We often find that the tax nuances of segregated funds are glossed over, with a general, high-level comparison to non-registered mutual fund trusts. It’s important to do a deeper dive, and really understand the tax reporting considerations on segregated funds, as such details will put you in a better position to help your clients. This article will focus on non-registered, personally owned segregated fund investments.

Structure - An inter-vivos trust

A segregated fund is considered to be an inter-vivos trust. Unlike a personal inter-vivos trust, where taxable income may be reported at the trust level or distributed out to the beneficiary/ies in certain instances, the taxable income of a segregated fund must be allocated among policyholders who held investments in the fund during the year.

The owner, annuitant and beneficiary are all separate roles regarding the contract itself. A bit of background on segregated funds: A segregated fund is an investment held under a segregated fund contract, which is a life insurance contract between the policyholder and the insurance company. The annuitant is the person upon whose life the contract is based. (Upon death of the last surviving annuitant, any death benefit guarantee becomes payable to the beneficiary designated for the contract.) The policyholder (unitholder) is the individual or corporation that acquires and owns the segregated fund contract (and owns the segregated fund units).

Upon death of the last surviving annuitant, the effective disposition of the segregated fund occurs in the hands of the owner (policyholder), with a potential capital gains tax liability occurring in their hands, or reported in their terminal return if the annuitant is also the owner.

Income and Capital Gains/Losses

From an investor/unitholder’s perspective, there are two sources of income and capital gains/losses to consider, namely:

  1. Fund level - the segregated fund must allocate income and capital gains/losses to its owners/unitholders each year on a time-weighted basis; and
  2. Investor/unitholder level – when an investor/unitholder redeems units, whether it be a systematic withdrawal, one time withdrawal or for fees, there will be a capital gain or loss to be reported.

The following provides additional details about the tax treatment of segregated fund allocations in the hands of its investors/unitholders:

  • Interest and foreign income are fully taxable;
  • Only 50% of the fund’s realized capital gains are reported for tax purposes; and
  • Eligible dividends are taxed based on a grossed up value of 38% of the actual dividend amount, with an enhanced dividend tax credit available of roughly 25.02% (combined federal-Ontario 2019 rate) of the grossed up amount.

The result is that taxable capital gains and eligible dividend income are generally tax favourable for a Client/investor when compared to interest and foreign income. As such, a segregated fund will apply its expenses at the fund level against the less attractive taxable income first, to minimize interest and foreign income in the investor’s hands. The non-loss allocations realized for tax purposes increases the Adjusted Cost Base (ACB) of the fund in the unitholder’s hands, thus avoiding double taxation. This differs from mutual fund distributions. See the chart below for a comparison using a simple example.

Example:

  Mutual fund trust distribution Segregated fund allocation
  Net asset value per unit (NAVPU) # of units Market value Adjusted cost base (ACB) Net asset value per unit (NAVPU) # of units Market value Adjusted cost base (ACB)
Before $10.00 10 $100 $100 $10.00 10 $100 $100
Market value = # of units/shares X unit/share value: 10 X $10.00 = $100
After a $1.00 distribution per unit After a $1.00 allocation per unit
After $9.00 11.1 - reinvested distribution buys 1.1 units ($10.00/$9.00) $100 (11.1 units X $9.00) $110 $10.00 10 $100 (10 units X $10) $110
In both instances, the market value after the distribution or allocation = $100

Investor/owner withdrawals

After a fund level income allocation item (e.g. dividend, interest, etc.) becomes taxable, it is treated as part of the investor/unitholder’s after-tax money invested effectively in the segregated fund.  When investors/unitholders withdraw funds from their segregated fund (systematic or one time) a potential capital gain or loss will be reported from the disposition of the segregated fund units (proceeds of disposition less adjusted cost base).   

Capital loss advantage

Unlike mutual funds, segregated funds can flow net capital losses through to the investor/owner of the segregated fund. That is, capital losses over and above those used to offset capital gains inside the fund may be used directly by the owner of the contract. The owner can apply these losses against other capital gains in the same year, or carry back such losses up to three years, or forward indefinitely. This unique feature creates additional tax planning opportunities. This segregated fund advantage ties in with the notion of investing in a greater proportion of equity-based funds due to consumer confidence in the underlying guarantees.

Adjusted Cost Base tracking

Ultimately, it is not the responsibility of the manufacturer to report capital gains and losses for mutual funds; it is that of the investor. Certain transactions that contribute to an increase in ACB may be overlooked, so non-registered investors can end up paying additional capital gains taxes unnecessarily. With segregated funds, the insurance company keeps track of each unit holder’s ACB. When non-registered units are redeemed, the insurance company will calculate the realized gain or loss and report this on the investor’s T3 form. As such, there is no need to spend time tracking ACB or hiring an accountant to do so. In the case of registered segregated funds, this does not amount to a benefit as the ACB is not accounted for in calculating taxable income.

Information contained in this article is provided for information purposes only and is not intended to provide specific financial, tax, insurance, investment, legal or accounting advice and should not be relied upon in that regard and does not constitute a specific offer to buy and/or sell securities. Information contained in this article has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made with respect to its timeliness or accuracy.

© Sun Life Global Investments (Canada) Inc., 2019

Sun life Global Investments (Canada) Inc. is a member of the Sun Life group of companies.