Posted by: Daryl & Wendy Ashby | February 23, 2010

A New Tax Coming for Mutual Funds

The federal government is finally getting what it wants.

After years of encouragement from federal Finance Minister Jim Flaherty, Ontario and B.C. are following the lead of the Atlantic provinces and harmonizing their provincial sales taxes with the federal GST, starting in July 2010.

The idea is that the harmonized sales tax (HST) will reduce paperwork and lower taxes for businesses, which will be able to claim back the HST they pay on their own expenses. But for investors and mutual fund companies, the announcement is bad news: The HST will be applied to mutual fund fees, which means lower returns for fundholders.

Currently, Canadian investors pay 5% GST on their mutual fund management expense ratios (MERs), but no provincial tax. Under the new system, both taxes will be applied, meaning the tax on MERs will jump to 12% in B.C. and 13% in Ontario. As a result, the mutual fund industry — backed by an odd bedfellow, the federal NDP’s Oliva Chow — is battling it out with the federal Tories and Dalton McGuinty’s Ontario Liberal government to have the tax increase on MERs killed.

If implemented, the tax will have a big impact on most Canadians’ nest eggs. For example, if you invest $10,000 every year for 25 years, assuming a management expense ratio of 2.6% and an annual rate of return of 6%, you will end up paying a total of $9,100 more in tax, according to Alan Rowell of  The Accounting Place in Stoney Creek, Ont.; say you have a portfolio of $250,000 in mutual funds. If you keep it for 25 years, you will end up paying $19,800 in additional taxes.

Ouch.

Think you’re safe if you don’t live in Ontario or British Columbia? Think again. It’s not clear at this point if the tax will be applied based on the residency of the purchaser or the location of the fund.

Most Canadian fund companies are based in Ontario, meaning the tax could impact investors across the country. Fund companies aren’t sure how they would administer the new tax, and it’s possible it could be averaged out amongst the owners of national funds, meaning everyone would pay a portion of the tax, regardless of where they live. (In Nova Scotia, Newfoundland and Labrador and New Brunswick, where they already have the HST, MERs aren’t subject to the provincial portion of the tax.)

Mutual fund industry representatives say the tax will make it harder for people to save for retirement, just when they need all the help they can get. “Seventy per cent of the mutual funds sold sit in RRSP vehicles, so this is really a tax on retirement savings,” says Joanne De Laurentiis, president and CEO of The Investment Funds Institute of Canada. “Given we have public policy concerns about the level of savings that people have for retirement, we think it’s problematic that we would tax them while they’re trying to save for retirement.”

The dispute took a bizarre turn in September, when it was reported that officials in Ontario Finance Minister Dwight Duncan’s office threatened to release a document showing the negative impact of high mutual fund fees on investors if the industry continued to complain — a claim the government later denied.

Industry representatives haven’t given up yet. They are still meeting with the federal and provincial governments in hopes that mutual funds will get an exemption, like the one given to books and children’s clothing. But they may be fighting an uphill battle. “The minister has publicly cautioned against making assumptions that any further exemptions will be applied to the HST in regards to fund companies,” says Alicia Johnston, press secretary in the finance minister’s office. In the House of Commons in October, federal Finance Minister Jim Flaherty didn’t offer much hope either, saying it was a provincial issue.

So what will this tax grab mean for your retirement planning? In short, it means that less and less of the money that you deposit in your RRSP is actually making it into your account. The solution that many will turn to, the fund companies fear, is to invest in products with lower fees, such as exchange-traded funds (ETFs). ETF management fees will also be subject to the HST, but since their fees are much lower in the first place, the tax increase will be small.

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