Fund switches, mergers and taxation
(updated, April 24, 2020)
Three friends connect on FaceTime to keep in touch during the physical isolation measures introduced to battle COVID-19. The conversation drifts to investments.
They are all interested in putting money into funds. They are confused about the income tax implications of making fund switches when looking at corporate class mutual funds, mutual fund trusts (the most common structure of mutual funds) and segregated funds when these investments are not sitting in registered savings plans. These people are not alone. Two of them think that fund switches between non-registered funds are not taxable. Well, are they? Here’s how fund switches work for each type of investment fund when it comes to taxation.
Mutual fund corporations or corporate class funds
New rules came into force on January 1, 2017 dealing with the taxation of mutual fund corporations set up as “switch funds”. Now, investors who switch between funds in non-registered plans will no longer be able to do so without incurring taxable capital gains or losses. When investors switch between funds, keep in mind that they are required to keep track of their capital gain or loss and include its taxable portion in their taxable income in the year of sale.
Two exceptions were made in the rules.
1. Shares of a class of the mutual fund corporation are exchanged for shares of the same class and
- the original and new shares derive their value in the same proportion from the same property plus
- that class is recognized under securities legislation as a single investment fund
2. The exchange or disposition occurs in the course of a transaction covered by s. 86 Income Tax Act (Canada) or an amalgamation under s. 87 Income Tax Act (Canada). The shareholder will be entitled to a tax deferral as long as the following three conditions are satisfied:
- all shares of the particular class are exchanged,
- the original and new shares derive their value in the same proportion from the same property, and
- the exchange was not done to obtain a tax deferral. It was strictly done for other bona fide reasons (change in risk tolerance, re-balancing, etc.)
Investors who switch between funds will no longer be able to do so without incurring taxable capital gains or losses.
While these exceptions exist, they may not apply in many situations. One potential benefit of corporate class funds is that a number of funds are pooled together within a corporation. This allows the taxable events of each fund to be traded off against one another before distributions are paid out to the investor. That does not extend to fund switches.
Mutual Fund Trusts
When investors switch between mutual fund trusts in a non-registered account, they are deemed to have sold units of one fund and purchased units in another. If the units sold have increased in value compared to when they originally purchased them, then the switch will generate a capital gain. If the units sold are worth less than what they were purchased for, then the switch will generate a capital loss. This is over and above any interest or dividend income that has been earned on the units sold.
When switching between funds, keep in mind that investors are required to keep track of their capital gain and include the taxable portion in their taxable income in the year of sale. This can become complicated over time with multiple purchases and switches.
Segregated Funds
Non-registered segregated fund switches are treated in a similar fashion to mutual fund trusts. Fund switches are a taxable event. There are two notable differences.
- Segregated funds pass through all realized capital gains and capital losses to unitholders. The capital losses may be used to offset capital gains in other investments.
- Insurers like Empire Life, do the tracking and reporting of capital gains and losses and report them on annual tax slips to investors, simplifying administration and tracking, reducing costs of doing so and reducing the errors that can so easily be made when done by investors or their accountants and tax preparers. There are other features and benefits of segregated funds which are covered by the annual fees charged.
The Income Tax Act (Canada) allows companies who issue mutual funds to merge funds on a tax-deferred basis, which means no capital gains tax is triggered. The Federal Budget 2017 extended this tax deferral treatment to facilitate the reorganization of corporate class funds into multiple trusts. Previously, the rule applied only to a merger into a single mutual fund trust. This move responded to the elimination of the ability to switch tax-free between investment funds held inside the same mutual fund corporation. Segregated funds that merge after 2017 will also be allowed the same tax deferral, so that all three types of funds are on equal footing.
peter a wouters
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? 2020 by peter a wouters
The material in this article is current as of the date published. This material is presented for informational purposes only, and is not a legal, tax or investment opinion. The provision of the information contained herein and any oral or written communication regarding the same should not nor is intended to be construed as such. Interested persons should seek and retain independent professional advice before acting or foregoing action in relation to any of the matters mentioned herein reflected as of the date published or updated.