The new capital gains inclusion rate requires investment funds to make an important decision.
Mutual funds and corporations — including ETFs — can pass on their capital gains to fund holders, but this year they must decide how to do it.
The fund industry “largely expected this type of election based on the recent change in inclusion rates,” said Grace Pereira, a partner at BLG LLP in Toronto. “People were hoping that (the government) would provide similar flexibility on how the transition year is treated as it has done before.”
Now, “everyone is asking, ‘Should we do detailed calculations in the context of the election?’” said Joseph Micallef, tax partner and national leader for financial services tax at KPMG Canada in Toronto.
The detailed calculations involve determining the exact capital gains incurred before June 25 (Period 1) and after that date (Period 2), and then disclosing and distributing the gains to fund holders on a period-by-period basis, in accordance with the information document accompanying the Ways and Means Notice filed on June 10.
Period 1 gains are subject to a 50% capital gains inclusion rate, and period 2 gains are subject to a two-thirds inclusion rate if the fund holder is an individual and has more than $250,000 in total capital gains for the year. (Fund holders that are corporations or trusts are not eligible for this threshold.)
Meanwhile, the election will recognize that the mutual fund’s basic capital gain was realized pro rata before and after June 25, based on the number of days in each period divided by the number of days in the tax year.
Because 2024 is a leap year, June 24 is the 176th day of the year and is 48% of a 366-day calendar year. Therefore, a calendar-tax-year mutual fund with a capital gain of $1,000 on December 31 would be considered to have realized a gain of $480 in Period 1 and $520 in Period 2 for purposes of distributing gains to fund shareholders.
The $480 gain would be subject to a 50% inclusion rate and the $520 gain would be subject to a two-thirds inclusion rate if the fund holder is an individual and has total capital gains exceeding $250,000 in a given year.
Investment funds that do not elect either option will be deemed to have realised capital gains after 24 June and will therefore be subject to the two-thirds inclusion rate in its entirety.
As Micallef explained, funds can choose the option that is more beneficial to their shareholders, but making the decision to carry out detailed calculations will require a cost-benefit analysis.
Micallef said KPMG recommends that retail-focused investment funds, which are more likely to be held in registered accounts and/or by individuals whose capital does not exceed the $250,000 threshold, should consider taking the plunge.
“We suggested that (the election) would be attractive to most of these types of funds and therefore much more cost-effective and easier to resolve, especially since (having two periods) is a one-time event,” Micallef said.
Mutual funds targeting institutional, high net worth and accredited investors may wish to carry out detailed calculations as fund holders are more likely to exceed the threshold.
“But if you think most of your investors (hold the fund) in tax-exempt accounts, which is not uncommon, then maybe (the detailed calculations) aren’t as important,” Micallef said. “So you really should do that analysis to make that determination.”
The detailed calculations will require a lot of work, he said, “and there will be some professional judgment on some of the interim calculations.” Micallef added that some calculations will not be possible until the bill includes them.
“Of course, as with most things in the mutual fund space, a lot will depend on operational issues and what is practically possible,” Pereira said. She noted that, for example, funds of funds will have to wait for calculations from their underlying funds before making their own calculations.
Still, “I think administrators are already trying to create systems that will give clients (and) funds access to information that will allow them to choose the best outcome,” she said.
Investment funds have time to decide between methods because the choice is required when the fund files its tax return. For investment fund trusts with a year-end of December 31, the deadline is March 31, for example.
“It’s not like they’re holding elections today and they’re committed to them,” Micallef said. There’s also no form available to do the counting, and “we probably won’t see it for a long time.”
Pereira said she will be keeping an eye out for all the relevant forms: “It would be great if that information came out as soon as possible because it’s not easy to move these big giants in terms of getting the systems up and running.”
Micallef suggested that fund producers use this time to determine which funds they offer are more likely to be held in tax-exempt accounts and by smaller retail clients.
Creators can also look at which funds have large capital loss carryovers (in which case the selection may make more sense) or large unrealized capital gains with low redemptions (in which case a detailed analysis may be cautious).
Other types of investment funds will have to make similar decisions.
“The tax treatment of mortgage investment companies and shareholders receiving capital gains dividends from mortgage investment companies will be similar to that applicable to investment fund companies,” we read in the information document.
In the case of segregated trusts, “a related segregated trust would be required to disclose deemed capital gains in relation to disposals of assets made in each period but would have the option to make a proportionate election, which is also available to commercial trusts,” the briefing paper reads.
The government has announced that a bill to change the capital gains tax rate will be presented at the end of July.
