This week, I was sitting on a park bench down by the waterfront in Oakville, Ont. Three elderly gentleman, who looked to be in their 80s, were at a picnic table close by and, though I couldn't really make out everything they were saying, it sounded like a story I'd heard before somewhere. I'll call them Larry, Curly and Moe. I think it went something like this:
Larry: "Windy, isn't it?"
Curly: "No, it's Thursday."
Moe: "So am I. Let's go get a milkshake."
Curly: "I said Thursday!"
Larry: "No, it's Monday!"
Moe: "Don't get me started on money. I just paid my taxes."
Curly: "Taxi? We don't need a taxi. The bus will come by in 20 minutes."
Larry: "Taxes! Let me tell you about taxes. My grandson, he has a clever idea about saving them."
Larry then spent about 15 minutes trying to tell the other two about some sort of technology that can save investors some serious tax dollars. As it turns out, it's an investment technology that really exists and I can tell you about it.
If you're an investor who uses mutual funds or investment pools to take advantage of professional money management, a tax liability can rear its ugly head in two common situations: First, you may receive taxable distributions from the fund on an annual basis. When the fund earns income or realizes capital gains, that income is generally distributed to you and is taxed in your hands. You have little or no control over the type, timing and amount of these distributions.
Second, you'll face tax when you sell all or some of your units in a particular fund if your investment has appreciated in value. The end result? Based on studies I referred to in my article on July 15, you could lose between 2 and 3 per cent annually to income taxes on distributions and dispositions.
Corporate class mutual funds. CCMFs are simply mutual funds that are not structured as trusts, as is most commonly the case, but as shares in a corporation. Most mutual fund companies offer CCMFs, and have for many years, but these are often misunderstood as a tax tool.
How do they work? A particular mutual fund company may establish a mutual fund corporation that consists of several share classes - class A, class B, class C, and so on. Each share class represents a particular mutual fund. So, if you own the class A shares of a mutual fund corporation, you might, for example, be owning a Canadian equity fund. The class B shares might represent a global fixed-income fund. You get the picture.
The key tax advantage is that you can now avoid one of the two tax problems I spoke of earlier. Specifically, you can avoid the tax when disposing of your interest in a particular mutual fund - as long as you switch to another fund, or share class, in the same mutual fund corporation. So, if you switch from the class A shares (Canadian equity fund) to the class B shares (global fixed-income fund) in my example, you'd pay no tax on the switch, even if your shares of the class A fund had appreciated in value.
What if you could not only reduce your taxation on leaving one fund and entering another (which any CCMF will do) but also control the other level of tax I spoke about: Tax on distributions? At least one mutual fund company has developed a way to offer this flexibility.
Nexgen Financial has created a mutual fund corporate structure that has different "tax classes." That is, you can choose the type of income you want to receive by simply choosing the appropriate tax class.
You could, for example, choose a bond fund (which normally would distribute interest income), but opt to receive your returns as Canadian dividends instead (eligible for a reduced rate of tax, thanks to the dividend tax credit). Nexgen has applied for patent protection on their "investment technology."
Of course, you still have to be content with expected investment performance and fees, but if you're satisfied with these, Nexgen's approach offers some interesting opportunities: Choose the capital gains class if you have capital losses you want to utilize or if you want to split income with minor children. Choose the return of capital class if you need cash flow but would rather pay tax on capital gains later than paying tax today. Choose the capital growth class if you want to make a donation of securities to charity. The planning ideas can go on and on.
Controlling the type and timing of your tax bill is a powerful capability when increasing your net worth.