Mutual funds are designed to provide a more economical and simplified way of investing for those who prefer not to wrestle with the intricacies of choosing individual securities and monitoring their performance in order to achieve a well balanced, diversified portfolio.
As long as you find value in the management fees, you can let professionals manage your portfolio. However, taking the fund route isn’t entirely without its complications, thanks to the taxation of income earned within your fund investments.
When you have a portfolio of individual stocks, bonds and cash instruments, you will receive a consolidated T5 tax-information slip from the investment dealer where you keep your portfolio. This will show the total interest and dividends received from all of the investments within your portfolio, which you then report on the respective lines of your income tax returns.
With a portfolio of mutual funds, on the other hand, you’ll receive T3 tax slips (for mutual fund trusts and, if a Quebec resident, a Relevé 16 for provincial tax purposes) for each individual fund your own. That can add up to a lot of individual tax slips, from which you’ll have to total the various amounts to consolidate for reporting on your tax return. (Some mutual funds are structured as corporations, rather than trusts, and issue T5 income slips, and Relevé 3 for Quebec tax returns. These “corporate class” funds are discussed below.)
This discussion only applies to investments held outside a registered account such as an RRSP, RRIF, TFSA or RESP. Income or capital gains earned from the latter are not taxable until money is withdrawn from the account (except in the case of a TFSA), at which time it is fully taxable as ordinary income at your marginal tax rate.
Tax on annual distributions
Most mutual funds, whether conventional or exchanged-traded funds (ETFs), are structured as inter-vivos trusts, and thus are required to distribute net taxable income earned within the fund. addition to interest and dividends, this also includes capital gains realized within the fund. (Losses realized within the fund are not distributable to investors.)
This differs from a portfolio of individual stocks or bonds, in which case you only report a capital gain or loss when you actually dispose of an investment.
A mutual fund will realize gains and losses whenever it disposes of securities within its portfolio, and the net amount of these are flowed through to fund unitholders. “The amount of capital gains or losses realized by a mutual fund generally is based on how active the fund trades its securities,” says Joseph Micallef, partner and National Tax Leader, Financial Services & Asset Management, with KMPG. “An investor generally would have access to the investment turnover activity for a fund as well as the transaction costs incurred by the fund in the execution of its investment strategy.”
Capital gains distributions and other income distributions are reported on your T3 slips and must be reported on Schedule 3 of your federal tax return (Schedule G for Quebec purposes).
Interest is fully taxable for an investor on accrual basis whether or not the amount is actually received by the investor; whereas dividends are taxed when received. Dividends from Canadian sources, although taxed at a more favourable tax rate for individuals, are still taxed higher than capital gains, on which are only one-half is taxable to an investor.
There are two other common types of distributions that may be reported on your tax slips:
- Some funds will provide a return of capital (ROC). While this amount is not taxable, it does reduce the adjusted cost base (ACB) – essentially what you paid to acquire the units – which will increase your capital-gains-tax liability when you eventually sell your investment.
- Reinvested distributions are 100% taxable no differently then if you received the amount in cash. Although this income may seem invisible and provide no cash to pay your taxes, it will increase your ACB. Thus, this amount is not taxed again when you eventually sell your funds units or shares.
Mutual fund corporations
While most mutual funds are structured as trusts, some are structured as corporations. The type of structure can have different tax implications for the overall investor. Here are the essential differences:
- Structure: Mutual fund trusts are individual stand-alone entities, whereas a corporation groups all of its funds, or classes, into a single corporate entity.
- Asset classes: A wide range of fund mandates are available within either framework.
- Taxation: Each mutual fund trust is treated as a separate entity and capital losses cannot be flowed through to investors. Corporate class funds, by contrast, are grouped together and taxed on a consolidated basis.
- Tax efficiency: With a trust, net taxable income, including interest and foreign dividends, are flowed through to unitholders. A corporate class funds can only distribute capital gains and Canadian dividends; all other income earned by the fund in excess of expenses is retained within the corporation taxed at the corporate rate, which will affect its investment yield.
“Recent federal budgets have undertaken to implement tax policies that have curtailed what the government perceives as some of the tax advantages that corporate class funds had enjoyed over the past several decades,” Micallef says.
This has resulted in the elimination of tax-deferred switching among classes of funds within a mutual fund corporation. Policymakers also have focused on blocking a fund’s ability to transform ordinary income into tax-favourable capital gains. The latter, known among tax professionals as “character-conversion transactions, “puts more pressure on ordinary income that is trapped in a mutual fund corporation and subject to a high rate of taxation,” he says.
While mutual fund trusts and corporations each have tax-related pros and cons, Micallef says investors should be aware of the above considerations when determining which investment structure may be the most tax-efficient for them, as well as the types of distributions a fund has generally made in the past or likely to make in the future.
Tax on sale of fund units
Regardless of fund structure, there are tax-compliance requirements when the time comes to report a gain or loss from the actual sale of a fund investment.
When you sell units/shares of a fund held in a non-registered account, you will realize a capital gain or loss. Investment dealers provide T5008 reports that list transactions of fund units and other securities made during the year in your account, and the proceeds from each disposition.
“Although the T5008 provides transaction details, including the number of units sold and the proceeds, Micallef warns that “it is up to the investor, or the investor’s tax advisor, to compute and maintain the tax cost base of its units/shares of the mutual fund investment for purposes of determining the amount of taxable capital gains and losses in the determination of your income tax.”
Some of the common items that affect a mutual fund investment’s ACB are:
Increase ACB:
- Amount paid for the investment units/shares on an acquisition
- Amount of commissions or fees charged on transactions
- Notional income distributions that are reinvested
Decrease ACB:
- Returns of capital (ROC)
Any capital gains or losses realized on a disposition would be reported on the individual taxpayer’s tax return on Schedule 3 (Schedule G on the Quebec return). “A taxpayer should be aware that any fees or commissions paid on the disposition of units/ shares of the mutual fund would also be included on the above-noted schedules since these represent selling costs and will impact the amount of realized gains or losses from the disposition,” Micallef says.
The year-end conundrum
Mutual funds generally make distributions of their net taxable income to unitholders of record at the end of the taxation year. However, there are some mutual funds that also make distributions at other times of the year. The type of distributions received (or declared, in the case of reinvestment) is determined at the end of the fund’s taxation year to be or capital gains, interest, dividends. “It should be noted that it is not uncommon for an investor to receive taxable distributions from a fund that does not reconcile to the fund’s performance,” Micallef says. “Thus, there may be situations where you invest in the fund during the year and do not realize any investment growth – yet still receive a taxable distribution from the fund.
This is because a mutual fund is a separate taxpayer and its tax liability is cumulative based on overall performance since the date of its inception, whereas the unitholder’s gain (or loss) is calculated from the time of his or her investment, which may not be when the fund was launched – hence the mismatch, Micallef says. “It would be prudent for an investor to understand these considerations with their investment advisor when making any investment decisions.”
