The Canadian investment funds industry is relatively mature. The range of investment funds is broad and includes:
It should be noted that alternative investment funds – such as private equity funds and other vehicles that are non-passive investors, and vehicles that engage in lending, real estate ownership or another business activity – are not considered "investment funds" under Canadian securities legislation, and are not subject to the regulations that are specific to investment funds.
Similar to investment funds, an alternative investment fund formed in Canada is generally structured as either a trust, a corporation or a limited partnership based mainly on the Canadian tax treatment of the vehicle and its investors. Please see 3.1.1 Fund Structures. An alternative investment fund that principally holds mortgages on Canadian residential real property may be structured as a corporation in order to take advantage of tax efficiencies provided under Canadian tax legislation for corporations that qualify as a "mortgage investment corporation". An alternative investment fund that holds Canadian real property may be structured as a trust in order to take advantage of tax efficiencies provided under Canadian tax legislation for "real estate income trusts". Otherwise, alternative investment funds tend to be structured as limited partnerships.
Please see 3.1.1 Fund Structures; an alternative investment fund is not required to be registered under Canadian securities legislation, but is subject to disclosure requirements if it makes a public offering of its securities. Please see 3.3.1 Regulatory Regime; an alternative investment fund is not required to retain a custodian for its assets.
Unlike investment funds, the manager of an alternative investment fund is not required to be registered under Canadian securities legislation as an "investment fund manager", but may be required to be registered as a "portfolio manager" or a "dealer". Please see 3.3.1 Regulatory Regime.
Please see 3.1.3 Limited Liability.
There is no ongoing disclosure prescribed by Canadian securities legislation for alternative investment funds that have not made a public distribution of securities. Please see 3.3.1 Regulatory Regime for the requirements of documentation relating to a public offering of securities.
Alternative investment funds that have made a public offering of securities and are publicly traded may attract interest from all types of investors, including retail investors. Alternative investment funds that raise capital without a prospectus are limited to sophisticated investors. Please see 3.3.1 Regulatory Regime. Where the alternative investment fund provides limited or no liquidity to investors, generally only institutional investors are sought.
Managers of alternative investment funds are typically structured as a corporation. Where the alternative investment fund is structured as a limited partnership, its manager may be the general partner of the limited partnership.
Please see 3.2.3 Restrictions on Investors.
Alternative investment funds are not currently subject to investment restrictions or operational requirements imposed by Canadian securities legislation.
A non-local firm that provides investment advice to an alternative investment fund may be required to register under Canadian securities legislation as a portfolio manager. A non-local firm that engages in activities to raise capital from Canadian investors may be required to register under Canadian securities legislation as a dealer. Please see 3.3.2 Requirements for Non-local Service Providers.
Alternative investment funds are not considered to be "investment funds" under Canadian securities legislation and therefore do not trigger any requirement for the manager be registered as an investment fund manager. However, depending on its activities, the manager may be required to register as a portfolio manager and/or dealer. Please see 3.3.2 Requirements for Non-local Service Providers.
Alternative investment funds are not regulated in a manner that requires regulatory approval.
Any communications with Canadian residents in connection with their possible purchase of securities of an alternative investment fund constitutes "trading" in those securities in Canada, and the party making the communication must either be registered as a dealer or able to rely on an exemption from registration. Where the communication is an invitation to the public to purchase securities of an alternative investment fund, the fund must have filed a prospectus that was reviewed and accepted by the Canadian securities administrators. Other types of activities (such as advertising and sales presentations) are regulated, but do not require prior authorisation from the Canadian securities administrators.
An alternative investment fund that makes a public offering of its securities using a prospectus can market its securities to all types of investors. If the alternative investment fund does not make a public offering of securities, its marketing must be limited to sophisticated investors. Please see 3.3.1 Regulatory Regime.
There are no additional investor protection provisions in Canadian securities legislation that apply specifically to alternative investment funds.
Please see 3.3.8 Approach of the Regulator.
There are no specific operational requirements imposed by Canadian securities legislation on alternative investment funds. This includes the absence of restrictions on activities, custody of assets, risk, borrowing or valuation.
Alternative investment funds can obtain loan facilities from a variety of sources to finance their activities. Lenders typically take security in all the assets of the alternative investment fund if they are used for general purposes. Otherwise, security may be taken in a specific asset that is purchased with the borrowed funds.
Please see 3.6 Tax Regime.
An investment fund formed in Canada is generally structured as either a trust, a corporation or a limited partnership. The reason for selecting one structure over another is based mainly on the Canadian tax treatment of the fund and its investors. Investors in funds structured as corporations hold "shares" of those funds, while investors in other forms of funds hold "units".
The Canadian tax regime applicable to an investment fund depends upon its structure. Generally, a fund formed as a trust pays tax on its net income at the rate of approximately 50%, but does not pay income tax if it distributes its net income annually to its investors. A fund formed as a corporation pays tax on its net income at the normal rates applicable to Canadian corporations, but is able to obtain a refund for taxes paid in respect of capital gains and Canadian dividends in certain circumstances. A fund formed as a limited partnership is not subject to Canadian tax and instead allocates its net income annually to its partners.
Funds Formed as a Trust
The most common structure for a Canadian investment fund is a trust formed by executing either a unilateral declaration of trust (where the manager acts as the fund’s trustee) or a bilateral trust agreement (where the manager retains a licensed trust company to act as the fund’s trustee). In this guide, we refer to either of these documents as the "trust document". Among other matters, the trust document sets out the powers of the trustee and the rights of investors (referred to as "unitholders"). Where the trustee is a licensed trust company, it retains the manager to perform all day-to-day activities of the fund, either in the trust document or in a separate management agreement.
Funds Formed as a Corporation (or a Class of Shares within a Corporation)
An investment fund can be formed as a corporation by filing articles of incorporation with the relevant Canadian government office. The corporation enters into a management agreement with the manager, under which the manager performs all day-to-day activities of the fund, other than those matters that the corporate legislation requires to be performed by the corporation’s directors.
A corporation can also be used to provide multiple investment funds within that corporation (a "multi-fund corporation") by having each investment fund represented by its own class of shares.
Funds Formed as a Limited Partnership
A limited partnership is formed by filing a declaration with the relevant Canadian government office. A limited partnership agreement is entered into between the general partner and each limited partner, and sets out the rights and obligations of the partners, similar to a trust document. The limited partnership, by its general partner, enters into a management agreement with the manager, under which the manager performs all day-to-day activities of the fund.
Other Material Contracts
Other material contracts entered into by an investment fund vary based on the structure of the fund. However, virtually all investment funds are required by Canadian securities legislation to retain a Canadian custodian to hold the assets of the fund. Fund assets outside of Canada are held by non-Canadian sub-custodians retained by the Canadian custodian. Managers also retain service providers (often related to the custodian) for valuation and investor recordkeeping services. The fund may also have agreements with portfolio management firms to manage some or all of the fund’s investment portfolio, as well as agreements with dealers to sell the fund’s securities.
The legal status of an investment fund depends upon three factors:
Mutual funds are an attractive structure for investors because they provide some assurance of liquidity for the approximate value of their securities. The terms of the redemption rights (such as frequency, notice period, redemption value, payment date, and limits on redemptions) can vary. However, mutual funds that are continuously offered to the public by a prospectus typically provide unlimited daily redemption rights at the net asset value per security, with settlement occurring on the second business day following the redemption (T+2).
There are four variations of mutual funds.
ETFs generally follow a passive investment mandate so that designated brokers can establish hedges for the units they hold in inventory. The passive nature of the fund’s mandate and the absence of embedded dealer compensation in the structure result in significantly lower annual expenses for an ETF compared to most conventional mutual funds. In the past ten years, ETFs have grown tremendously in popularity in Canada for this reason.
Some conventional mutual funds also offer one or more classes of securities that trade on an exchange similar to an ETF. This enables the fund to gather assets simultaneously as both a conventional mutual fund and an ETF.
Non-redeemable Investment Funds
Investment funds that are not mutual funds are categorised under Canadian securities legislation as "non-redeemable investment funds" (also called "closed-end funds"), even though these funds may provide investors with some redemption rights. Due to fewer available redemption rights, non-redeemable investment funds are typically listed on a Canadian stock exchange, and the main source of liquidity for investors during most of the year is found by trading their securities over the exchange.
Unlike conventional mutual funds, non-redeemable investment funds are allowed to use alternate investment strategies (including leverage and concentrated portfolio holdings), pay their capital-raising expenses (including commissions to dealers) out of their offering proceeds, and issue both common and preferred securities.
During the past few years, non-redeemable investment funds have declined in popularity due to a variety of factors. The greater availability of alternative strategies through alternative mutual funds is likely to further reduce the popularity of non-redeemable investment funds.
Retail investors tend to invest in conventional mutual funds and ETFs due to their availability through bank branches and mutual fund dealers that have lower minimum account size requirements. High net worth individuals often invest in a lower management fee class of conventional mutual funds and in ETFs, but are also the target audience for non-redeemable investment funds since these investors tend to have accounts at full-service investment dealers that can sell these funds. High net worth individuals also invest in pooled funds, particularly if their account is managed by a portfolio manager that delivers its strategies through a pooled fund. Institutional investors invest in both conventional mutual funds and pooled funds because they are able to negotiate lower management fees for their assets in these funds. All types of investors may invest a portion of their assets in alternative mutual funds to achieve greater diversification.
An investment fund is set up by forming either a trust, a corporation or a limited partnership with appropriate material contracts. If the investment fund intends to make a public offering of its securities, it prepares and submits a prospectus to the Canadian securities administrators for review and acceptance before the public offering commences. If the investment fund instead raises capital on a private placement basis, a private placement memorandum and related subscription agreement is prepared and circulated among interested dealers and investors, without any need for review or acceptance by the Canadian securities administrators. Unless the investment fund proposes to utilise a novel structure or investment approach, the process for setting up the fund is generally streamlined and cost-efficient.
Investors in Canadian investment funds generally have the protection of limited liability. There are theoretical circumstances in which an investor may be held liable to the creditors of an investment fund, but such liability has never been asserted and is sufficiently remote that legal opinions confirming the limitation of liability are not requested or given.
The basis for limiting liability varies depending on the structure used. In the case of a fund structured as a trust, legislation has been enacted in most Canadian jurisdictions where funds are formed that confirm the limited liability of unitholders of a trust that is offered to retail investors. The legislation governing corporations limits the potential liability of shareholders to returning certain unauthorised payments received from the corporation. The legislation governing limited partnerships expressly confirms that limited partners are not liable for the obligations of the limited partnership unless the limited partner becomes involved in the management of the affairs of the limited partnership (eg, ceases to be a passive partner).
The ongoing disclosure requirements applicable to an investment fund under Canadian securities legislation depend upon whether the fund is formed in Canada and whether the fund has made a public offering of its securities in Canada.
All investment funds formed in Canada must provide periodic "continuous disclosure" to their investors, which includes audited annual financial statements and unaudited semi-annual financial statements. If the investment fund is a "reporting issuer", it must also prepare management reports of fund performance for each set of its financial statements, an annual information form and other reports. The continuous disclosure by reporting issuers is publicly available on the website maintained by the Canadian securities administrators for this purpose under their System for Electronic Document Analysis and Retrieval (SEDAR), while the continuous disclosure by pooled funds is generally confidential.
An investment fund that is a reporting issuer must also make "timely disclosure" of any material change to its business or affairs that a reasonable investor may consider material in deciding whether to purchase or continue holding securities of the fund. Timely disclosure includes promptly issuing a press release and filing a material change report and, if the fund is currently offering its securities under a prospectus, filing an amendment to the prospectus. All timely disclosure is publicly available on the SEDAR website.
The range of Canadian investors in investment funds covers the full spectrum, from relatively unsophisticated retail investors with little money to invest, to large institutional investors seeking highly specialised portfolio management.
Investment fund managers are generally formed as corporations in order to limit the liability of the manager to its assets. However, some managers are formed as a limited partnership, which provides certain opportunities for tax efficiency while potentially exposing its limited partners to unlimited liability for the obligations of the manager should the limited partner become involved in the management of the affairs of the limited partnership.
An investment fund that files a prospectus is legally permitted to issue its securities to any investor in Canada. However, the investor must place his or her order through a registered dealer. Provided the dealer is not an "order execution only" dealer, a registered salesperson of the dealer must complete a know-your-client (KYC) review of the client’s circumstances and confirm that the investment fund is suitable for the client, before placing the purchase order. This nexus is where investors may be limited from investing in certain types of investment funds.
An investor may also be precluded from investing in certain types of funds, depending on the dealer with whom they have their account. While full-service investment dealers are qualified to sell any type of investment fund to their clients, they typically have minimum account size requirements beyond the reach of many retail investors. Those investors may, instead, have their account with a mutual fund dealer that is restricted to selling only conventional mutual funds. Mutual fund dealers cannot sell non-redeemable investment funds, generally do not have the proficiency to sell alternative mutual funds, and may experience operational difficulties buying and selling ETFs for their clients.
Investors who are not "accredited investors" cannot legally purchase pooled funds.
Categories of Regulated Activities
Canadian securities legislation differentiates between:
In most cases, a firm that performs investment fund management also performs portfolio management for some or all of the fund’s assets since the activities are complementary, but the firm may also retain other firms to perform portfolio management for a portion or all of the fund’s assets.
Requirements to be Registered
Unless an exemption from registration is available:
Subject to limited exceptions, dealers must also be members of either the Investment Industry Regulatory Organization of Canada (IIROC) or the Mutual Fund Dealers Association of Canada (MFDA), depending on whether they are full-service investment dealers or are limited to selling mutual funds, respectively.
Obtaining and maintaining a registration described above is fairly onerous since the firm must (among other matters):
The timeline for a previously unregistered firm to obtain its first registration in Canada is approximately six months, but could be longer if the firm or any of its relevant personnel request a waiver of any of the specific conditions associated with the registration. Thereafter, the timeline for adding to or changing an existing registration is shorter, including extending an existing registration to one or more additional provinces or territories. Delays due to personnel not having completed the prescribed courses or having the prescribed experience are the difficulties most commonly encountered with the registration process.
Once registered, the firm and its registered individuals become subject to the jurisdiction of these Canadian securities administrators, which includes periodic filings, frequent field audits and requests for information, and potential sanctions for non-compliance. Accordingly, unless a non-Canadian firm intends to establish a significant presence in Canada, the firm usually structures its relationships and restricts its activities in a manner that qualifies for exemptions from the registration requirements that would otherwise apply.
Investment Fund Manager Registration Exemptions
There are two circumstances where a firm that manages an investment fund formed outside of Canada and has one or more Canadian resident investors is exempt from the requirement to register as an investment fund manager.
The first circumstance is where the fund manager has not actively solicited Canadian residents to invest in the fund. This allows the manager to accept unsolicited purchase orders from Canadian investors. It also is the basis on which non-Canadian investment funds that trade on a non-Canadian exchange can have Canadian resident investors.
The second circumstance is where the manager only solicits investments from Canadian residents who are "permitted clients" under Canadian securities legislation. "Permitted clients" are those on a prescribed list of sophisticated investors that includes Canadian financial institutions, pension plans, Canadian portfolio managers for their managed accounts, individuals with financial assets exceeding CAD5 million, and companies with net assets exceeding CAD25 million. In order to rely on this exemption, the fund manager must also file documents with the relevant Canadian securities administrators giving notice that the fund manager is relying on the exemption, and annually file a report and pay a fee. The fund manager must also provide Canadian investors with certain prescribed disclosure regarding the risks associated with the fund manager being located outside of Canada.
Portfolio Manager Registration Exemptions
Non-Canadian firms that are advisers in their home jurisdictions on a registered or registration-exempt basis are exempt from the requirement to register in Canada as a portfolio manager in two circumstances.
The first circumstance (referred to as the "international sub-adviser exemption") is where the non-Canadian firm is retained by a Canadian registered portfolio manager, who takes responsibility for any losses incurred by the investment fund resulting from the non-Canadian firm failing to meet a prescribed standard of care.
The second circumstance (referred to as the "international adviser exemption") is available if the non-Canadian firm provides its advice only to certain permitted clients (which include Canadian investment funds) and not more than 10% of the aggregate consolidated gross revenue of the firm and its affiliates is derived from portfolio management activities in Canada. If relying on this exemption, the firm must limit its advice to non-Canadian securities (except for incidental advice regarding Canadian securities). The firm must also file documents with the relevant Canadian securities administrators giving notice that it is relying on the exemption, and annually file a report and pay a fee. Finally, the firm must provide Canadian clients with certain prescribed disclosure regarding the risks associated with the firm being located outside of Canada.
Dealer Registration Exemption
A non-Canadian firm is exempt from the requirement to register in Canada as a dealer in order to market and sell its non-Canadian funds to Canadian investors in circumstances known as the "international dealer exemption". To qualify for this exemption, the firm must be registered as a dealer and carry on the business of a dealer, in its home jurisdiction, and limit its marketing to Canadian residents who are "permitted clients". Similar to the international adviser exemption, the firm must file documents with, and pay fees to, the relevant Canadian securities administrators, and provide Canadian clients with prescribed disclosure.
If an investment fund makes a public offering of its securities in Canada, it must file a prospectus containing extensive prescribed disclosure with the Canadian securities administrators in each province and territory where it wishes to offer its securities. The prospectus in preliminary form is reviewed and commented upon by the principal regulator and, once acceptable, is refiled in final form and accepted by the principal regulator issuing a "receipt" for it. At that point, the fund is legally permitted to offer its securities to any investor in Canada without qualification. It is then the responsibility of each investor’s dealer to determine whether an investment in the fund is suitable for the client.
A fund that has filed a final prospectus becomes a "reporting issuer" under Canadian securities legislation, which significantly increases the amount of regulation applicable to the fund’s operations, including portfolio management, governance and ongoing disclosure requirements. For this reason, non-Canadian investment funds rarely make public offerings in Canada.
An investment fund does not need to file a prospectus or become a reporting issuer in Canada if the fund limits its capital-raising activities to a prescribed list of sophisticated investors and circumstances where Canadian securities legislation does not require a prospectus (referred to as "prospectus-exempt distributions"). Sophisticated investors (called "accredited investors") include:
A prospectus is also not required if the investor is a company that purchases, as principal, no less than CAD150,000 of securities of the investment fund, and the company was not created or used solely for the purpose of investing in prospectus-exempt distributions.
A private placement memorandum is referred to in Canadian securities legislation as an "offering memorandum", and includes any document describing the investment fund that has been prepared primarily for delivery to prospective investors to assist them with their investment decision, even if the document is not labelled as, or intended to be, a private placement memorandum (such as a PowerPoint presentation). However, it does not include a basic term sheet describing only the terms of the offering.
An offering memorandum is not generally required in order to make a prospectus-exempt distribution, although certain individual investors are required to sign a prescribed risk acknowledgement form. If an offering memorandum is provided voluntarily to Canadian investors, then it must not contain a "misrepresentation" as defined in Canadian securities legislation, and it must disclose the rights of investors in the event of a misrepresentation. If the fund is non-Canadian and wishes to use in Canada the private placement memorandum it has prepared for use in other jurisdictions, the requirements under Canadian securities legislation can usually be fulfilled by adding a Canadian notice to the document.
An exception to the above is where the investment fund makes a prospectus-exempt distribution by relying on the "offering memorandum exemption". In these circumstances, the content of the offering memorandum is prescribed and extensive, and the amount that can be raised from individual investors who are not accredited investors is capped.
A Canadian securities administrator will assert jurisdiction if a non-Canadian firm provides investment advice to a person in Canada (including portfolio management for a Canadian investment fund), even if all the activities of the non-Canadian firm occur outside of Canada. This triggers a requirement to register as a portfolio manager, but there are two possible exemptions, described above, that may be relied upon by the firm to avoid that registration in Canada.
A non-Canadian firm that provides portfolio management to a non-Canadian investment fund does not trigger a requirement to be registered as a portfolio manager in Canada, even if the non-Canadian fund has one or more Canadian investors. However, offering a non-Canadian fund to Canadian investors may trigger a requirement for someone to be registered in Canada as an investment fund manager and dealer, as described above.
A Canadian securities administrator will assert jurisdiction over a firm if the firm performs any activity in Canada (including marketing activity) that leads to a Canadian investor purchasing securities of an investment fund, even if the investment fund is formed and operated entirely outside of Canada. This triggers a requirement to register as a dealer, unless the firm can rely on the international dealer exemption described above.
There is no requirement for a Canadian investment fund to be managed inside of Canada. However, the manager of an investment fund formed in Canada is typically required to register with at least one Canadian securities administrator in one or more capacities, or to qualify for exemptions from those requirements.
A Canadian securities administrator will assert jurisdiction over the manager of an investment fund formed in their jurisdiction and, in the case of Ontario, Québec, and Newfoundland and Labrador, any investment fund with investors resident in their jurisdiction. This triggers a requirement for the fund manager to register as an investment fund manager, unless the fund manager can rely on one of the two exemptions from registration described above.
Marketing investment funds constitutes a form of "trading" activity and, if the offering is made to the public for securities to be issued by an investment fund, must be approved by the relevant Canadian securities administrators accepting a prospectus for the offering. If the offering is instead made as a prospectus-exempt distribution, it does not require regulatory approval.
Marketing investment funds triggers a requirement to be registered as a dealer with the relevant Canadian securities administrators, unless an exemption from registration is available in the circumstances.
Any communications with Canadian residents in connection with their possible purchase of securities of an investment fund constitutes "trading" in those securities in Canada, and the party making the communication must be either registered as a dealer or able to rely on an exemption from registration. Where the communication is an invitation to the public to purchase securities of an investment fund, the fund must have filed a prospectus that was reviewed and accepted by the Canadian securities administrators. Other types of activities (such as advertising and sales presentations) are regulated, but do not require prior authorisation from the Canadian securities administrators.
Public investment funds are required to comply with a common set of rules for marketing materials, which has been adopted in all the Canadian jurisdictions. These rules generally regulate all communications made to potential investors, regardless of medium. The rules cover, among other matters:
These rules are subject to an overarching requirement that the communication must not be misleading.
The manner in which public mutual funds and their managers compensate, support and incentivise registered dealers and their salespeople to sell public mutual funds is regulated by a common set of sales practice rules, which has been adopted in all Canadian jurisdictions. These rules prohibit all forms of monetary and non-monetary benefits, except those expressly permitted in the rules. Managers of public mutual funds (but not the mutual funds themselves) are permitted to pay sales commissions and ongoing trailer fees within tightly controlled restrictions, and to hold certain types of events promoting their funds and subsidise the costs of certain other events not organised by the manager.
None of the sales practices rules described above applies to the sale of non-redeemable investment funds or pooled funds.
It should be noted that marketing a fund to Canadian investors (including marketing a non-Canadian fund by its non-Canadian manager) can trigger a requirement to be registered as a dealer under Canadian securities legislation.
Retail funds are marketed to all types of investors. Unless the investor’s purchase order is made through an order execution only dealer, a registered salesperson of the dealer must confirm that the selected retail fund is suitable for that investor. The types of retail funds that a dealer may sell may be restricted by its category of registration. Please see 3.2.3 Restrictions on Investors.
Only accredited investors may purchase securities of a pooled fund. Any other investment fund that makes a public offering of its securities can be purchased by any investor, provided the investor’s dealer holds the necessary registration to execute the purchase and the dealer’s salesperson has confirmed that the purchase is suitable for the investor.
There are some differences in approach between the Canadian securities administrators, based upon (among other factors):
This can be seen in enforcement matters for non-compliance where some regulators are more likely to seek a formal acknowledgement of wrongdoing coupled with a sanction (typically a fine), while other regulators may be content with a commitment from the party to remedy the non-compliance and improve systems to prevent its recurrence.
Each Canadian securities administrator generally has the authority to enact new securities legislation in its jurisdiction after following a quasi-legislative process (called "rule-making") involving public consultation. On a shorter-term basis, some regulators will exercise discretionary powers under their legislation to effect change. When this happens, the regulator will sometimes publish a notice that describes the concern and the manner in which the discretionary power will be exercised.
Some Canadian securities administrators (particularly the OSC) publish guidance in other forms, including the results of their audits of market participants for specific issues, and their statement of priorities for the coming year. Several times each year, the OSC also publishes a document it refers to as The Investment Funds Practitioner, which describes recent issues it encountered in the investment funds industry, and its views on those issues.
Canadian securities laws impose a wide range of operational requirements on investment funds that are reporting issuers, including the following:
Pooled funds are subject to the requirement to prepare audited annual and unaudited semi-annual financial statements (but not MRFPs), the requirement to utilise a custodian, and certain bright line prohibitions relating to conflicts of interest, but generally not the other operational requirements described above.
A manager’s subscription financing (such as to pay sales commission) is typically obtained through a credit facility with a Canadian bank. Financing for an investment fund to leverage its portfolio is available from a variety of sources, subject to restrictions in Canadian securities legislation on borrowing cash and using leverage, which vary depending on the categorisation of the fund under Canadian securities legislation.
Conventional mutual funds are prohibited from borrowing cash except as a temporary measure to fund payment on the redemption of their securities, or to facilitate settlement in trading in portfolio securities, providing that, in either case, the aggregate amount borrowed does not exceed 5% of the fund’s net asset value. As a policy matter, conventional mutual funds are not allowed to leverage their portfolios.
Alternative mutual funds and non-redeemable investment funds are permitted to borrow cash up to 50% of their net asset value, which may be used for any reason, including to purchase additional portfolio securities. However, there are restrictions on the parties from whom these funds can borrow cash.
There are no restrictions on the ability of a pooled fund to borrow cash.
To the extent that conventional mutual funds borrow cash, the borrowing is typically made from the fund’s custodian.
Non-redeemable investment funds that intend to borrow to leverage their portfolios often establish a credit facility with a financial institution. Short selling and derivatives are other means by which a non-redeemable investment fund can obtain additional cash or market exposure for its portfolio. Alternative mutual funds are likely to follow the same approaches as non-redeemable investment funds for borrowing and adding leverage to their portfolios.
Financing through credit facilities to fund commissions paid to dealers is well established. The principal issue with arranging financing tends to be the financial terms offered by the lender.
The differences in the Canadian tax treatment of fund structures and their investors is the primary reason for selecting one fund structure over another. The manner in which a fund is categorised under Canadian securities legislation generally has no impact on how it is taxed.
Taxation of Trust Funds
A trust structure is attractive from a tax perspective because a trust does not pay tax on any income (including capital gains) it distributes to unitholders in the year. Consequently, it is common practice for a trust fund to distribute all of its net income annually to its unitholders, and to provide that the distribution is automatically reinvested in additional units of the fund, unless the unitholder elects otherwise.
Taxation of Corporate Funds
A corporate fund can have three types of income:
A corporate fund may pay certain dividends to its shareholders in order to receive a refund of taxes under the refund mechanisms described above. Consequently, it is common practice for a corporate fund to pay these dividends at least annually to its shareholders, and to provide that the dividend is automatically reinvested in additional shares of the fund, unless the shareholder elects otherwise.
A corporation is a single taxpayer under Canadian tax laws, even if it is a multi-fund corporation. Since a multi-fund corporation calculates its net income for the corporation as a whole rather than on a fund-by-fund basis, this creates an opportunity for the fully taxable income earned in one fund to be offset by the deductible expenses (principally management fees) incurred by other funds within the corporation.
Taxation of Limited Partnerships
A limited partnership is not subject to Canadian tax and instead allocates both its income and its losses to its investors. It is used principally when the investment fund expects to have net losses for a period of time. A mere allocation is sufficient – a limited partnership is not required to actually distribute its net income to its partners. Securities of a limited partnership cannot be purchased by a tax-advantaged account, which is the principal reason why Canadian investment funds are rarely structured as limited partnerships.
Tax Treaty Network
When a Canadian investment fund distributes income to a non-resident investor, the fund is required to withhold tax at the rate of 25%, unless the treaty between Canada and the investor’s jurisdiction of residence provides for a lower rate of withholding.
FATCA and CRS Regimes
Canadian investment funds are subject to, and generally satisfy, their obligations under Canadian law for enhanced tax reporting to the Canada Revenue Agency. As a result, certain investors in Canadian investment funds may be requested to provide information to the fund or their dealer relating to their citizenship, residency and, if applicable, a US federal tax identification number or such information relating to the controlling persons in the case of certain entities. If an investor or any of the controlling persons of certain entities is identified as a US taxpayer, or if the investor does not provide the requested information, Canadian tax laws will generally require information about the investor’s investment in the fund to be reported to the Canada Revenue Agency, unless the investment is held in a tax-advantaged account. The Canada Revenue Agency then exchanges the information with the US Internal Revenue Service.
Canadian tax laws also include equivalent provisions for accounts held by residents of foreign countries (other than the US) where the collected information is exchanged on a reciprocal, bilateral basis with the countries in which the account holders (or their controlling persons) are resident, that have agreed to a bilateral information exchange with Canada.
Tax Structuring Preferences of Investors
Investments held outside a tax-advantaged account
Where an investor holds units of a trust fund outside a tax-advantaged account, any income distributed by the fund to the investor (including reinvested distributions) must be included in the investor’s income, and is taxed at the investor’s marginal rate.
Where an investor holds shares of a corporate fund outside a tax-advantaged account, dividends (including reinvested dividends) paid by a corporate fund to the investor must be included in the investor’s income. Dividends may include ordinary taxable dividends or capital gains dividends. Ordinary taxable dividends are subject to gross-up and dividend tax credit rules that apply to taxable dividends received from taxable Canadian corporations. Capital gains dividends are treated as capital gains realised by the investor. In general, an investor must include one half of the amount of a capital gain in the investor’s income for tax purposes.
Both a trust fund and a corporate fund can pay cash distributions that are a return of capital. These distributions are not taxable when received by the investor, but will reduce the adjusted cost base of the investor’s securities in the fund, which will have the effect of increasing the size of the capital gain (or reducing the size of the capital loss) realised by the investor when they eventually dispose of their securities.
Investments held in a tax-advantaged account
Much of the investment by Canadian individuals in investment funds is through one or more forms of tax-advantaged accounts that defer tax on any returns generated inside the account, until assets are withdrawn from the account. Securities of an investment fund must satisfy certain requirements under Canadian tax laws before they can be held in a tax-advantaged account. Generally, the units of a public trust fund and the shares of a public corporate fund can be held in a tax-advantaged account. In these cases, no tax is payable at the time the distribution or dividend is received. Instead, tax is payable at the investor’s marginal rate at the time cash is withdrawn from the account.
On 3 January 2019, Canadian securities legislation was amended to create a new subset of public mutual funds called "alternative mutual funds". Alternative mutual funds are permitted to use leverage in their investment portfolios as well as certain other investment approaches previously available only through non-redeemable investment funds and pooled funds.
The Canadian securities administrators are also seeking to more closely align the interests of registered salespeople with the interests of their clients through enhanced requirements relating to conflicts of interest, and through the elimination of certain embedded compensation.
The sale of investment funds through online platforms remains at an early stage of development due to regulatory restrictions, but may see dramatic changes in the near future as the Canadian securities administrators become more comfortable with financial technology.