ETFs get reprieve on tax proposal

“They’re certainly favourable changes,” says Friedman.

March’s federal budget proposed to constrain mutual fund trusts’ (MFT) ability to deduct income or capital gains when unitholders redeem units. The proposals affect all MFTs (which include ETFs) that use the “allocation to redeemers” (ATR) methodology.

In July’s draft legislation, “there’s really no change with respect to the substantive provisions,” says Nigel Johnston, partner in McCarthy Tétrault LLP’s tax group in Toronto.

The legislation, if passed, will disallow allocations of ordinary income to redeemers if the unitholder’s redemption proceeds are reduced by the allocation. As expected, this would apply to all MFTs for tax years beginning after March 18, 2019.

The budget also proposed to deny MFTs the ability to allocate excess capital gains to unitholders who are redeeming units. Instead, only appropriate gains should be assigned to those unitholders.

The draft legislation includes a formula to determine which deductions for capital gains will be denied. An MFT wouldn’t be able to allocate any gains to a unitholder upon redemption above what would be actually realized by the unitholder.

The draft legislation also contains two administrative tweaks, which are “the result of [the Dept. of] Finance [Canada] hearing the concerns of industry stakeholders,” says Minal Upadhyaya, vice president, policy, and general counsel with the Investment Funds Institute of Canada (IFIC).

For one, ETFs now have an extra year to adapt to the new rules regarding capital gains. According to the draft legislation, the capital gains-related provision will apply to ETFs for tax years beginning after March 20, 2020, but will apply to all other mutual fund trusts for tax years beginning after March 18, 2019.

With this change, “the government is saying, ‘We’re going to give some breathing room while we pursue discussions with IFIC and other industry organizations to see if there needs to be some rethinking of the [proposals],'” Johnston says.

Friedman agrees: “We infer from the delay in enactment for [ETFs] that perhaps Finance [Canada] will continue to listen to concerns and study the matter.”

Following the 2019 budget’s release, MF industry groups raised concerns about the difficulty of calculating a unitholder’s cost base – an amount that is required to determine the appropriate capital gains to allocate to the unitholder who is redeeming units.

Because ETF manufacturers trade with designated brokers, not directly with individual unitholders, an ETF manufacturer doesn’t have “direct line of sight to the individual investor,” says Upadhyaya.

As a result, knowing unitholders’ identities and cost bases is difficult, if not impossible, for ETF manufacturers. That means accurately assigning capital gains upon redemption also is difficult.

If an ETF can’t assign capital gains accurately, the fund will have to rely on the capital gains refund mechanism, which Finance Canada acknowledges is imperfect because it can create double taxation for unitholders.

With the refund mechanism as is, “you could have circumstances in which additional capital gains are allocated to remaining unitholders in a way that would be unfair,” Friedman says.

The July draft legislation buys time for ETFs to manage these issues.

“The one-year delay for ETFs allows us to sit down and see if there is a way of better dealing with the tax situation,” says Pat Dunwoody, executive director of the Canadian ETF Association (CETFA). “We want to be able to inform [Finance Canada about] potential solutions.” She adds that CETFA and IFIC will be working on the matter over the next few months.

The government’s rationale for targeting the ATR methodology, as was described in the budget, is to prevent certain MFTs from overallocating capital gains to unitholders’ redemptions, which the budget stated “results in an inappropriate deferral.”

The government estimates that changing the ATR rules will create $350 million in revenue from fiscal 2019 to fiscal 2024 – more than the amount created from efforts to increase tax compliance.

“Reasonable efforts”

While mutual funds don’t have the same “line of sight” issue as ETFs do, there still are challenges for the former when calculating unitholders’ cost bases. For example, some unitholders hold units in nominee name while others hold units in client name. Clients also may hold the same units of the same fund through multiple dealerships.

The second administrative tweak in the draft legislation would mean that fund manufacturers need only make “reasonable efforts” to determine a unitholder’s cost base. In the explanatory notes to the draft legislation, reasonable effort is defined as using “records of initial subscription prices paid” and “accurate information as to transactions involving the units.” If the fund manufacturer doesn’t have this information, it should make “reasonable efforts” to obtain it, “for example, through inquiries to third parties or through a search of relevant records.”

What Finance Canada doesn’t expect, according to the explanatory notes, is for a mutual fund to “make inquiries regarding external factors (i.e., events that did not involve the MFT or transactions to which the MFT was not a party) unless the MFT has reason to believe that such external factors exist and could affect the cost amount of the units.”

Johnston, a member of the Portfolio Management Association of Canada’s Industry Regulation and Taxation Committee and IFIC’s Taxation Working Group, calls the test “a pretty practical solution.”

However, Friedman warns that the term “reasonable efforts” is ambiguous. Despite the guidance provided in the explanatory notes, he says, “there’s still lack of certainty of how much effort needs to be made. The hope will be that the [Canada Revenue Agency (CRA)] will issue clear statements over the next year indicating what it’s actually expecting from taxpayers.”

Instead of a reasonable efforts test, Friedman prefers that Finance Canada focus on “the evil it was trying to deal with, which is funds intentionally overallocating gains, and perhaps put a purpose test into the new legislation [stating] that if one of the purposes was to overallocate capital gains, then this section [in the legislation] would apply.”

Upadhyaya says that IFIC will be examining the draft legislation closely to see if the “reasonable efforts” test is “workable for our members.”

In the meantime, Friedman says, concerned advisors can “make inquiries of a fund to determine if [it will] have a formal policy on what [the fund] considers to be reasonable efforts, and [whether it] be documenting those efforts if the CRA chooses to challenge what [the fund] has done.” This would be particularly important for clients in unlisted mutual funds (i.e., not ETFs), he adds, as the rules apply for tax years beginning after March 18, 2019.

Fate of the legislation

IFIC is reviewing the draft legislation to determine whether the institute will submit another comment before the comment period’s Oct. 7 deadline, Upadhyaya says.

MPs are not expected to return to the House of Commons until after the Oct. 21 election, so the legislation isn’t likely to be passed before then.

Will the draft legislation pass if a new government is elected? “Our hope [is] that it will,” Upadhyaya says, “because it has been the result of discussions between industry and Finance [Canada], trying to create an approach that addresses Finance’s concerns, but also takes the industry’s operational concerns into account.”

“If you have legislative proposals that have been developed this far, it would be quite unusual for them not to get passed,” Johnston says – even if a new government is formed after the election. “People have been expected to rely on these proposals,” he adds, “as if they [were] enacted when they were first announced.”

Example of a capital gains overallocation

A mutual fund trust (MFT) disposes investments during a taxation year and realizes a capital gain of $90. A beneficiary who holds units in a capital account redeems the units during the same taxation year. The net asset value of the units is $100 and the adjusted cost base to the beneficiary of the redeemed units is $50 in that year. The beneficiary is entitled to receive $100 as a result of the redemption.

Using the “allocation to redeemers” methodology, the MFT treats the $100 payable to the beneficiary as a distribution to the beneficiary of the MFT’s entire capital gain of $90 and a payment of redemption proceeds of $10. This capital gain allocated to the beneficiary exceeds the capital gain of $50 that would otherwise have been realized by the beneficiary on the redemption of their units. The MFT claims a deduction under Subsection 104(6) in computing its income with respect to the entire taxable capital gain of $45 realized by the MFT. This deduction of $45 exceeds the deduction of $25 (i.e., 0.5 x $50) that the MFT would have claimed had it limited the allocated amount to the capital gain of $50 that would otherwise have been realized by the beneficiary.

Proposed new paragraph 132(5.3)(b) would apply in this scenario and limit the deduction by the MFT under Subsec. 104(6). The amount denied would be the portion of the allocated amount determined by the formula:

A – 0.5 ( B + C – D ) = $45 – 0.5 ( $10 + $90 – $50 ) = $20

where

A is the portion of the allocated amount of $90 that would be, without reference to Subsec. 104(6), an amount paid out of the taxable capital gains of the trust: $45

B is the beneficiary’s proceeds from the disposition of the unit on the redemption: $100 – $90 = $10

C is the allocated amount: $90

D is the beneficiary’s cost amount of that unit: $50

In sum, the proposed Subsec. 132(5.3) would deny a deduction of $20 of the allocated amount. This represents the difference between the claimed deduction of $45 and the deduction of $25 (which the MFT would have claimed had it limited the allocated amount to the capital gain of $50 that would otherwise have been realized by the beneficiary).

Source: Dept. of Finance Canada