A corporate class structure for mutual funds is when all of your funds are under one umbrella for tax purposes. You can switch between funds that issue all forms of income (interest, dividends, and capital gains) and pay no taxes until you withdraw the money from the entire structure. Any withdrawal would be taxed as capital gains even if the original income was in the form of interest or dividends. When profits are incurred, as well as when taxes are paid, is up to you. There is also the possibility of receiving a “capital return” before your capital gains, which is not taxable. A return on equity is receiving the money you invested instead of the money earned on the investment. This would defer your capital gains taxes until all of your capital is returned to you, which would defer your overall tax bill. This sounds good, right?
There are many factors to consider before using this structure to see if it is beneficial for you and they are described in more detail below. Some of the factors are: the type of income generated by the mutual funds, your level of income taxes, the amount of money you invest, the fees outside of this structure compared to within the structure, the frequency of your transactions between funds, your past and future capital gains or losses and your risk tolerance. Note that this is a type of tax shelter, much like an RRSP or TFSA, but the rules are different. You need to know how they all work so that you can use them to the best of your ability in the situation that works best for you. You also need to know when tax havens are not worth using.
Income generated by investment funds
If you are buying investments that only provide capital gains, such as small-cap funds or commodity funds, this structure will not make a difference to you, with the exception of receiving a return of capital earlier than when “the sale event” occurs. . If you sell a portion of your funds yourself, you will receive a capital return, however, but the timing would be different. The corporate class structure allows you to claim a capital return first, followed by capital gains. If you invest primarily in interest-bearing securities, such as fixed income (bonds, mortgages, GIC, etc.), the idea of taxing them as capital gains may help you. If you have dividend-generating stocks, the structure can also be helpful because capital gains are generally taxed more favorably than dividends. If you have dividends from foreign corporations, the tax rules are more complicated as foreign governments can withhold some of your income to pay foreign taxes before the money reaches you. This will depend on the type of investment you have (based in Canada or elsewhere as an example), the type of account you have (retirement, registered or not), and which country the dividends are coming from. Reference to dividends in this article assumes they come from eligible Canadian corporations that would receive the dividend tax credit.
Your income tax level
The corporate class structure is designed for people who pay a lot of taxes and who have no other avenues or tax shelters to reduce their tax burden. If your tax bracket is low, the incentive to invest in something more complex and requiring more planning will not be as attractive. The fact is that taxes for all forms of income (interest, dividends, and capital gains) will be higher in the high tax brackets and lower in the low tax brackets. Structure is beneficial if tax rates are high and will stay the same throughout your investment horizon. If tax rates are lower at any particular point in your income stream, this structure may be worth less than originally planned. Another thing to consider is that the higher your income tax bracket, the more beneficial it is for you to receive capital gains. You may have a lot of assets but not a lot of income, unlike a low amount of assets and a high income. The strategy in these two cases would be different from a fiscal perspective.
The amount of money you have in the structure
The more money you have to invest, the more likely you have exhausted the RRSP room, TFSA room, or other common registered tax shelters. On the other hand, the more money you have to invest, the more tax options you have to look at as well, such as corporations, trusts, charitable giving, or investments abroad. As the amount you invest increases, the fees will decrease, making the cost of the structure more attractive. The more money you have invested, the more flexibility you will have in diversifying funds and spreading income types across many funds. If you have assets of a million dollars or more to invest, the fees can be negotiated in some cases. There does not appear to be a minimum or maximum threshold amount for investment for most companies. Questions should be asked about the minimum or maximum assets before committing to invest to see if there are restrictions that could alter your investment strategy.
Rate
These corporate-class products tend to be more expensive than comparable products of the same type. Fees within the corporate class structure tend to be around 0.2 to 0.4% per year higher than a typical mutual fund. This is just the fund’s management expense ratio. There are also sales charges at the beginning or end (when you buy or sell) that can add to the cost significantly. The average cost increase exceeds 1%. To accompany the rates, there are generally fewer options in a structure than to be able to buy any product you want. There may also be restrictions on alternative asset classes or specific niche products. These structures tend to assume that active management (having someone pick the stocks or shares) is better than passive management (investing in an index). This is generally not true unless you have a good portfolio manager with a consistent track record. Finally, if there are products that have sales restrictions or minimum holding periods, this may affect your ability to switch funds even if it is the right time to switch products. The conditions may allow you to change products, but penalize you with additional fees. As the amount of your assets increases, the fees need to be lowered and can be negotiated as stated above. Make sure you understand the rules for entering and exiting the structure so that you can assess before committing.
The assumption in the investment literature is that gains are generally more common than losses, but the time period may need to be extended by 10 years or more before the averages are in your favor. The performance history of the S&P 500 from 2000 to 2010 is an example of this, as was the NASDAQ during that period, gold companies during the 1990s, or Japan in the 1990s. If you have to wait for this period of time and fees are higher, you will generally lose more money if everything else is equal. If you have no profit or loss for a 10-year period, however the fees are 1-2% higher each year for the same investments, this will mean a loss of a fair amount of principal.
The key question to ask yourself is: “Would you invest in the same products inside and outside the structure and would you be happy with the results?”
Trading frequency
If you are a buy and hold investor, this structure will not provide you as many benefits as a frequent investor. One of the selling features of this corporate class structure is that you can switch funds as often as you like without incurring tax consequences. you However, you may incur sales fees each time you switch funds. Unless you are very good at the time of the market, this advantage does not exist for you, as the change will create losses that can also be made outside of this structure. If you trade infrequently, but rebalance your portfolio from time to time with large swings in the market, this may be beneficial to you as these large gains will not be taxed until sometime in the future. If you trade very frequently (buying and selling the same funds 30 days apart), you may be able to avoid a tax rule that labels frequent trading as income or creates superficial losses. If, on the other hand, you intend to be a trader, you may want to examine the trade as a business and report the relevant expenses. These issues should be discussed with a tax advisor.
Accumulated capital losses
If you have accumulated capital losses from the past, this structure may not provide you much benefit because the gains you receive can be offset against these losses, resulting in no tax being paid until your losses are exhausted. On the other hand, if you have accumulated capital gains, this structure can provide you with immediate tax savings. If you have an unused RRSP or TFSA room, you are better off using these tax shelters instead of a corporate class structure because you are not paying taxes on your earnings. In the case of a TFSA, you will not pay taxes on the money you earn, regardless of how you earn it. There are contribution space limitations with these two products that would not exist with a corporate class structure.
Risk tolerance
Risk tolerance should also be considered before making any investment decisions. In this particular case, people tend to let tax decisions override the quality of the investment. There is also a tendency to try to time the market or take more risks, as the results will be treated as capital gains. The thinking is “I have the opportunity to take advantage of the tax rules, so I will increase my trading to try to maximize my tax savings.” The other line of thinking is “Normally I would not change funds, but since there are no consequences, I will do it more often.” These lines of reasoning need to be weighed against whether you are in fact successful at market time or are making the same amount of money when all is said and done compared to your usual investment pattern. This problem must be examined by understanding what your psychology is in terms of negotiation and where your weaknesses lie. If you use a gambling analogy, you can be a very skilled poker player and consistently win against other poker players. However, if you start betting on the horses, you tend to overdo it and lose large amounts of money because you believe that you will be successful as often as you are in poker. Tax structures are a game changer for investing, so keep that in mind with the investment strategies that work for you and see if the combination of tax shelter and your investment style is successful.
As with any investment idea, the pros and cons should be considered for your individual situation. This analysis should also be reviewed when there are changes such as tax bracket, income, investment preferences, or personal changes. This should be done by looking at your entire monetary situation to weigh all the alternatives and choose which one works best for you.