In light of recent global market volatility and its impact on clients’ portfolios, advisors are naturally investigating avenues to help investors mitigate losses while positioning their portfolios to benefit when the markets recover. One such avenue involves seeking out opportunities to help clients reduce the amount of tax they pay on their investment income. Consequently, the topic of the deductibility of investment management fees has become a popular, though not universally understood point of discussion among industry professionals. This column aims to help clear up some of the issues on the matter.
Investors in mutual funds and wrap investment programs pay fees for investment advice and management services. The fees in either of these investment arrangements may be deducted for income tax purposes as a carrying charge. However, there are a number of important qualifications that must be kept in mind when considering each individual case. Exactly what kinds of investment management fees are deductible? Is there any advantage to claiming these fees through a wrap account rather than a mutual fund? If such fees are allowable deductions, are there any exceptions?
Let’s look at these questions in order.
Fees can be deducted if they qualify on the following points:
- They have been paid for advice connected to the buying or selling of a specific investment
- They cover the cost of administering or managing an investment owned by the person making the claim
- They cannot be a commission
- They relate to advice on investments made in non-registered accounts. The CRA will deny a deduction of fees related to registered accounts including RRSPs, RRIFs, RESPs and TFSAs. An investor cannot circumvent this rule by charging fees related to a registered account to a non-registered account. For the remainder of this article, when referring to investment management fees I mean deductible investment management fees related to a non-registered account.
Investment management fees are paid in different ways and the tax implications show up differently too. Investors in mutual funds do not pay fees directly; they pay a management expense ratio (or MER) that’s built in so the fee is implicit. MERs are not disclosed separately on income tax slips or returns, but in effect, there is a deduction because mutual funds report distributions net of fees.
Investors in wrap accounts or separately managed accounts (for which annual or quarterly fees are charged for management of a portfolio) will pay fees directly so they are explicit. The amounts are deducted separately on income tax returns. For example, the investor reports gross income from his or her investment accounts and deducts investment management fees separately as a carrying charge.
Different payment methods — same results
No matter how these qualifying investment management fees are paid — meaning whether the fee is implicit or explicit in the investor’s tax picture — the net results are the same. What follows is an example of the tax and investment consequences for an individual at a 45% tax rate who pays investment fees indirectly or directly. The first column assumes an investor is paying fees inside a mutual fund (indirectly). The second assumes payment outside the fund (directly). The bottom line in both cases is identical. The investor ends up keeping the same amount of principal and after-tax income and paying the same amount of tax.
|Less: MER @ 2.3%||(2,530)||—|
|Net Asset Value (NAV)||107,470||110,000|
|Management fee @ 2.3%||—||(2,530)|
|Net income before tax||7,470||7,470|
|Personal tax @ 45%||(3,362)||(3,362)|
|Net income after tax||4,108||4,108|
What the investor keeps
|Net income after tax||4,108||4,108|
|Investment and cash in hand||104,108||104,108|
* Funds generally distribute all income to avoid paying tax at the fund level.
As with any deduction, the CRA requires that investment management fees be reasonable in order to qualify for a deduction. So what’s reasonable? Generally, fees that are based on a sensible percentage of the fair market value of the underlying investments are considered acceptable and the deduction will be allowed by the CRA. Arms length terms and conditions should apply to fees, although this is not a concern when the investor has no family or corporate relationship with the investment manager.
From Fidelity Investments Canada.