Mid-February, Franklin Templeton announced that its Franklin Brandywine Global Sustainable Balanced fund had temporarily lost its status as a mutual fund trust.
“The fund was a qualified investment for the 2023 tax year,” explained in an email Sarah Kingdon, senior manager of corporate communications with Franklin Templeton. “In January 2024, it temporarily ceased to qualify as a mutual fund trust under the Income Tax Act (Canada), but it regained its status as both a mutual fund trust and a qualified investment at the end of that month.”
Surprisingly, Franklin did not state why its fund had “ceased to qualify”. There could be four reasons why, explains Josée Baillargeon, senior policy advisor, taxation, at IFIC, related to the four requirements that the Income Tax Act (ITA) imposes on mutual funds. The trust must be resident in Canada, its units must be redeemable on demand, it must invest only in certain property, and must have at least 150 separate unit holders, each holding at least $500 worth of units. In addition, a mutual fund trust cannot be established primarily for the benefit of non-residents.
Status Loss Can Happen Because of Too Few Unitholders
“The most common reason for a fund to lose its status is because it does not meet the 150-unitholder threshold,” Baillargeon highlights. ITA sub-rules will allow a fund to retain its status for a temporary loss if the unit holder count falls below the 150 threshold at any point in the year “as long as you started and ended the year meeting the applicable requirements,” she adds. This could be the area in which Franklin Templeton’s fund landed.
Franklin issued a note stating that unit holders need not take any action, believing that these events would not result in any tax liability or filing obligations for investors who held units in a registered plan during January 2024.
A Penalty Can Apply if the Fund is in a Registered Account
Indeed, in a registered account like an RRSP or a TFSA in which a fund loses its status because of too few unitholders, “the holders will be subject to significant penalty taxes,” Baillargeon warns. The Canada Revenue Agency identifies it as a “special” tax, “that is equal to 50% of the fair market value of the property at the time that it was acquired or that it became non-qualified,” and it must be paid no later than June 30 following the end of the calendar year.
Baillargeon states that she is not familiar with consequences or potential tax implications related to other reasons that a mutual fund trust could lose its status. In the U.S., “there’s no rule for minimum shareholders,” notes John Rekenthaler, vice-president, research, for Morningstar Research Services. If a fund lost its mutual fund status, he continues, the firm “would simply work at increasing the unit holder count, close it or merge it into another fund, there’s no such thing as a delisting like in Canada, and no fiscal problem. The only problem is that, if it becomes very small, the expense ratio might go up, but that’s not a problem in practice.”
Other than the fiscal penalty imposed on a registered account holder, a status loss “is more an economic or investment problem,” agrees Dan Hallett, vice-president and director, asset management, at HighView Financial Group. “If a fund becomes too small, because there are fixed costs, the sponsor ends up subsidizing it when it wants it to be self-sustaining. If this happens in an ETF, typically the sponsor will just terminate it, while for a mutual fund, it will merge it into another product.”
Status loss is not something to lose sleep over, Hallett advises, because what happened to the Franklin Templeton fund is a rare occurrence. “In my thirty years in the industry, he asserts, this is a first for me; I haven’t seen it before.”
