Wednesday, 2 April 2008

Corporate Class Funds: Beware of Investing Only for a Tax Advantage

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.


Anonymous said...

I generally concur with your position on all the various Corporate Class offerings. If the funds are not wrapped in an actively managed program where frequent (quarterly?) re-balancing, as well as other tactical reallocations generate deferred capital gains - then it doesn't seem useful. Then it becomes an argument about active management versus buy and hold. I think there is some strong evidence to suggest making active asset allocation decisions (based on relative value/risk) can generate greater returns over the long run. But its difficult to measure. To the extent a corporate class lowers the barriers to engaging in this strategy then it could be worth the extra fees. But, I am not 100% convinced.

I think these tax deferral schemes generally confuse end investors (and even me, somewhat on top of it) - so they probably do not understand the tradeoffs. However, if an advisor says "this will lower taxes" - they'll buy in.

Here's a question for you - maybe you can enlighten me:

What are these "T-Class/Series" offerings? These are inside the corporate class structure but offer some other layer of tax effeciency?

Also - more info on this statement would be worthwhile: "Ottawa seems intent on extending the corporate class treatment to more funds. The government does not want to regulate two sets of structures, Mr. Tew said, and that means expanding the ability of investors to move tax-free among various financial vehicles."

CanadianInvestor said...

Anon, Found this Morningstar article whihc describes T-class
Essentially the T-class distributes your own capital back to you instead of income or gains so you don't have to pay tax ... until all the capital / cost base is used up.

The other statement about "Ottawa's" desires re two sets of structures puzzles me too. When did government ever want to reduce regulation except under extreme pressure from private industry? There is only one Income Tax Act and the feds did not pass any special amendments to enable corporate class funds. The fund companies tax whizzes found a way to defer some taxes in some cases. If anything is at risk, it is corporate class funds if the feds decides there is too much tax being deferred. My guess is that won't happen since not enough people with too few gains will use corporate class funds successfully.

Alpha Money Advisor said...

Great insight here. I think advisors still need to demystify corporate class funds in canada. They are a great opportunity to take advantage of while CRA still lets you. Nice blog. Glad I came across it.


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