ETFs are generally more tax-efficient than mutual funds, but there is one area where they’re at a disadvantage. Investors who use non-registered accounts can take advantage of corporate class mutual funds, which can reduce or defer taxes. Well, now the country’s newest ETF provider, Purpose Investments, has launched the first corporate class ETFs in Canada.
It’s little surprise the innovation comes from Purpose. The company’s CEO is Som Seif, who founded Claymore Investments back in 2005. Claymore was an ETF pioneer: they were the first to offer pre-authorized cash contributions (PACCs), dividend reinvestment plans (DRIPs) and systematic withdrawal plans (SWPs). Then they teamed up with Scotia iTRADE to offer the first commission-free ETF program. Seif exited Claymore after they were bought by BlackRock in 2012, and it was only a matter of time before he got behind a new project that shook up the ETF business.
Before looking at the new ETFs, let’s review how corporate class funds work. Most mutual funds are structured as trusts. Income flows through to investors and retains its character: in other words, if you receive Canadian dividends, foreign dividends, interest or capital gains, you pay tax on that income as if you had earned it from stocks and bonds you held directly. And any time you sell units of a mutual fund trust for more than you paid, you’ll incur a taxable capital gain.
Corporate class mutual funds are not trusts: they’re corporations. A single corporation is set up to hold several funds, each structured as a different share class. For example, a single mutual fund corporation might include a Canadian equity fund, a US equity fund and a bond fund. If you switch between an equity fund and the bond fund—while rebalancing your portfolio, for example—no actual sale has taken place. This allows an investor to defer capital gains until the shares are eventually sold. Unlike trusts, corporate class funds can’t pass along all their income to shareholders, so they also tend to have fewer taxable distributions.
To use an analogy, think of mutual fund trusts as individual houses. In order to move, you need to sell one house and buy another. Corporate class funds are more like a single house with several rooms: you can move from one room to the other without selling anything.
Flipping the switch
Purpose Investments currently has five funds under its corporate class umbrella:
Purpose Total Return Bond Fund (PBD)
Purpose Core Dividend Fund (PDF)
Purpose Monthly Income Fund (PIN)
Purpose Diversified Real Asset Fund (PRA)
Purpose Tactical Hedged Equity Fund (PHE)
If you hold more than one of these ETFs, you can move from one to another without placing orders to sell and buy. Instead, you request a switch. Currently you can do this once a week, with the cut-off being 4 pm every Tuesday. On Wednesday, shares of the old ETF will be exchanged for shares of the new ETF according to a “switch ratio” that reflects their relative price difference. Only whole shares can be switched, and any fractional amount will be paid in cash.
Now the big question: how exactly do you accomplish this switch? If you use an advisor, you can let him or her worry about the details. But if you’re a do-it-yourselfer, you need to pick up the phone and call your brokerage, since there is no way you can make the switch online.
At this point it’s not clear how easy this will be: in a recent discussion with Som Seif, he explained the switch is a type of “reorganization,” similar to what you’d do if you held a convertible bond and wanted to convert it to the company’s stock. Customer service reps will be familiar with this procedure in general, but they won’t have any experience with corporate class ETFs. Purpose Investments has given the brokerages a heads-up, but it’s quite possible you’ll get someone on the phone who has no clue what you’re talking about.
Claymore ran into the same issues when it introduced its PACC, DRIP and SWP plans several years ago. There is no technical or regulatory reason why these transactions can’t be done. But in practice, brokerages are slow to embrace these innovations, since they have little to gain: it involves more work and less revenue from trading commissions. Some brokerages still don’t support PACCs and SWPs, which helps explain why BlackRock grandfathered them for the old Claymore ETFs but has not extended them to the rest of the iShares family.
Will be watching to see if the corporate class structure catches on with ETF investors, and whether other providers will consider following suit.
I was wondering if you could talk a little bit about how PBD compares with CAB in terms of tax savings, notwithstanding the changes in legislation that will effect CAB. Does this fund get back what will be lost in tax savings with CAB?
Thanks for the explanation of corporate class ETFs. I’m still trying to understand the tax implications. If all investors collectively make a net switch from a stock fund to a bond fund, presumably the corporation has to sell some stocks to produce a capital gain (assuming the stocks have risen over time. Will the corporation pay tax on this or will they distribute the capital gain to investors? Will it look like a capital gain to investors or will it look like a dividend? There’s obviously still a lot I don’t understand about corporate structures.
I’ve been waiting for something like this… unfortunately I can’t see myself using any of these funds. For example the real asset fund sounds like a broader complement to the traditional REITs but it sounds like it is actively managed. I’m not sure if the large cash holdings are an investment decision or just a result of the fund being new. I’m not much interested in dividend or income funds, and I expect it will be a long time before I hold any bonds in a taxable account. On this blog I don’t think I need to comment on the tactical hedged equity fund :)
@Dan: Would one of these be preferable to HXT?
@Dave and Que: At this point I have only looked at the corporate class structure and how one would make the switch between different share classes. I haven’t researched the investment strategies and can’t comment on them in any meaningful way. Overall, though, I would say that none of these are plain-vanilla ETFs, so choosing one of them solely for tax purposes would be a mistake. Make sure you understand the strategy first.
To expand on Dave’s questions, is there only a tax savings if one holds more than one of these funds, because you can move between assets classes without selling/trigger a gain? As I understand your article, if you were to only hold one fund, say PDB, you would still be receiving fully taxed interest income similar to holding XBB. It would be like having a house with only one room? CAB is more like owning a waterfront mansion, but telling CRA you only have a 1 bedroom condo.
@sleepydoc: Love the CAB analogy. :) You raise a good point. The tax benefit with corporate class funds primarily comes from the ability to switch between share classes without incurring capital gains. So if you hold only one of the funds you’ve defeated the main purpose.
The distributions of corporate class funds are treated differently from mutual fund trusts. Corporations cannot distribute interest income to shareholders, and according to PDB’s web page the distributions are treated as either Canadian dividends or capital gains. Whether this results in higher after-tax returns, however, isn’t clear. The interest income would have to be taxed at the corporate level, so there’s no free lunch. I don’t think we’ll know the answer until the fund has a year or two under its belt.
Dan – I want to say thanks for all the quality information you pass on to us – I have a question which I want to ask which may be of some general interest to other readers as well as myself – it doesn’t specifically relate to today’s post – but a few months ago you explained in a posting how tax inefficient it is to hold premium bond etf’s in a taxable account and why – it was very beneficial to me as I was holding XSB – CBO – CLF in my taxable account – totally oblivious to the after tax consequences – and I was able to initiate my exit from them – for which I’m very grateful to you – so my question today is – would ZPR holding rate reset preferred shares also be subject to this type of tax inefficiency in a non-registered account – or is that situation only applicable to bond etf’s ? BMO ETFs website doesn’t provide yield-to-maturity for ZPR – which would give one some idea if there is a similar tax inefficiency – Thanks Dan
ETF market really getting crowded now! Analysis paralysis.. :)
Id watch this carefully before investing for tax purposes. Govt shut down income trusts in 2006 then derivative based structures earlier this year. They are sabre rattling targeting REIT structures now. Just sayin
@Jason: Government changes are always a possibility, but it’s important to appreciate that there’s no tax evasion going on here. The corporation is still paying tax on all of its income, and capital gains are typically just being deferred, not necessarily eliminated.
Just a generic comment on this and other recent posts – they seem to be making the Couch Potato philosophy much more complicated than it actually is! I am a convert to the CP because of this blog and Moneysense and books with a similar theme, and was attracted by its simplicity, but lately there is a lot of discussion about complicated things like tax loss selling, factor analysis and now this!
I do get that the core philosophy has not changed, and these really do not apply to me personally that much as I only use registered accounts. I also get that it is hard to keep coming up with good content for something that is simple! Finally, I get that these may be useful for others and that they are grateful for it! But for me, I think I will tune some of them out, and stick with my previous choices of simple, low cost ETFs, rebalanced first with the cash flows and then as needed annually.
@Mike D: Thanks for the comment. I am a huge fan of simplicity, and I hope readers won’t infer that if I write about new products or new research I am suggesting that you should all go out and act on it. I try to cover a mix of subjects from the basic to the advanced because different readers have different interests. There is only so much one can write about the basics, which are well known and well covered. But there’s nothing wrong with skipping over any posts you feel aren’t relevant to your situation.
CCP: I like to keep things simple, too, but really enjoy learning about more advanced topics and new products and research. There are a number of readers who have non registered accounts and a few that have Canadian controlled private corporate accounts. So please do keep the broad range of topics coming.
Great post DanB. The new Purpose offering is definitely unique and offers some good benefits. I thought it was worth offering a few comments.
On some of the finer points of mutual fund corporations, I offer a link below from an article of mine from a dozen years ago but we’ve posted an archived copy on our blog.
As the above article mentions, there is very good potential to effect better tax efficiency than would otherwise occur in a trust structure.
And as far as Purpose’s bond class, today it’s invested in – ironically – iShares bond ETFs. Perhaps that’s just to get started until it has more assets; I don’t know. But a mutual fund corporation cannot have too much fully taxable income generated inside of the corp without becoming tax inefficient. That’s why the derivative based funds proliferated through the 2000s.
Fund companies found that their corporate class funds investing in bonds and money market instruments directly were attracting too much money because there was too much interest income that could not be sufficiently absorbed by aggregate fees, expenses and non-capital losses. So the plain vanilla bond classes were hard-capped and derivative based versions were launched to provide a home to taxable bond money.
I have been unable to get response from TD Waterhouse on how they would be handling the switching between Purpose ETF’s . It seems to me that discount broker does not want to conflict with their advisor’s corporate class mutual fund business. Also I never received reply from Purpose Investments on whether they had discussed the issue of switching on TD Webbroker.
@Ben: Thanks for sharing. I suspected this kind of stuff would happen. It’s new ground for everyone and will take some time to work out. It would not be too surprising if some brokerages simply refused to do the switching. That did happen with the preauthorized contributions that Claymore launched several years ago. Clearly it doesn’t make sense to use these Purpose ETFs solely for the corporate class feature: make your decisions based on investment strategy and consider the corporate class feature a bonus.
I’m a newly independent consultant with a registered corporation. Over the past 6 months I’ve been reading over your blog and catching up on your podcast. I’m nearly ready to start up my couch potato portfolio on QT.
Recently a friend turned me onto the idea of using my corporation as a place to keep my savings and invest those savings through corporate class funds. I met with an investment adviser who came up with a flashy plan I expect was the result of plugging a few numbers into excel and voila, then I saw the funds they were offering. MERs as high as 2.7%. I was wondering if you’ve written any articles on this more recently or have any updated thoughts when it comes to corporate class ETFs? Is this something I could do on my own?
@Greg: Investing within a corporation creates an extra level of complexity, and in my experience many DIY investors find that it moves them outside their comfort zone. Corporate class ETFs are definitely not the solution, especially since Purpose is (as far as I am aware) the only provider in Canada that currently offers them. My colleague Justin Bender is working on a series of blogs about investing in a corp. You may find these helpful:
I appreciate the advice and will look for another solution. Thanks for the linked articles too, I understand my own corporate tax much better now. You’re really not saving much, just deferring the rest of the tax until you pull it out for personal use. I guess the advantage is that you can use the deferred amount towards a corporate investment portfolio until then.
I have a small account, way under PWL’s minimum thresholds (I think I read 300k to start). I’d like to get a good foundation plan in place. Any advice on where to start? In the mean time, I’ll keep combing through Justin’s site.
Looking forward to your next podcast!