Fund industry seeks extension to implement federal budget measure

The budget proposal is putting an end to the use of derivative instruments for “character conversion transactions” that transform ordinary income to capital gains, only 50% of which are taxable. These derivative strategies have enabled fund managers to give investors more in the way of after-tax returns, a significant investor benefit in the current low interest rate environment.

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The measure applies to derivative forward agreements entered into by investment funds on or after budget day of March 21, 2013. Derivative contracts arranged before budget day will be grandfathered. However, as these contracts expire, interest income will become fully taxable.

While the Department of Finance has given firms 180 days from budget day as a “transition period,” IFIC has asked Finance representatives to extend the transition period until Jan. 1, 2015 to enable an orderly wind-down. Prior to budget day, many investment fund managers had set up short-term derivative contracts that renew automatically, such as 30-day rolling contracts, and these must be discontinued by the end of the transition period.

There are no industry estimates on the value of assets affected by the proposed new rules, but most major fund companies offer tax-advantaged income funds that employ derivative strategies to reduce investor taxes — and they are popular. Although existing derivative contracts are grandfathered, they all face varying expiry dates, and this creates an advantage for those with long-dated contracts, Carman says. For example NexGen Corporate Bond Fund, sponsored by NexGen Financial Corp. of Toronto, has in place a five-year derivative contract that covers $9 million of its $45 million in assets.

“Some funds, particularly closed-end funds, have longer contracts, and until those contracts expire they continue offer the tax advantage,” says Carman. “That creates an uneven playing field, and is one of the points we are making in asking for a longer transition period.”

Carman says it is the intention of Finance that effective budget day, for the protection of existing investors in the funds, new money should be prevented from coming into fund structures that use character conversion transactions. Consequently, fund companies have been issuing press releases saying their funds are capped and closed to new contributions. However, many funds have pre-authorized contribution plans (PACs) and dividend reinvestment plans, and these can take time to wind down – another reason for a longer transition period, Carman says.

“Each individual fund company is looking at what it can do to stop the flow,” Carman says.

He says funds will be affected to varying degrees, depending on the percentage of assets covered by forward contracts. Some funds may decide to continue to operate with similar portfolios even though they are no longer able to use derivative contracts to convert interest income to taxable gains, while others may have to change their investment objectives. Once all of the derivative contracts expire, there is nothing to stop a fund from uncapping and operating as a regular fund, he says.

“Fund companies are looking at their options,” he says. “If they no longer can use derivatives or forward contracts, do they invest directly in the underlying securities and become a regular bond fund or yield fund, or do they merge with other existing funds? We expect some funds will close and others will reappear with new objectives.”

The $3.2 billion Renaissance Corporate Bond Capital Yield Fund, sponsored by CIBC Asset Management Inc. of Toronto, one of the largest funds employing derivative contracts to convert income to capital gains, has announced it will continue to offer the fund with same underlying investment focus in corporate bonds, even after the income conversion contracts are no longer allowed.

Carman says corporate class structures that contain individual funds within the corporate family that use derivative contracts must assess not only the impact of the budget measure on those specific funds but on the entire corporate structure. Typically, corporate class structures offer reduced taxation to investors by mixing and matching taxable interest income produced by some funds with offsetting expenses from other funds within the same family. The level of complexity involved in these multi-fund structures is another argument to extend the transition period, he says.