Corporate class mutual funds: A smart tax play for your clients’ portfolios

This article is sponsored by Manulife Investment Management

Corporate class mutual funds may not get the same attention they once did, but their tax efficiency still makes them a savvy choice for investors in the know. While the elimination of the famed tax-deferred fund-switching benefit left some believing these funds had lost all of their appeal, John Natale, Head of Tax, Retirement and Estate Planning Services at Manulife Investment Management, argues otherwise. There are still compelling advantages that can boost after-tax returns for those managing non-registered investments.

At first glance, corporate class mutual funds might seem like just another option in the mutual fund lineup, but their unique structure - a mutual fund corporation is a single, taxable entity consisting of several classes of shares, with each class representing a different fund, offers an often-overlooked edge. “Think of it like having multiple investment choices housed under one corporate umbrella,” explains Natale. “You can take the expenses and capital losses of one fund and use them to reduce the income and capital gains of another.” This kind of tax flexibility isn’t just a convenience—it’s a significant advantage that can help reduce taxable distributions and defer capital gains.

Moreover, corporate class mutual funds avoid distributing some of the least tax-efficient types of income, like interest income or foreign dividends. As Natale points out, these funds can’t flow through such income onto investors under current tax laws, making them a more tax-friendly option. “If I could wave a magic wand and avoid any type of income,” Natale says, “interest and foreign dividends would top the list.” Instead, investors can only receive Canadian dividends, capital gains, or return of capital—income forms that benefit from more favorable tax treatment.

For advisors, understanding this structure is key to unlocking the benefits for their clients. The primary advantage lies in the way corporate class funds consolidate tax attributes, creating opportunities to reduce taxable distributions and improve after-tax returns.

Key tax perks: The two big benefits

Natale argues that corporate class mutual funds still offer two primary tax advantages that can make a meaningful impact on a client’s investment strategy:

1. Pooling of expenses and capital losses: In a corporate class setup, the ability to share expenses and capital losses across multiple funds can reduce taxable income at the corporate level. “With mutual fund trusts, each fund is its own taxable entity—any unused losses have to be carried forward,” says Natale. “But in a corporate class structure, expenses and capital losses from one fund can offset income and capital gains from another. It’s a way to minimize taxable distributions, and that's always a good thing for clients looking to keep more of what they earn.”
    
2. Avoiding interest and foreign dividend distributions: Another crucial benefit is how corporate class mutual funds handle income types that would otherwise be taxed at higher rates. Unlike mutual fund trusts, corporate class mutual funds can’t distribute interest income or foreign dividends, which are less tax-efficient. Instead, they only distribute Canadian dividends, capital gains, or return of capital. “The structure ensures you’ll never see interest income or foreign dividends on your tax slip with corporate class funds,” Natale points out. “That’s important because those are the two least tax-efficient types of income, and avoiding them can make a big difference in the tax bill.”

Advisors should also think of corporate class funds as a tool for converting interest income and foreign dividends (collectively known as “bad” income), into capital gains. The receipt of this “bad” income will increase the net asset value of the fund eventually resulting in a capital gain when the fund is sold. This results in you realizing tax-efficient capital gains, which are deferred until you sell, instead of earning interest or foreign dividends which would have been taxable immediately if received through a mutual fund trust or directly as an investor. However, the tax efficiency of this strategy depends on the mutual fund corporation having sufficient pooled expenses to offset these types of “bad” income. This approach helps defer taxes and lowers the effective tax rate on interest and foreign dividends.

Perfect fit: Identifying ideal clients for corporate class mutual funds

The benefits of corporate class mutual funds go beyond just tax savings—they’re about strategic tax management across various client scenarios. Here’s how advisors can target the right clients for this approach:

• Corporate clients with retained earnings: “For corporate investors, using corporate class mutual funds can help reduce the taxable income generated,” says Natale. “This is very attractive because every dollar of investment income within a corporation is taxed at high rates, unlike personal income which benefits from graduated tax rates.”

The small business deduction (SBD) allows corporations to pay a low rate of tax (approximately 11% but it varies by province) on the first $500,000 of active income (16% for active income between $500,000 and $600,000 in Saskatchewan). However, for every dollar of passive investment income over $50,000 in a year the SBD is clawed back or reduced by $5 ($6 in Saskatchewan). Once your passive investment income reaches $150,000, your SBD is completely clawed back and all of your active income is now taxed at a higher rate (approximately 25-30% depending on the province). Corporate class mutual funds help mitigate this risk by providing a tax-efficient investment vehicle that can minimize reportable investment income, enabling corporations to preserve their SBD. This strategic advantage makes these funds a practical solution for advisors aiming to optimize corporate clients' tax positions.

• Retirees wanting to maximize benefits: Seniors, too, can find value in corporate class mutual funds. By lowering taxable income, they can reduce the taxes they pay and can potentially preserve income-tested benefits like Old Age Security (OAS). “I've seen seniors at a casino who are fine with losing a couple hundred dollars, but if they lose a few hundred to an OAS clawback, they’re up in arms,” Natale says.
   
• Families engaging in income splitting: For clients who want to set up trusts for minor children or grandchildren, corporate class mutual funds are particularly appealing. By avoiding funds that could distribute Canadian dividends you can ensure that the only potential distributions are capital gains or return of capital. “This is important because capital gains can be taxed in the hands of the minor as they are not subject to the attribution rules” says Natale. “This helps clients execute income-splitting strategies more effectively.”
   
• High-net-worth individuals avoiding U.S. estate tax: Canadian residents who are not U.S. citizens may face U.S. estate tax exposure on their U.S. situs property (aka U.S. situated property) if the value of their worldwide estate at the time of death is above a certain threshold. Canadian corporate class mutual funds offer a solution by being classified as Canadian situs property, even if the fund invests in U.S. securities, thereby shielding clients from U.S. estate tax on those assets. “Clients are often surprised to learn that owning U.S. equities directly could expose them to U.S. estate tax,” Natale explains. “Canadian corporate class funds help avoid that by keeping the investment classified as Canadian property.”

Why advisors should revisit corporate class funds

The belief that corporate class mutual funds lost all of their value after the elimination of tax-deferred switching between funds is a misconception. While that particular benefit may have disappeared, Natale emphasizes that many tax advantages remain intact and relevant. “The ability to switch between funds without a taxable event was a big selling point, but that’s not all these funds had to offer,” he says. “The enduring tax efficiencies can still significantly boost a client’s after-tax returns.”

For advisors, this means the opportunity is still very much alive. Whether you’re helping a corporate client save tax and preserve their small business deduction, guiding retirees on how to avoid OAS clawbacks, facilitating tax-efficient income splitting, or avoiding U.S. estate tax, these funds provide practical solutions that can be tailored to meet diverse client needs.

“In a landscape where tax efficiency can sometimes feel like an afterthought, corporate class mutual funds give advisors a way to deliver real value,” Natale concludes. “They’re not just a relic of the past; they’re a sophisticated tool for today’s tax-aware investor.”

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