enhanced Plus mutual fund.

The size of the gain was what floored him. In the 10 years his wife had owned the fund, it often distributed no capital gains at all. When it did, the amounts were usually small. Now, his wife was facing a tax hit of more than $4,000.

After digging through documents online and spending an hour on the phone with a Royal Bank of Canada representative, Mr. Bellan finally figured out what had happened: RBC had triggered the capital gain – and a related one in 2014 – when it sold the fund's individual stocks and bonds and replaced them with RBC's own mutual funds.

"I was shocked and dismayed," said the Winnipeg resident, who promptly complained to his wife's financial planner and to RBC's ombudsman.

The episode, which has elicited complaints from other unitholders, highlights what can happen when a financial institution changes one of its products without fully explaining the potential consequences to investors. RBC is now dealing with the fallout.

"There has been an uptick in questions and concerns," said Jonathan Hartman, vice-president and head of investment solutions for RBC Global Asset Management. "It's an education process for advisers and for clients, and with the feedback we're getting from investors on how we communicated this to date, an education process for us as well."

Ironically, the fund was popular with many investors precisely because of its supposed tax benefits. With about $2-billion in assets, the RBC Managed Payout Solution – Enhanced Plus fund is one of three RBC "managed payout" mutual funds. It aims to deliver an annual cash distribution of about 7 per cent, consisting of dividends, interest, realized capital gains and – when those aren't sufficient to generate the cash flow target – a portion of return of capital, or ROC.

Some investors see ROC as a benefit because, instead of getting taxed in the year it is received, ROC is subtracted from the investor's cost base. This gives rise to a larger capital gain (or smaller capital loss) when the investor eventually sells his or her units, effectively pushing out the tax liability to a future year.

RBC's motivation for changing the fund's composition was twofold. First, it wanted to bring the fund in line with its two other two "managed payout" products that were already investing in other RBC funds. Second, the managers wanted to increase the fund's exposure to U.S. equities and international bonds in an effort to boost the fund's returns. Having the flexibility to invest in other RBC funds – instead of executing a large number of individual securities trades – would make the process more efficient, Mr. Hartman said.

Such a "material change" of the fund's investment objectives required the approval of unitholders. RBC announced the proposal – which also affected the RBC Asian Equity Fund – on March 31, 2014, and mailed a management information circular to unitholders, inviting them to vote at a meeting in Toronto on June 20. Investors who were unable to attend could mail in a proxy ballot or vote by phone or Internet.

In the information circular, RBC encouraged investors to vote in favour because it "believes that the proposed change is in the best interests of security holders." It also attached a Q&A in which one of the questions was: "Will the proposals result in increased costs to me as a security holder?" The answer stated: "All costs and expenses associated with the proposed changes (including the costs and expenses incurred in connection with this mailing and the meeting itself) will be paid by RBC GAM. The management fees for each of the funds will not increase and the management expense ratios will remain substantially the same as a result of the proposed changes to the funds."

However, nowhere in the circular or Q&A was there any mention of potential tax consequences. Unitholders approved the proposal and the fund subsequently began selling individual securities and replacing them with RBC funds (a process which did not result in any financial gain for RBC, Mr. Hartman stressed). Why weren't the potential tax consequences mentioned? RBC had performed its own tax analysis, but because market conditions are constantly changing it could not know in advance the precise level of any capital gains, Mr. Hartman said.

Asked if RBC could have included a general statement in the Q&A indicating the move might result in unspecified capital gains, he responded: "That's a fair comment … and something we'll have to think about in terms of similar circumstances, and not just in the management information circular but how we talked about it with advisers and clients and the communications that we put forward."

Mr. Hartman said RBC did try to mitigate the tax hit by spreading the selling over two years, resulting in capital gains distributions of 44 cents and 85 cents a unit in 2014 and 2015, respectively (for Series A units). The 2015 capital gain was equivalent to about 12 per cent of the fund's $7.02 unit price immediately prior to the December distribution.

Even so, the upshot for unitholders was that a supposedly tax-friendly fund became anything but. Because of the gains realized in 2014 and 2015, the fund distributed no ROC in either year, compounding the frustration of investors such as the Bellans, who had bought the fund partly for its tax-deferral advantages.

Why didn't the Bellans object when the proposal was announced? Mr. Bellan conceded neither he nor his wife read the information circular and she did not vote on the proposal. But even if they had read the circular, they probably would not have understood the potential tax implications, he said.

According to Mr. Hartman, the change to the fund's composition did have at least one positive consequence: It improved the fund's return in 2015 because U.S. stocks outperformed Canadian stocks that year and – on a Canadian-dollar basis – U.S. stocks also benefited from a falling loonie.

But that's of little comfort to the Bellans, who are still smarting over their hefty tax bill. "I suppose it was legal. But was it ethical or moral? … No. I say absolutely not," Mr. Bellan said.