A detailed look at segregated fund taxation: how it’s different, and why

We often find that the tax nuances of segregated funds are not well understood. There are a few key differences compared with mutual funds. It’s important to do a deeper dive, to understand key tax reporting differences with segregated funds. These details will better position you to help your clients. This article will focus on non-registered, personally owned segregated fund investments.

Structure

A segregated fund is an insurance contract. There are three parties to the contract - owner, annuitant and beneficiary.

The owner is the individual that owns the segregated funds contract and is responsible for income taxes. The annuitant is the person upon whose life the contract and guarantees are based. The beneficiary is the individual to which the death benefit is paid upon death of the last surviving annuitant.

Upon death of the last surviving annuitant, the contract ends, and the death benefit is paid out. There could be a resulting capital gain or loss to the owner.

Income and Capital Gains/Losses

There are two sources of income and capital gains/losses to consider:

1. Fund level - the segregated fund allocates income and capital gains/losses to its owners each year on a time-weighted basis; and
2. Owner level - when an owner redeems units, whether by a systematic withdrawal, one-time withdrawal or for fees, there may be a capital gain or loss.

The following provides additional details about the tax treatment of segregated fund allocations for the owner:

• Interest and foreign income are fully taxable;
• Eligible dividends are taxed based on a grossed-up value (by 38%) of the actual dividend amount. A dividend tax credit can be claimed, and
• Capital gains, net of capital losses are taxable at the applicable capital gains inclusion rate. 

Mutual fund distributions are, also, taxed as outlined above.

One of the key differences between a segregated fund contract and a mutual fund is in the case where the fund has recognized a net capital loss. When a net capital loss is recognized within a mutual fund, it is retained within the fund. This means that the owner is unable to claim it on their tax return. But, when a net capital loss is recognized within a segregated fund contract, the net capital loss is allocated to the owner. As a result, the owner can:

• Use the net capital loss to offset other capital gains realized in the year;
• Carry back the loss to any of the three previous tax years to recover tax previously paid;
• Carry it forward to a future year.

Another key difference is that a mutual fund "distributes" its income, whereas a segregated fund contract “allocates” its income. A distribution reduces the fund's net asset value. An allocation does not change the fund’s net asset value, because the income is reinvested automatically. See the chart below for a comparison of a mutual fund and segregated fund contract using a simple example.

Example:

Market value = # of units/shares X unit/share value: 10 X $10.00 = $100

This hypothetical case scenario compares a segregated fund allocation versus a mutual fund distribution for the investor:

• Abraham has $200 to invest
• He purchased 10 units of a segregated fund and 10 units of a mutual fund, both with similar underlying investments
• The net asset value per unit (NAVPU) of each fund was $10 when he made his original investment
• $10 of income was earned by each fund during the year, bringing the NAV at year-end to $110
• Income of $1 per unit was allocated/distributed by the respective funds in the year
• The mutual fund distribution was reinvested in the year