Mutual funds: Character conversion

“It’s a huge win,” says Melody Chiu, senior manager in the tax services department of Pricewaterhouse Coopers LLP in Toronto.

The extended grandfathering period will give investment firms more time to restructure the affected funds. The extension also gives existing investors a bonus period in which to continue to access the tax advantages of these products.

In July, the Department of Finance Canada proposed changes to the transitional rules governing character-conversion transactions in response to requests from the financial services industry. The new rules give investment firms until the end of 2014, in most cases, to unwind derivative forward agreements that involve character-conversion transactions.

As Suzanne Prebenski, a spokesperson for Finance Canada, wrote in an email reply to a query regarding the proposed changes: “This is about clarity to ensure smoother transition to transitional rules.”

Prior to these new transition rules, the industry was essentially given a window of 180 days after the federal budget date of March 21, 2013, to unwind derivative forward agreements, a time frame the industry felt was inadequate.

“The industry has been lobbying very hard to extend the transition period for character-conversion transactions,” says Jamie Golombek, managing director of tax and estate planning with Canadian Imperial Bank of Commerce‘s private wealth-management division in Toronto. “I think [the new transitional rules] are very helpful.”

Derivative contracts

Certain mutual funds and ETFs have been using forward derivative contracts to convert what would otherwise have been ordinary interest income into capital gains, which are taxed at half the rate of income.

Many investment firms offered tax-advantaged or capital-yield funds to investors, attracting clients interested in realizing a higher return in an environment of low yields.

Ottawa announced in the 2013 federal budget that it would be eliminating the tax benefits of using character-conversion transactions, indicating the feds want “to ensure the appropriate tax treatment” of a fund’s return.

“We weren’t actually all that surprised that the government shut [character-conversion strategies] down,” says Peter Bowen, vice president of tax research and solutions for Toronto-based Fidelity Investments Canada ULC. “It’s something we figured would eventually happen.”

Following the budget announcement, a number of firms elected to make changes to their funds that were using character conversion transactions to prevent new contributions, stating they wanted to protect existing investors.

The extended period of time now provided by the proposed transitional rules, as well as the greater certainty regarding Finance Canada’s intentions, will give firms more flexibility and time to make adjustments.

“We think that Finance has come to a fair decision,” says James Carman, IFIC’s senior policy advisor for taxation, “that will really allow us in the industry to treat our investors fairly and ensure as smooth a transition as possible for them.”

The proposed transition rules include “growth limit” provisions intended to prevent any new assets from using the character-conversion tax advantages of the forward derivative arrangement in these funds while still providing for a fund’s growth through, for example, the rise in the value of the underlying investments.

“[The growth limits] confirm the message,” Chiu says, “that these forward [contracts] should not be increasing in size due to new investments.”

Manage the transition

Fund companies may choose from a number of alternatives to manage the transition away from using character-conversion transactions, depending on the structure of the product, including maintaining the fund’s investment mandate but without the tax advantage, merging funds, changing the investment mandate or closing the fund.

Fund companies would appear to have no incentive, however, to stop rolling forward the derivative agreements in these funds before they have to. Thus, existing investors in the funds will be able to enjoy the tax advantages of character conversion until that time.

“Investors get an extension of the advantage of the tax classification,” Carman says, “potentially, until the end of 2014.”

In fact, a fund employing a derivative forward agreement with a settlement date beyond 2014 at the time of the budget announcement will enjoy grandfathering until the settlement date.

However, no fund will be able to access the tax advantages of character conversion beyond March 21, 2018, the fifth anniversary of the budget announcement.

“The government,” Golombek explains, “doesn’t want to have an indefinite grandfathering.”

The extension also will give investors and their financial advisors more time to consider their next steps.

“Instead of having to rush through that decision,” Golombek says, “you now can take your time and look at the fund and really go back to the basic principles – ‘Does this fund make sense in my portfolio as part of my asset allocation, and will it help me achieve my financial goals?’ – because that should really be the No. 1 question that people should have been asking from the beginning.

“Hopefully, people aren’t just buying these funds because of the tax consequences.”

© 2013 Investment Executive. All rights reserved.