On March 28th, The CBC website posted an article titled Corporate Class Funds Offer Tax Advantages which extolled the virtues of these special funds whose basic aim is to allow the investor to defer the immediate payment of capital gains tax when switching funds. This is accomplished through the corporate structure, as opposed to the usual trust structure for mutual funds, which passes through capital gains to investors each year. The theory is that deferring the tax on gains assists greater long term growth, much like an RRSP does.
Hmmm, any financial advice the CBC publishes bears closer scrutiny (That the article says that these funds are "suitable for both registered and non-registered portfolios..." seems a bit crazy since registered portfolios are already tax-protected) before jumping in with investment dollars. It seems the main (only?) selling point of Corporate Class funds is the tax advantage. This alone makes me suspicious. How often does one read that one should never make an investment merely for the tax advantage?
A bit of Googling uncovers Rob Carrick's much more balanced and sensible article Investor Unbound in the Globe Advisor magazine, which describes the Corporate Class advantages and disadvantages much better. It turns out that the Corporate structure involves more costs and higher management fees, 0.2 to 0.4% per year according to Rob, reducing the net gains for the investor. The
person for whom such a structure is suitable is the high tax bracket investor who regularly makes capital gains (and no capital losses since those are not deductible) with a taxable account and who switches often between funds. Sounds like the proverbial elusive successful market timer, doesn't it?
The sidebar of Carrick's article links to another helpful Globe Advisor article by Phil De Mont, A Capital Decision, in which he cites the fact that the Corporate class funds must pay an extra tax, the capital tax. This reduces the rate of fund return by an additional 0.225% according to the article.
Taking the total return hit of about 0.5% (0.2-0.4% + 0.225%), I did a simple calculation to see the difference between the Corporate and regular funds in net after-tax returns. I assumed an investment policy more like my own, with infrequent fund switching only to re-balance. In my example, the regular fund pays capital gains tax of 20% (a high rate taxpayer with over 75k in taxable income) after a gain of $1000 on a $10000 investment in year 1and then at cash out after year 5, while the Corporate fund makes the same gain but pays tax only after year 5. The regular fund with lower fees meanwhile gains 5% a year vs the 4.5% (i.e. less 0.5%). As you can see, the regular fund comes out ahead by $168. Even for a high rate taxpayer in a taxable account, the Corporate class fund can easily be a loser under some fairly reasonable assumptions.
Add to that the inability to deduct capital losses ( will every investment be a winner?) and the incentive to frequent un-necessary fund switching that the idea of tax-deferral could easily engender, as noted in the De Mont article, reduces their attractiveness quite a bit. Caveat investor.
Wednesday, 2 April 2008
Posted by CanadianInvestor at 15:21
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