This week, let’s talk about dividends paid inside a segregated fund.
Clients may be asking why do I not receive dividends when I’m in a dividend fund? I see them in my mutual funds.
Here’s a review of the mechanics of how dividends are treated in segregated funds vs. mutual funds.
Let’s start off with the same client owning 1,000 units of both a mutual fund and a segregated fund and both the mutual fund and the segregated fund have a $10 unit price. So, the client has $10,000 invested in both funds.
Now, a dividend is realized in both funds that is equivalent to $1 per unit. This is where the treatment of dividends differ between mutual funds and segregated funds.
In the mutual fund, this dividend will be used to purchase additional units. The client has received $1 x 1,000 units = $1,000. This $1,000 will be used to purchase more units, $1,000/$10 unit price equals 100 more units. The mutual fund client now has 1,100 units priced at $10 per unit or an account value of $11,000.
In the segregated fund, this dividend will be added to the assets of the segregated fund. Now the segregated fund is worth $11,000 and the client has the same number of units, 100. So, their unit price is now $11 per unit. Therefore, their account value is $11 x 1,000 units or $11,000.
As you can see, when the dust settles, the client has the same amount of money. The only difference is how the account value is calculated.
From a technical standpoint, a mutual fund is a trust and therefore can flow out distributions to clients. Segregated funds are not a trust, more a pooled account, which takes in distributions which can increase unit prices.
So, if a client ever asks if they can get the dividends from a segregated fund, the answer is no, the dividends get reinvested.
But, from a tax perspective, the mutual fund client and segregated fund client will have the same dividend reported to them on their T3 slips. That’s because segregated funds are deemed to be trusts for tax purposes.
To take this one step further, suppose a client does wishes to receive the dividends instead of reinvesting them. In a mutual fund, the dividends can be flowed out directly to the client. With a segregated fund, the client would have to make a withdrawal equal to the amount of the dividends.
The question then becomes, which is more tax efficient? After noodling around on a spreadsheet, we discovered the difference in taxes owing is minimal. The details on the spreadsheet are a bit too much for this communication, so we’ll discuss this at the next Money Monday on August 12th, we hope you can join in.
As always, we look forward to your comments.
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