Linked notes changes having major impact

Adds Domenic D’Aoust, director of structured products with Laurentian Bank of Canada in Montreal: “Clearly, the demand will be cut by a huge amount on the principal-at-risk products.”

In fact, D’Aoust adds, sales of PARNs are down by as much as about 50% since the federal government proposed eliminating a tax-planning opportunity long associated with linked notes as part of the federal budget presented in March.

According to Toronto-based asset-management research firm Strategic Insight Inc., there was an estimated $37 billion in total assets under management held in Canadian linked notes as of June 30, up from $21.5 billion as of Dec. 31, 2011. The large majority of outstanding linked note issues are PARNs, as opposed to principal-protected notes (PPNs), according to the firm.

Linked notes are debt obligations in which the return is tied in some way to an underlying equity, basket of securities or index over the term of the obligation. A PPN offers a guarantee of capital plus the possibility of a return based on the underlying asset. A PARN offers investors the opportunity to boost the return on the underlying asset through leverage, but with some of the invested capital at risk.

Under current legislation, an investor who sells a linked note before maturity in the secondary market effectively can convert the return on the note to capital gains from ordinary income, which is taxed at twice the rate of capital gains. To help achieve this result, issuers of linked notes often establish a secondary market, via an affiliate company of the issuer, in which investors can buy and sell the note. If a note is held to maturity, however, any positive return is taxed as ordinary income.

Under Ottawa’s proposed legislation, the return on a linked note would be treated as ordinary income whether the note is held to maturity or sold before maturity in a secondary market. The government made the change as part of a broader set of initiatives aimed at “enhancing domestic tax integrity.”

The budget stated that the change would be effective for all linked notes sold in October or afterward. However, in September, the government indicated that the new legislation would be effective only for linked notes sold in 2017. The three-month delay will give the financial services sector more time to update internal systems to prepare for the change, the government stated.

In general, the financial services sector has expressed reservations about the proposed tax change.

“We would have preferred that Finance Canada maintain the existing [tax] treatment [of linked notes],” says the Toronto-based Canadian Bankers Association (CBA) in a statement.

One key concern is that the proposed legislation may have the effect of limiting choice for smaller investors who are looking for some exposure to the higher returns that equities can provide while ensuring that their capital is fully or partially protected.

“In this low-return environment, [linked notes are] about the only product that can help you get more risk, but manage that risk at the same time,” D’Aoust says.

There also are concerns about the tax treatment of PARNs, in particular, under the proposed legislation. Although some of an investor’s capital would be at risk, the returns would be taxed as ordinary income even when sold before maturity in a secondary market. “I strongly believe, and others in the industry do, that an unfair taxation [situation] arises,” D’Aoust says.

However, the government has not provided any signal about changing the proposed legislation regarding linked notes.

“Our principal concern at this stage is to ensure that the transition to the new tax rules is minimally disruptive to clients,” adds the CBA in its statement, “and that clients have sufficient time to work with their financial advisors to manage their investments properly.”

Some investors who are holding linked notes may be advised to dispose of them in the secondary market before the end of the year, when the proposed legislation becomes effective.

“Anyone who owns one of these in a non-registered account, and is sitting on a good amount of profit, may well choose to sell them,” says Dan Hallett, vice president and principal at HighView Financial Group in Oakville, Ont.

However, investors holding a linked note also should consider “the potential future return of that note, and what [the investor] would do with the money if he or she chooses to crystallize it” before making a decision, says Debbie Pearl-Weinberg, executive director of tax and estate planning in the wealth strategies group with Canadian Imperial Bank of Commerce in Toronto.

Even with the proposed tax changes, linked notes continue to offer attractive features and could be well suited for a client’s portfolio, Pearl-Weinberg says. These features include full or partial protection of principal and the potential for higher returns. Also notable, linked notes held in a registered account are unaffected by the proposed tax changes.

Linked notes offer the possibility of tax deferral because the return on a note often is not determined until maturity or disposition, Pearl-Weinberg says: “Because of that feature, you’re not required to include an amount in income until the note terminates or you dispose of it.”

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