Reprinted with permission from London Life Insurance Company.

London Life and design are trademarks of London Life Insurance Company.

RIS ADVANCED SALES ARTICLE

Tax-efficient investing with D series corporate class funds

From savings to income and beyond

As more of the baby-boomer generation approaches retirement, income-related solutions and tax efficiency for non-registered assets will become increasingly important.

It’s possible for those who invest in a non-registered portfolio using corporate class funds to:

1. Realize little or no taxable income or capital gains annually while saving2. Defer capital gains when switching and rebalancing3. Defer capital gains when switching into D series shares for income4. Receive payments that are initially tax-free and defer any capital gains5. Avoid tax on realized capital gains by making a charitable donation

It all starts with a mutual fund corporation, such as Quadrus Group of Funds, offering D series shares.

1. Realize little or no taxable income or capital gains annuallyThe mutual fund corporation structure combines the income and expenses from each class of shares in the corporation for income tax purposes. Combining the income and expenses can mean lower overall year-end distribution to the client.

Corporations, including mutual fund corporations, do not distribute interest income. The fund managers manage the amount of interest income earned in the funds, and they offset any interest income earned with expenses first to minimize or eliminate tax the fund would pay on left over interest income. Any distributions by mutual fund corporations are dividends or capital gains that are taxed more favourably than interest income.

Example:$1,000,000 invested for 10 years, during which time the markets averaged a six per cent return per year, would grow to over $1,790,000. As market values for stocks and bonds fluctuate, dividends and interest continue to be paid and are taxable. Income distributions could have easily been $27,000 or more per year on average, compared to as little as zero in the mutual fund corporation.

Reprinted with permission from London Life Insurance Company.

London Life and design are trademarks of London Life Insurance Company.

2. Defer capital gains when switching and rebalancingWhen the need to rebalance arises, it can be done without triggering immediate taxable capital gains. Unlike mutual fund trusts or individual securities, switching among classes of shares of the mutual fund corporation does not trigger a taxable disposition.

Example:$1,000,000 invested for 10 years, during which time the markets averaged a six per cent return per year would grow to $1,790,000. Assume after 10 years it’s appropriate to rebalance and move from equities to fixed income classes or vice versa. In most securities investments, the switch could have triggered up to a $790,000 capital gain compared to no immediate taxable capital gain in the mutual fund corporation. At 50 per cent capital gains inclusion and 40 per cent marginal tax rate, the taxes owing in the year of the switch could have been over $150,000 if the capital gain was not deferred.

3. Defer capital gains when switching into D series shares for income The tax-deferred switching advantage for rebalancing also extends to switches among series of funds. Moving from Quadrus or H series funds into a D series fund in the same mutual fund corporation wouldnot immediately trigger taxable capital gains or losses.

Moving accumulated capital into D series mutual funds from mutual fund trusts, or any other individual securities, would normally consist of disposing of the existing assets, which is a taxable disposition.

Example:$1,790,000 switched into D series funds provides an initial income stream of $89,500 using the five per cent series or $143,200 using the eight per cent series, or any amount in between, by using a combination of five and eight per cent series funds. Similar to the example in part 2, this switch defers taxes that may have been over $150,000 if the switch was not within the same mutual fund corporation.

4. Receive payments that are initially tax-free and defer any unrealized capital gainsD series funds provide a monthly cash flow based on the chosen distribution rate of either five or eight per cent per year. Instead of redeeming mutual fund shares, the monthly distribution is the return of a portion of the original investment – a return of capital. This portion of the payment isn’t immediately taxable, resulting in a deferral of taxes until the future. The fund may also distribute taxable income in the form of dividends and/or capital gains. Return of capital distributions lowers the adjusted cost base (ACB) of the client’s mutual fund until it reaches zero. Only then are return of capital distributions taxable as capital gains.

Example:Assuming the $89,500 return of capital distribution from the five per cent series is constant, the distributions defer unrealized capital gains for over 11 years until return of capital distributions reduce the $1,000,000 ACB to zero.

Reprinted with permission from London Life Insurance Company.

London Life and design are trademarks of London Life Insurance Company.

5. Avoid tax on realized capital gains by making a charitable donationThe Income Tax Act provides for a taxable capital gains inclusion rate of zero per cent when capital gains on publicly traded stocks, bonds, mutual funds and other securities are donated in kind to a qualified charity. Therefore, the amount of tax payable on any capital gain, which would otherwise be realized on securities donated to the Quadrus charitable giving program, is $0. The tax receipt for donations of mutual funds is the market value of those securities at the time of donation.

Example:Assume investment market growth provides five per cent per year returns. Five per cent returns and five per cent distribution means the market value of the D series funds remains level. After approximately 12 years, the value of your D series funds could still be $1,790,000 but with a zero ACB. The unrealized capital gains are $1,790,000, which have been deferred for all these years. At 50 per cent capital gains inclusion and 40 per cent marginal tax rate, the taxes on that gain would be $358,000. Donating the D series shares in kind to the qualified charity reduces this tax burden to $0, gives $1,790,000 to charity and generates a charitable tax receipt in the amount of $1,790,000.

ConclusionWith corporate class D series funds, it’s possible to reduce taxable income and defer capital gains right through the savings and income phases, despite rebalancing and moving to an income product. It’s also possible to eliminate the tax altogether with a charitable gift.

The decision to invest in a mutual fund corporation should not be based solely on income tax considerations. You should ensure that an investment in a mutual fund corporation suits your client’s objectives as well as their risk profile.

The information provided is for Canadian residents and is accurate to the best of our knowledge as of July 2010. The information contained in this article is intended to provide general guidelines only. The application and impact of the law can vary widely from case to case based on the specific or unique facts involved. Accordingly, the information in this article is not intended to serve as legal, accounting or tax advice. Users are encouraged to consult with their professional advisors for advice concerning specific matters before making a decision.