As part of its 2013 budget, the federal government is proposing changes to prevent the use of financial arrangements involving derivatives contracts that allow for the character conversion of ordinary income to capital gains. The use of these financial arrangements has become popular in the financial services industry with tax-conscious investors. The proposed changes will affect some Canadian mutual funds that promote the re-characterization of income to capital gains as a significant feature.

“It appears, on first reading, that this proposed change could eliminate the advantage enjoyed by many if not all mutual funds that have been specifically created to convert what otherwise would be taxable interest income to capital gains,” says Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management.

There has been an appetite among investors, in today’s low interest rate environment, to keep more of what are already relatively low yields. One way to achieve that result is to invest in mutual funds that allow an investor to have a bond portfolio, but one in which the income receives the favourable tax treatment of capital gains. Interest income is taxed at an investor’s marginal tax rate, while only 50% of capital gains are included in taxable income.

The government is proposing to treat a derivatives-based return on a derivative forward agreement as distinct from the disposition of a capital property that is purchased or sold under the derivative forward agreement. This measure will apply to derivative forward agreements with a duration of more than 180 days.

Character conversion transactions can be challenged by the government based on existing rules in the Income Tax Act. However, as these challenges can be time-consuming, the government says that it has decided to introduce specific legislative measures to ensure that the appropriate tax consequences apply to these transactions.

The proposed measure will apply to derivative forward agreements entered into on or after Budget Day. It will also apply to derivative forward agreements entered into before Budget Day if the term of the agreement is extended on or after Budget Day.