Canadian resident investors who hold U.S.-based (or other foreign-based) mutual funds in their non-registered accounts should pay close attention to the potentially negative tax consequences arising from the fact these funds are not considered pass-through type vehicles under Canadian law when it comes to the tax nature of their distributions.
Investor Donald Ian Moyes learned this the hard way when his appeal of last year’s Tax Court decision was recently rejected by the Federal Court of Appeal in January 2010 (Moyes v. the Queen, 2010 FCA 18).
Moyes is a retired accountant who was a controller with a large company. He personally maintains two U.S. currency brokerage accounts with TD Waterhouse where he invested in various American Depositary Receipts (ADRs), shares, and exchange traded funds (ETFs).
At year-end, TD Waterhouse provided Moyes with investment summaries for each account, which categorized the distributions he received throughout the years in question as either “Code 3 – Ordinary Dividends” or “Code 5 – Stock dividends or distributions of long-term capital gains realized by investment funds.”
It is the Code 5 distributions that became the issue of the tax case.
Moyes felt these distributions should be classified and taxed on his Canadian return as capital gains, at the favourable 50% inclusion rate.
The Canada Revenue Agency argued these distributions are dividends from foreign corporations and as a result, fully taxable as foreign income.
The Court looked to the nature of the “Code 5” distributions to get a sense of how they arose. Included among these amounts were distributions received from Chile Fund Inc., H&Q Life Sciences Investors and Korea Fund Inc.
Taking a closer look at the Korea Fund, for example, we find this fund is registered under the U.S. Investment Company Act of 1940 as a “closed-end, non-diversified management investment company organized as a Maryland corporation.” It seeks “long-term capital appreciation through investment in securities, primarily equity securities, of Korean companies.”
In other words, it’s essentially a U.S.-based mutual fund that focuses geographically on the Korean equity market. According to its Web site, the Fund’s distributions may be comprised of “ordinary income, net capital gains, return of capital or a combination thereof.” Past history has shown that “net capital gains” have included both short-term and long-term capital gains—both U.S. tax terms—the latter taxed quite favourably for U.S. investors.
Moyes argued flow-through treatment should apply to capital gains realized by these U.S. mutual funds and paid to Canadian investors since the funds act in “an agency capacity.”
Unfortunately, Moyes could not point to a specific section of the Income Tax Act that would characterize distributions he received from these funds as capital gains. Rather he “seems to suggest they should be taxed as capital gains on general principles.”
Both the Tax Court Judge and the Federal Court of Appeal rejected this argument and found that the distributions were dividends from foreign corporations and thus must be fully included and taxable as “foreign income” at Moyes’ full marginal tax rates for the tax years involved.
This case should serve as a warning to investors that not all funds are treated equally when it comes to Canadian tax laws. Investors using funds in the context of non-registered investing would do well to explore Canadian-based funds.
These funds, which can invest in U.S. or other global equities, have the added advantage of being able to distribute any capital gains earned by the fund itself out to investors as a capital gains distribution—eligible for the 50% tax-preferred tax treatment in non-registered accounts.
The same cannot be said for U.S. or other foreign-based funds.