Tax efficiency of Canadian investment vehicles

To the point

• Tax efficiency in Canada: Canada offers tax-efficient mechanisms for investment funds, attracting investors to the industry.
• Canadian investment vehicles: Partnerships’ tax transparency makes them favorable for certain funds in Canada. Trust structures, especially mutual fund trusts, provide tax advantages, including capital gains refunds, while the appeal of mutual fund corporations declined after tax rule changes, resulting in conversions into trusts.
• Monitoring regulatory changes: Fund managers must stay vigilant to adapt to evolving tax regulations in Canada’s investment funds industry. 

The tax landscape in Canada has undergone significant changes over the past decade and recent regulatory developments have spurred Canadian fund managers to adapt to the evolving landscape. However, the general Canadian tax framework for Canadian investment funds and investors has remained relatively stable, creating a conducive tax and regulatory environment for fund managers. Like tax rules in many other countries, the application of Canadian tax rules varies depending on the legal structure of investment vehicles. The legal entities that Canada recognizes in tax law are trusts, partnerships and corporations. While partnerships are transparent for tax purposes, trusts and corporations are not. Nonetheless, investment funds structured as trusts and corporations also benefit from tax efficiency through various mechanisms.

Canadian investment vehicles

Partnership funds – Flow-through feature

Canada treats partnerships as flow-through entities that are generally not subject to taxation. For tax purposes, income earned by a partnership fund retains its character and is allocated to investors of the fund and taxed in their hands. Fund managers and investors often choose limited partnerships as the vehicle for private equity and alternative investments because of their tax-transparent nature. This setup enables investors to access partnership losses in the initial years when the funds may not have income.

Canadian investors in a partnership fund are subject to different tax rates depending on the character of the income allocated by the partnership. As a general rule, Canada taxes capital gains at 50% of the rate it taxes interest income and foreign-sourced (non-Canadian) dividends. Canada taxes dividends from Canadian corporations at a rate higher than capital gains but lower than interest and foreign dividends. An investor who is a non-resident of Canada may be subject to Canadian withholding tax on Canadian-sourced income at a rate of 25%, subject to any available treaty relief.

A partnership fund with non-Canadian resident investors may be exempt from filing information returns with Canada’s taxation authorities provided the fund does not carry-on business in Canada or dispose of taxable Canadian property. This compliance exemption reduces the administrative burden for funds with diverse investor bases.

Mutual fund trusts and unit trusts – Embracing tax efficiency

Most regulated investment funds in Canada are structured as trusts due to regulatory requirements. Trusts are taxable entities under Canadian tax law. Nevertheless, they can be tax-efficient because trusts can allocate and distribute income and capital gains, so the amounts are taxed at the investor level and the trust itself is not taxable. Unlike a partnership, a trust cannot allocate its losses to investors. However, losses incurred by the trust can be carried forward to offset taxable income in future years, subject to certain limitations.

Investment trusts are generally set up as “unit trusts” from a Canadian tax perspective. A mutual fund trust is a unit trust that meets additional conditions. Specifically, to qualify as a mutual fund trust, it must maintain at least 150 unitholders that meet certain minimum unit holding requirements. Mutual fund trusts enjoy tax benefits not available to unit trusts. As an example, tax-exempt retirement plans can invest in mutual fund trusts without being subject to penalty taxes. In addition, mutual fund trusts are exempted from many penalty taxes and adverse rules that may apply to unit trusts. Furthermore, these mutual fund trusts may also reduce their capital gain distributions to investors using a mechanism called the capital gains refund and can shield remaining unitholders from immediate taxation on realized capital gains due to liquidating investments to fund redemptions. Both unit trusts and mutual fund trusts can use other mechanisms to allocate capital gains resulting from redemptions.

Income and capital gain distributions made by mutual fund trusts and unit trusts to Canadian investors retain their character, leading to different tax rates based on the type of income. For non-resident investors, income distributions and capital gain distributions from these trusts are generally subject to Canadian withholding tax at a rate of 25% or 12.5%, unless a treaty relief applies. However, capital gain distributions from mutual fund trusts to non-resident investors are usually exempt from withholding tax, making mutual fund trusts more tax-efficient for non-Canadian investors.

Canadian-resident trusts are required to file annual income tax returns and information returns with the Canadian taxation authorities. Trusts are responsible for providing tax slips to both Canadian and non-Canadian investors and for reporting those tax slips to the Canada Revenue Agency.

Mutual fund corporations – A previously popular investment vehicle

A Canadian mutual fund corporation is typically an umbrella entity with multiple classes of shares representing distinct investment strategies. Mutual fund corporations are taxable entities subject to Canadian income tax on interest and foreign-sourced income. Provided the corporation makes sufficient distributions, Canadian dividend income and capital gains dividends are usually taxed in the investors’ hands and not at the corporate level. Unlike trusts and partnerships, mutual fund corporations cannot allocate other types of income and are thus less tax-efficient vehicles given the potential for tax leakage.

At one time, mutual fund corporations offered investors the opportunity to switch between classes on a tax-deferred basis which made them attractive investment vehicles. This led to large fund managers establishing mutual fund corporations in Canada, with an array of 30 to 100 different classes. When Canada permitted investors to switch classes on a tax-deferred basis, Canadian mutual fund corporations experienced exponential growth despite the potential tax leakage with certain investment income.

In 2017 Canadian tax rules were altered to prevent tax-free class switches. This eliminated the main tax advantage of mutual fund corporations over mutual fund trusts. Since then, many fund managers have shifted from mutual fund corporation structures to trusts.

Canadian mutual fund corporations must file annual income tax returns and issue tax slips. Corporate tax filings are generally more complex and onerous compared to trust tax filings, resulting in higher administrative and compliance costs for corporate structures.

Conclusion

Canada promotes the attractiveness of its investment funds industry by providing tax efficiency through a diverse range of mechanisms. Partnerships are attractive because of their flow-through and non-taxable status. Trust funds are taxable but are still effective flow-through vehicles that can allocate income to investors for taxation. Recent tax rule changes have limited the attractiveness of mutual fund corporations, making them the least favored vehicle, and leading many fund managers to adopt trust structures instead.

Therefore, monitoring regulatory changes in Canada is crucial for fund managers seeking to navigate the evolving tax landscape effectively.