By Scott Ronalds
In our discussions with investors, we’ve found there are a few misconceptions surrounding the deductibility of investment management fees. The most common misunderstanding is that mutual fund investors are at a disadvantage (from a tax standpoint) to investors who hire an investment counselor, as the latter receive an invoice for their fees directly which can be used as a deduction on their tax return.
The fact is, there is no advantage to investors whether the management fee is charged within a fund or billed outside of a private investment account, except in rare circumstances.
The structure of most mutual funds is such that they allocate all realized capital gains, dividends and interest income to unitholders in the form of distributions. This income represents a taxable liability and is reported to investors each year on the tax slips (T3’s) they receive from their fund company. Importantly, however, the management fees and other expenses that the fund company charges are deducted from this income prior to the distributions being paid out. In other words, the fees are used to offset any taxable income, thereby reducing the amount of the distributions. Consider the following example:
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XYZ Fund has $50 million in assets under management and charges a management expense ratio (MER) of 1.5%.
- There are 5 million units of the fund outstanding ($10/unit).
- The fund earns $1 million in interest income and $1 million in realized capital gains. It therefore has $2 million that it needs to distribute to unitholders.
- The fund company collects a fee of $750,000 (1.5% of $50 million).
- This amount is deducted from the $2 million in income generated within the fund, resulting in a net amount to be distributed of $1.25 million, or $0.25/unit, as opposed to $0.40/unit before the deduction. The deduction is first applied against the interest income, as this is the least tax favourable form of income.
- While they cannot “see” the mechanics of the deduction, unitholders receive a lower distribution and their net taxable liability would be the same as if they collected the gross income from the portfolio, paid the fees directly, and claimed a deduction on their tax return.
To expand on this last point, assume a large investor held the same assets in a private account and paid an investment counselor the same fee for managing the portfolio. The investor would receive a fee invoice of $750,000, which she could use as a direct deduction against the income generated by her portfolio ($2 million), but she would still have to pay tax on the balance of $1.25 million. In the end, she would be no better off from a tax standpoint than investors in the mutual fund.
Where a benefit may arise for the private account scenario is when the management fees exceed the income generated by the portfolio. In such a circumstance, the individual could deduct the fees against the full amount of the investment income and apply any excess amount (loss) against other sources of income. Under the mutual fund structure, the loss cannot be distributed to investors to offset other forms of income, but is instead carried forward by the fund to be applied to investment income generated in a future year(s). As long as the individual continues to hold the fund, they will eventually receive the benefit of the carried forward loss.
The second misconception that we’ve run into is the belief that fees incurred with respect to the management of registered accounts (e.g., RRSPs, RRIFs, TFSAs) can be deducted for income tax purposes. This is not the case. Canada Revenue Agency (CRA) does not permit the deduction of fees related to registered accounts. So while individuals who use investment counselors may receive a fee invoice for these accounts, it is of no use to them from a tax perspective, although it is certainly beneficial from a fee transparency standpoint. But that’s another topic.