Segregated Funds or Mutual Funds – Can You Tell the Difference?

There are several taxation issues of which you should be aware. Although investments in segregated funds are similar to an investment in mutual fund trusts (mutual fund corporations are also discussed in less detail), there are some tax provisions that are quite different. Since most of the differences relate to non-registered funds, registered funds will not be discussed here.

Segregated funds

Access to segregated funds is made via individual variable annuity contracts. For income tax purposes, the segregated funds are considered to be inter vivos (living) trusts. The policyowners are deemed to be beneficiaries of the trust. Trusts are inter vivos trusts and must pay taxes at the highest tax rates. They are permitted to deduct all income paid to beneficiaries from their taxable income. As a result, insurance companies allocate all the segregated fund income on a time-weighted basis (i.e. for the actual time the policyowner had an interest in the fund). Since income can be allocated without actually being distributed to owners, there is no post-allocation drop in the fund price. The fund price reflects the allocation. The policyowner’s adjusted cost base is increased by the amount of income allocated to the contract.

Segregated funds are flow-through vehicles so all income allocated retains its character.

For example, Canadian dividends allocated by the segregated fund are taxed as Canadian dividends in the hands of the beneficiary. There are two ways a policyowner can incur capital gains or losses. If the segregated fund manager sells a stock, bond or other security the fund may have a capital gain or loss. Insurance companies allocate this gain or loss to the policyowners. The second way is if the policyowner sells or otherwise disposes of units in the segregated fund for an amount different from the policyowner’s adjusted cost base. Insurance companies report both of these gains or losses on a T3 (and a Relevé 16 to Quebec residents) tax slip. The amounts on the policyowner’s year-end statement may not match with the tax slip. This is because the tax slip only reports realized gains/losses. The unit value reflects all unrealized gains or losses on investments which have not yet been sold.

Mutual fund trusts / Corporations Trusts

Mutual fund trusts are a pooled investment and are inter vivos trusts. Income from the trust is flowed through to the unit owners so that the trust does not have to pay taxes at the highest tax rates. The income of the fund is paid to the unit owner and reported on a T3 (Relevé 16 in Quebec) tax slip. Fund managers distribute income and capital gains, usually at year-end, to the owners on record at the date of distribution. Mutual fund trusts are flow-through entities so distributions retain their character. Since income is actually being distributed to owners, there is a corresponding drop in the unit price. Unless clients reinvest the distributions, their adjusted cost base remains the same.

There are two ways an owner can incur capital gains. If the fund manager sells a stock, bond or other security, the fund may have a capital gain or loss. Fund managers will distribute a proportion of a gain to the owner and report it on a T3 (and a Relevé 16 to Quebec residents) tax slip. Unlike segregated funds, a capital loss cannot be flowed through to the owners. Rather, net capital losses of the fund must be carried forward to be applied to future capital gains in the fund. The amounts on the owner’s year-end statement may not match with the tax slip. This is because the tax slip only reports realized gains/losses. The unit value reflects all unrealized gains or losses on investments which have not yet been sold. The second way to incur capital gains or losses is if the owner sells units in a fund for an amount different from the owner’s adjusted cost base. Gains or losses from redemption of units must be computed and reported by the unitholder. In order to compute the amount of the gain or loss, th unitholder must calculate the adjusted cost base for tax purposes.

The calculations can be done using information on client statements and possibly on form T5008. Most mutual fund companies do not provide form T5008 to clients when they sell or otherwise dispose of units. The fund company electronically reports all dispositions of units to the Canada Customs and Revenue Agency.

Mutual fund corporations

Mutual fund corporations pay tax as corporations and investors in them are shareholders.

Although the assets and liabilities attributable to each class of the mutual fund corporation are tracked separately, the corporation must compute its earnings for tax purposes as a single entity. Mutual fund corporations provide limited flow-through. In general, a mutual fund corporation will not pay tax on Canadian dividends that it receives or on net realized capital gains because it will pay enough ordinary dividends and capital gains dividends to its investors to eliminate its tax liability on these types of income. In effect, these types of income are flowed through to investors and treated as if they earned them directly. Other types of income (such as interest and foreign dividends) will be subject to tax in the corporation at full corporate rates and the after tax income can be paid in the form of a dividend to shareholders. The amount of dividends and capital gains dividends are reported on a T5 (and a Relevé 3 to Quebec residents).

Any mutual fund corporation with multi-class structure must compute its earnings for tax purposes as a single entity. As a result, the dividends paid to an investor in a mutual fund corporation will differ from the distributions that would be paid to an investor of a mutual fund trust that made the same investments. For example, if a particular class of a shares of a mutual fund corporation has a net loss or net realized capital loss, that net loss or net realized capital loss will be applied to reduce the income and net realized capital gains of the corporation as a whole.

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Death under non-registered plans

Different rules apply to non-registered segregated funds and non-registered mutual funds when the owner or annuitant dies. Generally, segregated funds are more complex because there is an owner, an annuitant (the person whose life is insured) and a beneficiary, whereas with mutual funds, you only have an owner. Knowing the unique features of both segregated funds and mutual funds can help you determine which clients would benefit most from which product.

Segregated fund contracts reduce probate fees

The death benefit of a segregated fund annuity passes directly to the named beneficiary

and is not included as part of the deceased’s estate for probate purposes. On the otherhand, the value of the mutual fund account at the date of death is included in the deceased’s estate for probate purposes. (Probate is not a consideration in Quebec.)

Income tax rules

Segregated funds

For income tax purposes, the death of an annuitant results in a disposition. When theannuitant of a segregated fund dies, the insurance company pays the death benefit to the named beneficiary and the contract ends. This is a disposition to the owner on the annuitant’s death and the owner must include any capital gains/losses that arise from this disposition in his income tax return. If there is a single annuitant and that annuitant dies, the contract ends, so there is no ability to roll the contract over to a surviving spouse or common-law partner (as defined by the Income Tax Act [ITA]). If the owner of the segregated fund, who is not the annuitant dies, the policy remains in effect and ownership passes to the new owner as outlined in the deceased’s will. In this situation, the ITA deems that the deceased owner disposed of the annuity at fair market value and as a result any capital gains or losses must be reported in the final tax return of the deceased owner.

However, the ownership can be transferred tax-deferred to the surviving spouse or common-law partner, provided both parties were residents of Canada on the date of death.

Mutual funds

If a mutual fund owner dies (remember, there is no annuitant), the account remains in effect and ownership passes to the new owner as designated in the will. The ITA deems that a disposition occurs at fair market value on the date of death of the owner. As a result, the amount of any capital gain or loss arising from the deemed disposition must be reported in the final tax return of the deceased owner, except if the ownership is transferred to the deceased’s surviving spouse or common-law partner. Provided both parties were residents of Canada for income tax purposes at the time of death the transfer takes place at the adjusted cost base of the mutual fund units for both the disposition by the deceased owner and the acquisition by the spouse or common-law partner. The result is that the investment passes to the spouse or common-law partner with no immediate tax consequences.

Withdrawal fees generally only apply to mutual funds

Fees are also a consideration at death. For most segregated fund contracts, any backend fees are waived when the annuitant dies. The proceeds are paid out as a death benefit, rather than as a voluntary withdrawal. This is because the contract ends at the death of the annuitant. But a mutual-fund owner’s estate usually must pay any applicable withdrawal fees if it withdraws money to pay estate beneficiaries. Some mutual fund companies may waive these fees if the money stays with them in another account.

The information contained in this article is intended to provide general guidelines only. The application and impact of the law can vary widely from case to case based on the specific or unique facts involved. Accordingly, the information in this article is not intended to serve as legal, accounting or tax advice. Users are encouraged to consult with their professional advisers for advice concerning specific matters before making a decision.

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