Reader Question: Are MERs tax deductible?

I received an email from a reader and thought I would share my response for everyone.

QUESTION

Preet: Are MERs eligible to claim as  carrying charges on income tax return? I’ve been told they are not but I don’t understand why since they are an expense to the investor. Look forward to your answer.
Thanks

ANSWER

As always, I need to remind everyone I am not a tax professional and you need to verify anything you read on this blog with your own professional advisor.

Having said that, mutual fund Management Expense Ratios (MERs) are never tax deductible. This seems to be since income distributed by the fund to the unitholder is done after the fund has deducted the MER first, so being able to deduct the MER would be a double deduction of sorts.

However, when an advisor uses F-Class mutual funds and charges a separate fee, normally called the Client Advisory Fee (CAF), this CAF is potentially tax deductible. Suppose you have Mutual Fund XYZ which can be sold as either a B Class fund (with a 2.25% MER, of which 1.00% is a trailing commission to the advisor), or it can be sold as an F-Class version (which has an MER of 1.25%, but the advisor chooses to charge 1.00% as the CAF).

In both cases the before tax cost of owning either class is 2.25%.

However, if you hold the F-Class fund in a non-registered account the CAF is potentially tax deductible. Assuming you were in a 30% marginal tax bracket, that means your after tax cost might only be 1.95% (1.25% MER + [1.00% CAF x (1 – 0.30)] = 1.95%).

You’ll notice I’m emphasizing that the deduction is potentially allowable. This is because the fee charged must relate substantially to investment advice. If the advisor performs a substantial amount of financial planning services which is included in this CAF, then it is possible that CRA will only allow deduction of a portion of the CAF that relates to the investment advice. I have never seen a CAF challenged, and your advisor’s firm will issue a letter or form indicating how much the CAF is for each tax year – but they will also indicate that it is only potentially tax deductible and that you need to have it verified by a tax professional.

MER – Management Expense Ratio
CAF – Client Advisory Fee
CYA – Cover Your Ass

Also note, Scott Ronalds at Steadyhand had a great blog post that elucidates why MERs are not deductible: http://www.steadyhand.com/industry/2010/07/08/management_fee_deductibility_clearing_the_air/

For more info:

• http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns206-236/221/menu-eng.html
• http://www.cra-arc.gc.ca/E/pub/tp/it238r2/it238r2-e.html