Mutual Fund Trusts vs. Corporations

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1 Mutual Fund Trusts vs. Corporations May 2015 Most mutual funds in Canada are structured as mutual fund trusts. However, a number of managers offer funds under the umbrella of a mutual fund corporation. These structures are more commonly known as corporate class funds. Dimensional s investment process continually balances the tradeoffs between competing premiums, diversification, and costs. Although the structural choice between a trust and a corporation is outside the scope of the investment process, a mutual fund s structure may impact the net return to investors. Consequently, Dimensional has carefully considered the tradeoffs between these two alternatives. This paper describes some of these tradeoffs, explains why trusts are the preferred structure for Dimensional s Canadian-domiciled mutual funds, and highlights some areas where the costs and benefits of corporate class funds are often misconstrued. COMPARING THE STRUCTURES A mutual fund corporation is a single legal entity for tax purposes, with classes tracking the portfolios of securities that make up the various funds. Each fund is a class of shares in the corporation attributable to a portfolio of securities, and the tax positions and expenses of all funds When evaluating mutual fund structures, advisors should carefully weigh costs and benefits to determine which structure may best serve clients. under the corporate umbrella are rolled up and included in computing the corporation s overall taxable income. As a result, when determining the corporation s overall tax position, one fund s attributes (e.g., capital losses, fees in excess of taxable income, etc.) may be used to offset taxable income in the other funds. The board then declares and pays capital gains or ordinary dividends to shareholders of the various funds in a manner deemed fair and reasonable. Mutual fund trusts, on the other hand, are separate legal entities in which taxable income is determined on a fund by fund basis. This method is equitable, transparent, and does not rely on a board to determine what is fair and reasonable.

2 DIMENSIONAL FUND ADVISORS 2 THE MYTH OF TAX-FREE REBALANCING One of the primary benefits touted by managers of corporate class funds is that investors can rebalance tax free due to a specific tax act provision that deems switches between funds under the same corporate umbrella to not be a disposition of shares in the corporation. At best, the result of this provision is a tax deferral, not a tax savings, because tax on capital gains will be paid eventually, when shares of the corporation are sold. 1 Shares are considered sold when the investor redeems fund holdings rather than switching funds within the corporation. A tax deferral offers the ability to harness the time value of money on the amount deferred. Despite this benefit, a tax deferral is still worth significantly less than a tax savings. Moreover, when all sources of capital gains are considered as a whole, there may not even be a tax deferral. Mutual fund investors realize capital gains in two ways: (1) when the manager sells appreciated securities held in the fund and the related capital gains are distributed by way of capital gains dividends or capital gains distributions, and (2) when investors sell their appreciated fund shares or units. Mutual funds can rely on the capital gain refund mechanism (CGRM) to minimize the potential for double taxation that could arise from the combined effect of these two sources of capital gains. The rather complicated formula 2 aims to reduce the amount of capital gain that must be distributed from the fund (i.e., the first source) by the aggregate capital gains realized by all investors who sold their holdings of the fund itself (i.e., the second source). Exhibits 1 and 2 illustrate how these capital gain sources and the CGRM apply to mutual fund trusts and corporations. While both structures can use the CGRM, no capital gains refund is available when investors switch between funds under the same corporate umbrella. Consequently, the amount of capital gain that must be distributed from a mutual fund corporation increases by roughly the amount of capital gain that is otherwise deferred by tax-free switching between funds under the same corporate umbrella. 3 Ultimately, the aggregate amount of capital gain is more or less the same between the two structures. The difference EXHIBIT 1: CAPITAL GAINS TAX TREATMENT MUTUAL FUND TRUST FUND A Switches Taxable event CGRM applies FUND B Capital Gain Distribution Reduced by CGRM from switches and other redemptions from the fund. Capital Gain Distribution Reduced by CGRM from switches and other redemptions from the fund. Fund A Fund B

3 DIMENSIONAL FUND ADVISORS 3 EXHIBIT 2: CAPITAL GAINS TAX TREATMENT MUTUAL FUND CORPORATION FUND A Switches Non-taxable event CGRM does not apply FUND B Mutual Fund Corporation Capital Gain Dividend CGRM applies only to redemptions that are taxable events (i.e., a redemption of shares of the corporation), not to switches that are not taxable events. Allocation to Fund A and Fund B determined by the board of directors. Fund A Fund B When a mutual fund corporation rebalance into another fund under the same corporate umbrella, they defer realizing a capital gain on the sale of appreciated shares of the fund, but the CGRM does not reduce the capital gain dividends the board declares on shares of various funds within the corporation. may be in who gets the capital gain and how. For example, Exhibit 3 outlines the amount of CGRM available to each Dimensional fund as a percentage of average net assets in Hypothetically, the capital gain distributions from these funds would have increased by this amount had they been structured as share classes of the same corporation and had all of the redemptions been the result of tax-free switching into other funds. LET IT FLOW All types of income including interest, derivative income, foreign dividends, Canadian dividends, and capital gains flow through a mutual fund trust. In contrast, only capital gains and Canadian dividends flow through a mutual fund corporation. Capital gains flow through the corporation as a capital gains dividend that is taxed as such in the hands of shareholders, while Canadian dividends flow through the corporation as an ordinary dividend. Other types of income, such as interest, foreign dividends, and derivative income, are taxable in the corporation unless otherwise sheltered by deductible expenses or losses. The tax reduces the net asset value (NAV) by the amount of tax paid. A lower NAV is less visible than a mutual fund trust income distribution reported on a T3 for inclusion on the unitholder s tax return. The NAV reduction is also more opaque because the board of directors does not have to disclose the methodology used to allocate any tax payable within the corporation against the NAV of the various funds.

4 DIMENSIONAL FUND ADVISORS 4 EXHIBIT 3: CAPITAL GAIN REFUND MECHANISM (CGRM) FOR DIMENSIONAL FUNDS IN 2014 Fund CGRM (% of Average Net Assets) DFA Canadian Core Equity Fund 0.74% DFA Canadian Vector Equity Fund 0.00% DFA US Core Equity Fund 4.35% DFA US Vector Equity Fund 5.31% DFA International Core Equity Fund 1.03% DFA International Vector Equity Fund 0.36% DFA Five-Year Global Fixed Income Fund 0.67% DFA Global Real Estate Securities Fund 2.76% DFA Global Investment Grade Fixed Income Fund 0.69% Source: Dimensional Fund Advisors. Paying tax on net income within the corporation may be more costly than receiving a distribution of net income from a trust since the latter reduces your unrealized gain on units of the fund by the amount of income distributed. On the other hand, tax payable within the corporation reduces the NAV of the fund to which it is allocated, and this reduction in NAV only reduces the unrealized gain on shares of the fund by the amount of tax paid on the net income. In effect, the after-tax amount of income in the corporation will increase the unrealized gain 4 on shares of the fund compared to how the income would flow through a trust. This leads to the potential for double taxation when the increased capital gain on the fund is realized upon redemption of shares of the corporation. Exhibits 4 and 5 highlight the difference in tax treatment for a trust vs. corporation, assuming $10 of income earned from interest, foreign dividends, or other sources. The calculations are net of expenses and assume only one fund. In this example, an investor with a marginal tax rate below 55% would be better off with the trust structure, 5 and the corporation would be particularly disadvantageous to non-taxable investors, such as RRSPs and other registered plans. The benefit of a trust increases as the spread widens EXHIBIT 4: TAX IMPACT ILLUSTRATION MUTUAL FUND TRUST Mutual Fund Trust Income from securities held by the fund = $10 Distribution of income to investors (i.e., T3) Tax paid within the fund (i.e., reduction in NAV) Unrealized gains on units of the fund $10 $0 Unrealized gain on units of the fund decreases by $10 income distribution, therefore, no double taxation $4.60 of income tax payable at 46% Effective Tax Rate: $4.60 $10 = 46%

5 DIMENSIONAL FUND ADVISORS 5 EXHIBIT 5: TAX IMPACT ILLUSTRATION MUTUAL FUND CORPORATION Mutual Fund Corporation Income from securities held by the fund = $10 Distribution of income to investors Tax paid within the fund (i.e., reduction in NAV) Unrealized gains on shares of the fund $0 $4.20 of tax payable at 42% Unrealized gain on shares of the fund decreases by $4.20 reduction in NAV Effective Tax Rate: ($ $1.33) $10 = 55.3% $1.33 tax payable at 23% on additional capital gain of $5.80 ($10.00 $4.20) upon redemption of shares of the corporation between the investor s marginal tax rate and effective tax rate (i.e., combining the two levels of tax) of the corporate structure. The benefit of a trust is moderated when the second level of tax from the increased capital gain of the corporate structure is deferred. It is very common for corporate class funds to be structured as a fund-of-funds whereby the investments made by the corporation are in units of the funds offered by the manager in trust form. For investors with low or zero marginal tax rates, this approach gives them the option to invest in the trust version of the fund. But the fund-of-funds approach also adds an additional layer of cost to the fund complex. In an effort to ensure a corporation does not have net income, many fund managers apply one or both of the following strategies: They try to reduce the amount of interest, foreign dividends, and other income generated by the underlying investments, or they charge fees and expenses that are high enough to deduct against all of the income from the funds under the corporate umbrella. The corporate structure is disadvantageous for Dimensional because low fees, combined with the foreign dividend and interest income-generating nature of our broadly diversified holdings, would almost always result in the corporation paying tax on its net income. Higher management expense ratios (MER), such as those typically found in the Canadian mutual funds, would offset some, if not all, of this income, but the reduction in tax would obviously be worth less than the increase in cost. GIVING CREDIT Dividends received from non-canadian companies are usually subject to foreign withholding taxes because most countries require tax to be withheld from dividend payments to foreign investors and remitted to the local government. Although withholding taxes vary by country, 15% is the most common rate. Taxable mutual fund trusts generally receive a credit 6 for the amount of foreign taxes paid (up to 15% of dividends), so the tax paid to foreign governments is substantially, if not completely, offset by a reduction in Canadian taxes. 7

6 DIMENSIONAL FUND ADVISORS 6 A little-known disadvantage of mutual fund corporations is they cannot make designations to shareholders with respect to foreign taxes paid, which would allow the shareholders to claim foreign tax credits. Mutual fund corporations can deduct the foreign taxes paid from the corporation s taxable income. 8 However, the benefit of a tax deduction is the amount deducted multiplied by the marginal tax rate, whereas the benefit of a tax credit is generally the full amount of the credit. Exhibit 6 shows foreign taxes paid as a percentage of average net assets in Dimensional s US and International equity funds for 2014 and compares the value of an investor claiming the amounts as a credit 9 and the value of a deduction from the corporation s taxable income. 10 The difference would have been 15 to 23 basis points of additional cost to taxable investors if the funds were corporations deducting foreign taxes instead of trusts in which investors can claim foreign tax credits. This assumes the corporation has taxable income, which it may not have for reasons explained in the section Let It Flow. In that case, the deduction has no value, and the difference would have equaled the full amount of the foreign tax credit (i.e., 25 to 40 basis points). This additional cost is often overlooked because investors feel the impact of lost tax credits when they file a tax return but may not realize they lost tax credits that would have been applied if they had invested in a mutual fund trust. EXHIBIT 6: VALUE OF A FOREIGN TAX CREDIT VS. TAX DEDUCTION IN DIMENSIONAL FUNDS, 2014 (PERCENT OF NET ASSETS) Fund Foreign Taxes Paid Value of Foreign Tax Credit Value of Foreign Tax Deduction* Difference between Foreign Tax Credit and Deduction DFA US Core Equity Fund 0.26% 0.26% 0.11% 0.15% DFA US Vector Equity Fund 0.25% 0.25% 0.11% 0.15% DFA International Core Equity Fund 0.40% 0.40% 0.17% 0.23% DFA International Vector Equity Fund 0.38% 0.38% 0.16% 0.22% *Deduction x Marginal Tax Rate. Assumes a 42% marginal tax rate. Source: Dimensional Fund Advisors. SUMMARY Mutual fund trusts are Dimensional s preferred option for the following reasons: 1. Low fees and expenses compared to the interest and foreign dividends expected from our investment strategies would result in a corporation paying tax on the remaining net income. 2. Deducting foreign taxes paid from a corporation s taxable income instead of enabling a trust to claim foreign tax credits would cost taxable US and International equity funds approximately basis points, depending on the dividend yield and the extent to which the corporation would have had taxable income. 3. The highly touted benefit of tax-free rebalancing is dubious when considering how the capital gain refund mechanism is applied. The aggregate amount of capital gain is more or less the same between the two structures. The difference may be how and to whom the capital gain is applied. 4. The accounting method for trusts is equitable, transparent, and does not rely on a board to determine what is fair and reasonable without disclosure. Corporate class funds have been heavily promoted in recent years, although proponents have emphasized the potential benefit without much regard for the potential cost. When evaluating mutual fund structures, advisors should carefully weigh costs and benefits to determine which structure may best serve clients.

7 DIMENSIONAL FUND ADVISORS 7 1. Assuming shares of the fund have appreciated prior to being sold. 2. CGRM formula: A/B x (C + D), where A = total of all amounts paid by the corporation in the year on the redemption of shares of its capital stock, B = total of the fair market value at the end of the year of all the issued shares of its capital stock and the amount determined for A in respect of the corporation for the year, C = 100/14 of the corporation refundable capital gains tax on hand at the end of the year, and D = amount determined by the following formula: D = (K + L) (M + N), where K = amount of the fair market value at the end of the year of all the issued shares of the corporation capital stock, L = total of all amounts each of which is the amount of any debt owing by the corporation, or of any other obligation of the corporation to pay an amount, that was outstanding at that time, M = total of the cost amounts to the corporation at that time of all its properties, and N = amount of any money of the corporation on hand at that time. 3. A CGRM balance cannot be carried forward, so this assumes the full amount of CGRM could have been used (i.e., net realized capitals gains CGRM) had the switches been considered a redemption (i.e., taxable event) like they are for trusts. It is prudent for managers to monitor their CGRM balances compared to realized capital gains and to harvest gains, in effect increasing the cost basis, prior to year-end so that the CGRM can be fully utilized. 4. Or reduce the unrealized loss. 5. Assuming a redemption of shares of the corporation in the current year. 6. Provided the fund makes the appropriate designation. 7. Withholding tax rates vary by country (i.e., some are more and some are less than the typical 15% rate). A maximum foreign tax credit of 15% is applied at the portfolio level, not by country, but if the weighted average withholding tax rate exceeds 15%, then the full amount would not be recovered and some withholding tax would apply. 8. A mutual fund corporation can claim a foreign tax credit or take a deduction, but most take the deduction because calculating the tax credit has the administrative burden of obtaining detailed information on a country-by-country basis. 9. Assumes the credit is the amount of the investor s tax payable. 10. The deduction (or credit, if applicable) only has value to the extent that the corporation has taxable income and many do not for reasons explained under Let it Flow. If the corporation has no taxable income then the deduction has no value. FOR ADVISOR AND DEALER USE ONLY. NOT FOR PUBLIC USE. DO NOT DISTRIBUTE. These materials are by Dimensional Fund Advisors Canada ULC (DFA Canada) for educational purposes only and should not be construed as investment advice or an offer of any security for sale. The material in this publication is provided solely as background information for registered investment advisors and dealers and is not intended for public use. This material is not a sales communication and should not be distributed to clients of DFA Canada, to unitholders of mutual funds managed by DFA Canada or to potential mutual funds managed by DFA Canada. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.

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