Ottawa is hoping to plug some of the perceived tax leakage created by income trusts by putting the brakes on pension plans playing in this hot sector.

The government is proposing to limit the pension funds‚ exposure to income trusts by restricting them to holding no more than 1% of their assets in “business” income trusts (this does not include REITs or resource-based royalty trusts). It would also limit pensions from holding mutual funds that have more than 1% of their assets in these trusts (which would give pension funds indirect exposure to business income trusts).

As well, pension funds will also be restricted from controlling more than 5% of any business income trust, even if this stake leaves the fund below the 1% restriction. Funds that exceed either restriction would be subject to a penalty tax of 1% per month.

Don Webster, principal with Mercer Human Resources Consulting, says that the government’s aim is to avert the possibility of massive tax leakage that could occur if pension plans started to seriously play the trust sector.

At present, pension funds have largely avoided this asset class for fear of the unlimited liability that may attach to these vehicles. However, with legislation pending in Ontario and other provinces that would close this loophole, the federal government appears to fear the effect of large tax deferrals if pension funds became big players in these vehicles.

One possible side effect of these new restrictions is that pension funds could be prevented from investing in index funds or other passive securities with large exposure of business income trusts, such as exchange-traded funds. This could either keep these trusts out of the index, spark the creation of new indexes, or force pension plans to rewrite their investment policy statements to accommodate the restriction. According to the budget documents, this effect could also affect the Canada Pension Plan.

The government indicates that funds with existing investments in income trusts will be given transitional relief from the new restrictions for the next 10 years — so, existing investments in these now-restricted trusts will not trigger a penalty tax themselves, but they will be taken into account in determining the extent to which new restricted investments can be acquired.

Transitional relief for indirect holdings, such as mutual funds that hold restricted trusts, would end after five years. The government says that the shorter transition period for these holdings reflects “the greater risk for pension funds to expand their holdings in income trusts through indirect investments such as pooled investment vehicles and other mutual funds”.

The government proposes that the penalty taxes apply for months that end after 2004, to ensure that mutual funds have sufficient time to develop systems required to monitor the new limits and possibly restructure their portfolios.

The proposals only apply to registered pension plans.