2013 Federal Budget: Proposals Impacting the Investment Fund Industry

The recent federal budget included a proposal that will put an end to a planning technique that has become common in the Canadian investment fund industry in recent years. So-called “character conversion transactions” were targeted by the Minister of Finance as a “loophole” that warranted closing. Mutual funds, closed-end funds and ETFs have used these transactions in order to provide an effective method of converting unitholder distributions that would be fully taxable as income into either partially taxable capital gains or tax-free returns of capital.

“Character conversion transactions” involve the use of derivative contracts, referred to as forward agreements, by mutual fund trusts or mutual fund corporations to gain exposure to the economic return on an investment portfolio (the “Reference Fund”) in a tax-advantaged manner. These arrangements are structured in one of two ways, a traditional forward structure and a pre-paid forward structure.

In a traditional forward structure, the mutual fund trust holds a portfolio consisting of non-dividend paying common shares of ten or more public companies that qualify as “Canadian securities” for the purposes of the Income Tax Act (Canada) (the “Tax Act”). The mutual fund enters into a forward agreement with a counterparty (typically a Canadian Schedule I bank) whereby the mutual fund agrees to sell Canadian securities to the counterparty at future dates. The purchase price for the Canadian securities would not be based on their value; rather, it would be based on the return of the Reference Fund. Oftentimes, the Reference Fund generated returns that would be taxed as regular income. For income tax purposes, the mutual fund would make an election under the Tax Act to treat all of its gains and losses from the disposition of Canadian securities on capital account. As a result, the amount received from the counterparty for the sale of the Canadian securities under the forward agreement would be taxed on capital account rather than income account.

In a pre-paid forward structure, the mutual fund enters into a forward agreement with a counterparty whereby the mutual fund agrees to purchase Canadian securities from the counterparty at future dates. The mutual fund advances an amount raised from investors to the counterparty as a prepayment of its obligations under the forward agreement. The value of the Canadian securities periodically delivered by the counterparty to the mutual fund would be based on the return of the Reference Fund. The mutual fund would sell the Canadian securities shortly after receiving them from the counterparty and distribute the proceeds to its unitholders. As with the traditional forward structure, the disposition of the Canadian securities would be on capital account for tax purposes.

The budget proposes to treat the gain or loss on these types of derivative forward agreements on income account rather than capital account. This measure is to apply to forward agreements with a duration of longer than 180 days entered into on or after March 21, 2013. It will also apply to derivative forward agreements entered into before that time if the term of the agreement is extended on or after March 21, 2013. Accordingly, forward structures that are currently in place will be grandfathered until the end of their term.

This grandfathering provision has created some question as to whether an existing forward agreement could be “up-sized” to increase a mutual fund’s exposure under an existing forward agreement after March 21, 2013 without amending the terms of the forward agreement. The prevailing view on this issue is to not “up-size” an existing forward agreement until draft legislation is introduced by the Minister of Finance, as it would not be prudent to risk losing the grandfathered tax status for the current unitholders of a mutual fund with one of these structures in place. As a result, we are likely to see mutual fund managers closing their existing funds to new investors and launching new funds with similar investment strategies to those mutual funds that currently use one of the tax-advantaged forward agreement structures.

This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.