Do you suffer from T3 and T5 tax-slip shock after completing your 2010 tax return and realizing how much taxable income your mutual funds pay out every year? While owning profitable funds is a good problem to have, no one wants to pay Canada Revenue Agency (CRA) any more tax than is absolutely necessary.
Fortunately, there are Canadian mutual funds with the stated objective of reducing the tax that investors pay. Moreover, some intriguing new products of this type have hit the marketplace in the past few years.
Corporate-class or "switch" mutual funds are the main vehicle for reducing the tax that fund owners pay on profits made in non-registered accounts. A fund company offering a group of such funds sets up one mutual-fund corporation with multiple share classes. Each class represents a different mutual fund and all the major asset classes and geographic sectors are usually represented within the corporation.
Some or all of the funds may simply be versions of the company's regularly structured funds. The key tax feature of corporate-class funds is that investors can switch among funds within the corporation, for example to take profits or rebalance their portfolios, without triggering capital gains or losses.
Additionally, many switch funds do not issue regular distributions or dividends, so fund holders have no T3 or T5 tax slip income to report. Tax is paid when the shareholders redeem their shares in the corporation and the resulting profits, even interest income, are taxed at the tax-advantaged capital-gains rate.
NexGen Financial Limited Partnership, a relatively new player in the corporate-class mutual fund space, has raised the bar on tax-efficient fund investing. The innovative, patent-pending structure of their corporate-class funds allows investors to choose the tax treatment of the returns generated from any of the firm's 18 fund mandates. (This number will fall to 15 if planned mergers are approved.)
The NexGen line-up covers a wide range of popular and widely held fund categories: Canadian, U.S. and global equity; balanced; fixed income and money market. There are also several more specialized equity mandates, including Canadian and global small- and mid-cap equity, and natural resources equity.
Each of the NexGen investment mandates, with the exception of Canadian money-market, is available in four tax-managed versions. They are:
Compound growth class: No distributions are issued. This fund is designed to defer all taxes and to compound tax-deferred returns.
Capital-gains class: Annual distributions in this class are pure capital gains, which are taxed at 50% of the rate of interest income.
Return of capital class: This class provides tax-deferred monthly cash flows which are considered 100% return of capital.
Dividend tax credit class: Monthly distributions are in the form of Canadian eligible dividends. They attract the dividend tax credit resulting in a reduced tax rate.
Though NexGen serves mainly investors in taxable accounts, all of its fund mandates are also offered in registered versions. These are suitable for RRSPs or tax-free savings accounts (TFSAs).
NexGen's unique design offers investors the flexibility to customize their portfolios on the basis of their personal financial needs and reduce their tax bills. For example, seniors who need cash flow while keeping their income below the threshold for the Old Age Security clawback could choose the return-of-capital class. The capital-gains class would be the best choice for an investor who has outstanding capital losses which, according to CRA rules, can only be deducted against capital gains.
NexGen funds should be of particular interest to those who invest in interest-producing assets. Consider an Ontario resident in the top marginal tax bracket who earns $5,000 in a non-registered account. If the income is interest from Canadian bonds, she would owe $2,321 in tax.
If, instead, it is distributions from NexGen Canadian Bond's capital-gains class, her tax bill would be only $1,160. If the income source is the return-of-capital class of the same fund, she would pay no tax until she sold her holdings. At that point, the capital-gains tax rate would apply to her profits.
Thus, using NexGen funds, an investor could pursue a lower-risk bond-investment strategy and gain some relief from the punishing tax rate normally applicable to bond-interest payments. This exceptional tax flexibility is, of course, only of value if the funds produce satisfactory profits.
As is the case with most fund companies, NexGen has funds that have performed well, and others that have had poor results. The firm is relatively new (it was launched in late 2006), so all funds have a track record of less than five years. Of the 14 mandates with track records of at least three years, the Canadian balanced growth funds have been outstanding. All tax-managed versions currently hold a Morningstar 5-star rating.
This good-news tax story comes at a price; the management expense ratios (MERs) of NexGen funds are higher than average. Unfortunately, these MERs are well hidden at the NexGen website. Only the management fees are shown on the Fund Facts web pages. For the aforementioned Canadian balanced growth funds, these fees are 2% for the regular, deferred and no load versions.
The MERs for these same funds, which can be found if you dig into the management report on fund performance, are 2.69% for most classes, but could range up to 2.84% for the compound growth class, which has a 15-basis-point performance fee. The median MER for the relevant fund category, Canadian Neutral Balanced, is much cheaper at 2.32%.
It should also be noted that a substantial portion of the management fees is paid in the form of trailer commissions to the third-party brokers and dealers through which NexGen distributes its funds. You're paying for advice if you buy NexGen funds, so be sure to get your money's worth.
NexGen president Laurie Munro told me that as the company grows (assets held are currently $885 million) and enjoys better economies of scale, they hope to lower their fees. Still, the higher-than-average MERs should be more than offset by the attractive after-tax returns that NexGen's tax-efficient funds are capable of delivering.
Depending on your personal financial situation, the tax savings available by investing in NexGen funds could be significant. Let's hope that the Canada Revenue Agency does not find a reason to shut down this promising solution to T3 and T5 tax-slip shock.