The purpose of a corporate class structure is to achieve greater tax efficiency by minimizing taxable dividend payments.

One of the ways your investment in a mutual fund generates income for you is through distributions. Here is a brief overview of how this process works.

Before we begin, please note that many mutual funds are organized as mutual fund trusts. Dividends by corporate class mutual funds will be discussed later in this article.

When a mutual fund trust earns income from its investments, it may pass on these amounts to the unitholder as a distribution. This income is generally from any combination of the following sources:

  • Interest earned from bonds and cash holdings
  • Foreign dividends paid by foreign stocks
  • Canadian dividends paid by Canadian stocks
  • Capital gains realized from the sale of securities for more than they were purchased for.

First, the fund will use its expenses such as management fees, operating costs, and HST, to offset income. The excess will be distributed to unitholders, so that it will be taxed in their hands, rather than being taxed within the fund. This is more efficient, since the fund would pay tax at a higher rate than most unitholders.

Tax treatment of distributions

If your fund is held in a non-registered account, you will be required to pay tax on your distributions at your personal rates. Note that the character of the income (interest, Canadian dividends, etc.) is preserved when distributed to unitholders. This is important because interest income and foreign dividends are fully taxable, whereas capital gains and Canadian dividends are generally taxed at lower rates.

Many unitholders elect to have their distributions reinvested into the fund, so that they receive additional units of the fund. You can also opt to receive a distribution in cash. A distribution is taxable in either case.

If your fund is held in a registered account, then the distribution is not taxable. (For registered plans other than Tax-Free Savings Accounts, which is tax-free, the tax is deferred until you make a withdrawal from the registered plan.)

Other important facts about distributions

  • The distribution is not representative of the performance of the fund. For example, a fund can have strong performance, yet make minimal or no distributions.

  • The fund’s price or net asset value (NAV) per unit is affected by a distribution. The NAV per unit is reduced by the amount of the distribution in order to reflect that the fund has paid out a portion of its assets. In a simple example, if the NAV per unit is $12.50, and there is a distribution of $0.25 per unit, then the NAV will decline to $12.25. However, the investor is no worse off because they have received cash or units equivalent to $0.25 per unit.

  • Distributions can be made on a monthly, quarterly or annual basis. Typically, only funds designed to produce a steady stream of income will make monthly distributions.

Corporate class dividends

Unlike mutual fund trusts, corporate class funds are part of a corporation that house multiple funds (or share classes). The purpose of a corporate class structure is to achieve greater tax efficiency by minimizing taxable dividend payments.

With a mutual fund corporation, capital losses incurred by one fund can be used to offset capital gains in another fund within the structure. The same goes for expenses – the corporation has the flexibility to share expenses across the structure.

If there is excess dividend income or capital gains, a corporate class fund will pay an annual dividend to its shareholders. Due to the corporate structure, only capital gains and Canadian dividends can be issued to shareholders. As noted above, capital gains and Canadian dividends generally face lower rates of tax compared to interest and foreign dividends.

For those reasons, corporate class funds may be a good choice for non-registered accounts.

A note on return of capital

A distribution from a fund may also include a return of capital (ROC) component. ROC is simply a portion of your original investment being returned to you.

ROC can occur when a fund is committed to making a fixed distribution (which ensures a predictable cash flow for unitholders), but has not earned enough income to fund the distribution. ROC is not taxable because it is not income generated by a fund.

In the case of T-Class funds, the distributions are intended to consist primarily of ROC. T-Class is designed to provide investors, such as retirees, with a tax-efficient cash flow.

While ROC is not taxable, it will reduce the adjusted cost base (ACB) of your units or shares, which can result in capital gains tax on sale. For more information, please visit the T-Class section of this site.