Tax-efficient Investing - maximizing after-tax returns
Wealth management is a process that involves a number of key components. Ultimately, the goal of this process is to create a plan that will maximize the after-tax return from your financial assets. We define tax-efficient investing as the added after-tax value of an investment attributed to its tax characteristics for a given risk profile. It is important to make clear that any investment you choose should be selected on the merits of the investment and your objectives. Once this decision has been made the next step is to maximize the tax efficiency of the investment. The problem is that not all income is taxed equally.

For example, if you're a conservative investor and hold mostly government bonds and GICs, you will receive interest income which is taxable at an investor's highest marginal rate. Alternatively dividends and capital gains income are taxed at much lower rates. Corporate class mutual funds allow you to control the type and timing of the income you receive. By controlling the amount of tax you pay on interest income, you can add 2%-3% to your annual after-tax rate of return, often without increasing the risk profile of your portfolio.

Corporate Class Funds
One solution for conservative investors is to consider Corporate Class mutual funds for their non-registered assets. The Corporate Class Mutual Fund structure was introduced in this country in 1987 and is recognized in the Canadian Income Tax Act. Prior to this date all mutual funds in Canada were structured as Trusts. The Trust format is still dominant in the Canadian market to this day. The Corporate Class Mutual Fund structure is like any other privately owned Canadian corporation. A family of funds can be grouped within a single Mutual Fund Corporation (MFC) and be treated as a single tax entity. This creates three distinct tax advantages:

1. Tax-efficient switching: Tactical shifts within a portfolio without triggering a taxable event.
2. Tax-efficient growth: Minimizing distributions and therefore facilitating compound growth.
3. Tax-efficient cash flow: Generating a desired level of cash flow while deferring tax.

Here's How it Works
Basically there are four characteristics of a MFC that combine to create these tax advantages.

1. A mutual fund corporation can set up a different class of shares for each mutual fund within the corporation. If there are twenty different mutual funds in the corporation there are twenty different classes of shares.

2. A MFC is one of the few corporations allowed to distribute capital gains intact to the investor. To avoid double taxation, the corporate class mutual fund receives a capital gains refund when it distributes a capital gain.

3. High tax rate income such as interest and foreign income are used first to offset expenses of the MFC. These expenses are primarily the management fees paid to the Fund Company, and general administrative expenses. This usually leaves the more efficient dividends and capital gains available for distributions.

4. A recent innovation to the MFC is the introduction of Return of Capital (ROC). ROC is considered after-tax so that there is no tax liability on the cash flow. Again this is not unlike any other Canadian Corporation where the owners of the corporation can choose to withdraw their investments (which they made with after-tax dollars) first before receiving the taxable income.

Tax-efficient Switching
So let's assume you have a large capital gain in an equity fund within this MFC and you are getting nervous about the market. You can make a switch into any other fund (bond fund) within MFC and not pay tax on the capital gain. Just like any other family corporation in Canada you are not required to pay tax if income is moved between different classes of shares within the corporation.

Tax-efficient Distributions
One of the principal errors of tax efficient investing is to receive a distribution that you don't need. These unwanted distributions get taxed and the remaining funds usually get reinvested. Because MFC's have a number of different funds within their structure and are taxed as a single entity, they are able to use expenses and losses from any of their funds in order to reduce the unwanted distributions. In the past many of these MFCs have made minimal or no yearend distributions. By minimizing unwanted distributions you help to facilitate the compound growth of your financial assets.

Tax-efficient Cash Flow
Most MFCs allow you to receive a steady stream of income from your investment; this class of fund is commonly referred to as T-Series. T-series distributions are made up, in part, as a return of capital. ROC is not immediately taxable. Instead the adjusted cost base (ACB) of the investment is reduced.

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