How Are Private Mutual Fund Trusts Taxed in Canada?

Nick Wright, BA, JD, MBA, LLM (Tax)
Wright Business Law

A private mutual fund trust (“MFT”) is often described as a flow-through investment vehicle. Technically, that description is incomplete. An MFT is itself a taxpayer. Its tax efficiency generally results from deductions for amounts made payable to unitholders, tax designations that preserve the character of certain income and gains, and additional rules that apply specifically to MFTs.

These rules are particularly important for private real estate, mortgage, private credit and other alternative investment funds. An investor can receive a taxable distribution without receiving corresponding cash, or receive cash that represents a return of capital rather than current taxable income. Redemptions introduce a separate set of tax considerations.

This article explains how these rules work in the context of a private MFT after the fund has been established. The requirements for establishing and qualifying an MFT are addressed separately in our article, Setting Up a Mutual Fund Trust (MFT) in Ontario.

1. A Mutual Fund Trust Is a Taxpayer

An MFT is not generally exempt from income tax.

The trust calculates its income for each taxation year under the Income Tax Act (Canada) (the “Tax Act”). Depending on its investments, that income may include interest, rent, dividends, partnership income and taxable capital gains.

The principal mechanism that allows a trust to function economically as a flow-through vehicle is found in section 104 of the Tax Act. In simplified terms, subsection 104(6) generally permits a trust to deduct specified amounts of its income that become payable to its beneficiaries during the year, while subsection 104(13) generally requires the beneficiaries to include the corresponding amounts in income.

The basic structure is therefore:

Fund earns income → amount becomes payable to unitholders → MFT claims applicable deduction → unitholders report corresponding income

This mechanism can permit the MFT to distribute its taxable income without having that income taxed both in the trust and in the hands of its unitholders.

The deduction and the character of the amount received by the unitholder are separate tax issues. An amount does not retain the character of the income from which it arose merely because the MFT is entitled to deduct it. Separate provisions of the Tax Act permit certain amounts, including taxable capital gains and dividends from taxable Canadian corporations, to be designated so that they receive the applicable tax treatment in the hands of the unitholders.

2. What Does It Mean for Income to Be “Payable”?

The concept of an amount becoming “payable” is important to the trust distribution rules.

For these purposes, subsection 104(24) provides that an amount is deemed not to have become payable to a beneficiary in a taxation year unless it was paid to the beneficiary in the year or the beneficiary was entitled in the year to enforce payment of it.

This is one reason private MFT declarations of trust contain detailed distribution provisions. Simply deciding internally that income should eventually be distributed is not necessarily equivalent to making an amount payable for tax purposes.

A declaration of trust will commonly authorize the trustees to determine the MFT’s income for distribution purposes, declare regular distributions and make additional year-end distributions where necessary. The terms should permit the fund to establish the unitholders’ entitlement to a distribution in the relevant taxation year.

Private MFTs generally seek to make sufficient taxable income payable to their unitholders to reduce or eliminate Part I tax otherwise payable by the trust.

3. Cash Flow Is Not the Same as Taxable Income

Consider a common real estate structure:

Investors → Private MFT → Fund LP → Real Estate Investments

Fund LP may receive rent, incur operating expenses and financing costs, claim capital cost allowance and realize capital gains. The MFT, as a partner of Fund LP, is allocated its share of the partnership’s income or loss.

The amount of income allocated to the MFT for tax purposes may differ from the amount of cash distributed by Fund LP.

Assume Fund LP has the following results for a year:

• $900,000 of income from its operations;
• a $500,000 capital gain from the sale of an investment; and
• $1 million of cash distributed to the MFT.

Assume further that the MFT incurs $100,000 of its own deductible expenses and has already paid $700,000 of regular cash distributions to investors.

The fund cannot determine its year-end tax position merely by comparing the $1 million received from Fund LP with the $700,000 distributed to investors. It must determine its taxable income, including its share of the partnership’s income and taxable capital gains, apply its own deductions, and determine what additional amounts should become payable to unitholders.

This can create a liquidity issue. The MFT may need to make a taxable amount payable to investors even though some of the cash associated with that income has been retained by Fund LP or used elsewhere in the structure.

For this reason, the distribution provisions in the limited partnership agreement and the declaration of trust should be considered together.

4. Regular Distributions and Year-End Tax Distributions

Private funds frequently offer investors a target monthly or quarterly distribution. For example, a fund may target an annual cash distribution equal to 8% of the subscription price, payable monthly.

That distribution policy does not determine the fund’s taxable income.

Suppose an MFT pays $800,000 of regular cash distributions during the year. Near year-end, the fund determines that it should make $1 million of taxable income payable to its unitholders.

The declaration of trust may permit the trustees to declare an additional $200,000 distribution.

The opposite can also occur. The fund may have distributed $1 million of cash while only $800,000 represents income allocated to investors. Depending on the circumstances, part of the remaining $200,000 may constitute a return of capital.

Accordingly, a private fund’s stated distribution rate should not be confused with its taxable yield.

5. Reinvested or “Phantom” Distributions

An MFT may need to make additional taxable income payable near year-end while preferring to retain cash for investments, reserves or working capital.

Depending on the terms of the declaration of trust, the fund may be able to make a distribution and reinvest the amount in additional units or otherwise implement a reinvestment mechanism.

The result can be a taxable distribution without the investor retaining an equivalent amount of cash. These are sometimes referred to as “phantom distributions.”

For example, an investor might receive $6,000 of cash distributions during the year and have another $2,000 year-end distribution reinvested. The investor could have $8,000 of reportable income or other taxable amounts attributable to the distributions even though only $6,000 was retained in cash, depending on the character of those amounts.

Where a taxable distribution is reinvested in additional units, the acquisition of those additional units will generally increase the aggregate cost of the investor’s units. This should be distinguished from a return of capital, which generally reduces the ACB of the investor’s existing units. Proper ACB tracking is important because the investor will eventually calculate a gain or loss when units are disposed of.

6. The Character of Distributions

Not every amount distributed by an MFT is taxed in the same manner.

Depending on the MFT’s investments and the applicable provisions of the Tax Act, amounts reported to investors may include:

• ordinary income;
• taxable capital gains;
• dividends from taxable Canadian corporations; and
• return of capital.

Separate designation provisions can permit certain amounts earned by the trust to receive corresponding tax treatment in the hands of its beneficiaries.

For example, subsection 104(21) provides the mechanism under which a trust may designate an amount in respect of its net taxable capital gains so that the designated amount is treated as a taxable capital gain of the beneficiary, subject to the statutory requirements. Subsection 104(19) provides a separate designation mechanism for taxable dividends received from taxable Canadian corporations.

The trust computes its income and claims applicable deductions, while specific statutory rules determine the treatment of designated amounts in the hands of investors.

7. Return of Capital

Part of a cash distribution may represent a return of the investor’s capital rather than current taxable income.

A return of capital generally reduces the ACB of the investor’s units.

Suppose an investor subscribes $100,000 for units and receives an $8,000 cash distribution during the year. If $5,000 represents taxable income and $3,000 represents a return of capital, the $3,000 return of capital generally reduces the investor’s ACB from $100,000 to $97,000, subject to other applicable adjustments.

The investor has deferred tax on that $3,000 rather than necessarily avoided it permanently. A lower ACB generally increases the capital gain, or reduces the capital loss, when the units are subsequently disposed of.

If a return of capital or other applicable adjustment reduces the ACB of the units below zero, the negative amount is generally treated as a capital gain and the ACB of the units is reset to nil.

8. Capital Gains Earned Inside the Fund

Capital gains can arise at different levels of a private fund structure.

Suppose Fund LP sells a real estate investment. The partnership realizes a capital gain and allocates the MFT’s share to it. The MFT then takes the relevant amount into account in computing its own income.

Subject to the applicable rules, the MFT may designate taxable capital gains to its unitholders.

Fund LP may retain some of the sale proceeds while nevertheless allocating taxable amounts to the MFT. The MFT may therefore need to address the resulting taxable income without receiving corresponding cash from Fund LP.

9. Redemptions Are Different From Distributions

An ordinary distribution does not generally involve the investor disposing of units. A redemption does.

When an investor redeems units held as capital property, the investor generally determines a capital gain or loss by reference to the proceeds of disposition, the ACB of the redeemed units and applicable disposition costs.

The fund may simultaneously need to generate the cash required to satisfy the redemption.

Consider a simplified example.

An investor subscribes $100 for units. The MFT invests the money in portfolio assets. Those assets appreciate, and the investor’s units are subsequently worth $150.

Assume the investor’s ACB of the units remains $100 and there are no relevant disposition costs or other adjustments. If the investor redeems the units for $150, the investor would generally realize a $50 capital gain.

Assume the MFT does not have sufficient cash to satisfy the redemption and sells capital property with an adjusted cost base of $100 for proceeds of $150. Subject to the applicable rules, the MFT would also realize a $50 capital gain.

Economically, both gains arise from the same $50 of underlying appreciation.

Without additional rules, a redeemable investment fund could therefore realize a capital gain at the fund level in respect of portfolio gains while the redeeming investor also realizes a gain reflecting the same economic appreciation.

The Tax Act contains MFT-specific rules that address aspects of this potential duplication.

10. The Capital Gains Refund

Section 132 provides a formula-based capital gains refund for mutual fund trusts. The mechanism can provide relief where an MFT has paid tax in respect of capital gains while also redeeming units whose value reflects appreciation in the fund’s portfolio.

Broadly, subsection 132(1) limits the capital gains refund by reference to the MFT’s “capital gains redemptions” for the year and its “refundable capital gains tax on hand” at the end of the year. Both terms are themselves determined under statutory formulas. The calculation therefore does not simply match a particular gain realized by the MFT with a particular redemption.

The capital gains refund is therefore one reason MFT status can have tax consequences beyond the ordinary trust distribution rules in section 104, particularly for a fund with significant redemption activity.

11. Allocations to Redeeming Unitholders

Another approach historically used by investment funds was to allocate income or capital gains to investors whose units were being redeemed.

The economic rationale is understandable. If a redemption causes the fund to realize gains, allocating an appropriate amount to the departing investor can appear to align the tax burden with the investor whose redemption contributed to the realization.

The Tax Act now contains specific restrictions governing this practice.

Subsection 132(5.3) applies where an MFT pays or makes payable an amount to a beneficiary on a redemption and the beneficiary’s proceeds of disposition do not include that allocated amount. In those circumstances, the provision restricts the amount the MFT may deduct in computing its income.

For income other than taxable capital gains, paragraph 132(5.3)(a) denies the deduction for the applicable portion of the allocated amount. For taxable capital gains, paragraph 132(5.3)(b) applies a formula that limits the deduction by reference to the portion of the allocated amount paid out of the MFT’s taxable capital gains, the beneficiary’s redemption proceeds, the allocated amount and the trustee’s determination of the cost amount of the redeemed unit.

This has a direct drafting implication. A declaration of trust may give the trustees broad authority to allocate income or capital gains to a redeeming investor, but that contractual authority does not determine the amount that the MFT may deduct for tax purposes. Allocation-to-redeemer provisions should therefore be reviewed against the current rules in section 132 rather than relying on older investment fund precedents.

12. Losses Do Not Simply Flow Through to Unitholders

The description of an MFT as a flow-through vehicle can also be misleading when the fund incurs losses.

A loss incurred by the MFT generally does not pass directly through to its unitholders in the same manner as income made payable to them. The loss generally remains relevant at the trust level, subject to the applicable loss utilization and carryforward rules.

Similarly, where Fund LP allocates a loss to the MFT, the loss is relevant to the MFT’s tax computation, subject to the partnership and other applicable tax rules. It does not automatically become a deductible loss of the MFT’s investors.

This can be a material structural difference when comparing direct investment in a limited partnership with investment through an MFT that itself owns the limited partnership interest.

13. Can an MFT Still Pay Tax?

An MFT does not automatically eliminate its own tax liability simply by having distribution provisions in its declaration of trust.

Tax can remain payable at the trust level where, for example, the MFT retains taxable income rather than making sufficient amounts payable to investors, a claimed deduction is unavailable or limited, or the fund’s actual tax results differ from the estimates used in determining distributions.

The objective of distributing sufficient taxable income is therefore an annual tax-administration exercise rather than an automatic consequence of MFT status.

14. Unit Trust Status and the 21-Year Rule

An MFT must be a unit trust resident in Canada and satisfy the additional requirements in subsection 132(6).

Unit trust status also has an important consequence independent of MFT status.

Most ordinary trusts can become subject to the deemed disposition regime in subsection 104(4), commonly known as the 21-year rule. For purposes of subsection 104(4), however, the definition of “trust” in subsection 108(1) excludes a trust that, at the relevant time, is a unit trust.

Accordingly, while a trust is a unit trust, it is excluded from the definition of “trust” for purposes of subsection 104(4) and is therefore not subject to the ordinary 21-year deemed disposition rule under that subsection.

For many private MFTs, qualification as a unit trust relies on the redemption-based test in paragraph 108(2)(a). Broadly, units representing at least 95% of the fair market value of all issued units, determined without regard to voting rights, must satisfy the applicable redemption conditions, including conditions requiring the trust to accept their surrender at the demand of the holder at prices determined and payable in accordance with the conditions attached to the units.

This gives redemption provisions a tax-status function in addition to their commercial function.

A proposed amendment introducing redemption gates, broad suspension rights, trustee discretion to refuse redemptions, cash payment limitations, redemption notes or in-kind settlement should therefore be reviewed for its effect on unit trust status.

A provision intended only to manage fund liquidity can have consequences for the tax classification of the trust.

15. MFT Status Must Be Maintained

MFT qualification is not simply a formation requirement.

Under subsection 132(6), an MFT must satisfy requirements relating to Canadian residence, unit trust status, its undertaking and prescribed conditions.

The Tax Act contains limited relieving rules. Under subsection 132(6.1), a trust that becomes an MFT before the 91st day after the end of its first taxation year may, if it makes the required election, be deemed to have been an MFT from the beginning of that year until the time it actually became an MFT. Subsection 132(6.2) can also deem a trust to be an MFT throughout a calendar year in specified circumstances where it would otherwise cease to qualify because the condition in paragraph 108(2)(a) ceased to be satisfied, because of the application of paragraph 132(6)(c), or because the trust ceased to exist. The relieving rule is subject to additional statutory conditions, including that the trust was an MFT at the beginning of the year, and should not be treated as a substitute for ongoing compliance.

Events that can warrant tax review include:

• amendments to unit or redemption terms;
• creation of new classes or series;
• changes in the investor base;
• material changes to the fund’s activities;
• reorganizations involving the trust or underlying entities; and
• changes to the manner in which redemptions are processed.

16. Implications for Private Fund Documents

The tax architecture should be reflected in the fund’s operative documents.

The declaration of trust will commonly address regular and special distributions, reinvested distributions, income and capital allocations, tax designations, redemption rights, alternative forms of redemption consideration, and trustee powers relating to the maintenance of MFT and unit trust status.

The offering memorandum or private placement memorandum should distinguish targeted cash distributions from taxable income. Depending on the structure, the tax disclosure should address return of capital, reinvested taxable distributions, capital gains, redemption consequences and the possibility that taxable amounts may exceed cash retained by an investor.

The limited partnership agreement, where the MFT invests through an underlying LP, should be reviewed together with the declaration of trust. Cash may need to move from the LP to the MFT so that the MFT can satisfy its distribution and tax obligations.

The subscription agreement may collect investor information relevant to tax administration and reporting, including residency information.

17. Annual Administration of a Private MFT

The tax position of a private MFT should generally be reviewed before the end of each taxation year. The fund and its advisers should determine:

• the MFT’s estimated taxable income and the character of material income and gains;
• amounts already paid or made payable to unitholders;
• whether an additional year-end distribution is required and whether any portion will be reinvested;
• the extent of any return of capital;
• the tax consequences of material redemptions, including the potential application of the capital gains refund and any allocations to redeeming investors; and
• whether the fund continues to satisfy the requirements for unit trust and MFT status.

Where the MFT owns an interest in an underlying limited partnership, this review requires timely information from the partnership concerning the income, gains and other tax attributes allocated to the MFT. Differences between those allocations and cash distributed by the partnership may affect the MFT’s year-end distribution requirements.

The fund must also complete the applicable T3 reporting and provide investors with the information required to report amounts allocated or designated to them and maintain the ACB of their units. Capital distributions that result in ACB adjustments are generally reported on the applicable T3 slip.

18. Conclusion

A private MFT is itself a taxpayer, but the trust distribution and designation rules generally permit taxable income and certain gains to be allocated to investors while reducing corresponding tax at the trust level. The amount and character of those taxable allocations can differ materially from the cash distributed by the fund.

For private funds, the distinction is particularly important where the MFT invests through a limited partnership or offers periodic redemptions. Partnership allocations, return of capital, reinvested distributions and redemptions can each produce tax consequences that do not correspond directly with cash movements.

These rules also affect fund documentation and administration. Distribution provisions, redemption mechanics and the terms required to maintain unit trust and MFT status should be considered together with the fund’s underlying investment structure and annual tax reporting.

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If you are establishing or operating a private mutual fund trust in Canada, contact us to schedule an initial consultation with Nick Wright.