On July 11, 2013, the Department of Finance issued a long
awaited News Release and Backgrounder announcing changes to the
grandfathering rules for "character conversion
The 2013 Federal Budget eliminated the tax benefits associated
with character conversion transactions — forward sale and
forward purchase agreements used by many mutual funds and other
investment funds to convert the return on a portfolio of
investments from fully taxable ordinary income into capital gains.
Only 50% of capital gains must be included in income for tax
purposes. Grandfathering was available for a "derivative
forward agreement" entered into before March 21, 2013.
However, many investment funds used a series of 30-day or 90-day
forward agreements to implement their character conversion
strategies. A series of "derivative forward agreements"
was not grandfathered under the original Budget proposal. However,
a series of agreements had a transition period of approximately 180
days before tax benefits would be eliminated.
To provide additional transition time for short-term forwards,
Finance is now proposing to extend grandfathering to including a
continuous series of short-term forward agreements first entered
into before March 21, 2013. Grandfathering for long-term forward
agreements will end on March 21, 2018. All grandfathered forward
agreements will be subject to "growth limits", as
For a "derivative forward agreement"—a forward
sale or purchase agreement (or a series of agreements) with a
duration exceeding 180 days that was entered into before March 21,
2013 and the terms of which provide for final settlement of the
agreement before 2015 (or that is part of a series of agreements
that concludes before 2015) —Finance proposes to extend
grandfathering until the end of 2014 for investment funds that stay
within the specified growth limits. Also, the grandfathering rules
will be amended to make it clear that agreements entered into
before March 21, 2013 will be considered when determining whether a
series of agreements has a term of more than 180 days. However, it
is proposed that this change will apply prospectively, so that an
investment fund that exceeded the growth limits before July 11,
2013 will have a 180-day transition period. Finance provided the
following example: if a taxpayer entered into a 180-day derivative
forward agreement on April 1, 2013 as a continuation of a series of
derivative forward agreements that were entered into before March
21, 2013 and the new derivative forward agreement exceeded the
growth limits described below, the taxpayer would still be entitled
to 180 days of grandfathering after April 1, 2013.
For a grandfathered "derivative forward agreement"
that was scheduled to finally settle after 2014, grandfathering
will now end on March 21, 2018, and will be subject to the growth
limits described below.
To qualify for grandfathering, the notional amount of the
derivative forward agreement after March 20, 2013 cannot exceed the
the notional amount of the forward immediately before March 21,
any net increase in the notional amount of the forward after
March 20, 2013 resulting from a net increase in the value of the
reference assets (i.e., excluding new investments in the
any forward settlement amounts after March 20, 2013 that are
reinvested in either the forward or a replacement forward;
any cash on hand immediately before March 21, 2013 that can
reasonably be considered to have been committed to the forward
before March 21, 2013;
if the forward was entered into, and an over-allotment option
in respect of an offering of securities was granted, before March
21, 2013, amounts invested in the forward using proceeds from the
exercise of the over-allotment option after March 20, 2013;
any other increases in the notional amount of the forward
occurring after March 20, 2013 and before July 11, 2013, that do
not exceed 5% of the notional amount of the forward immediately
before March 20, 2013.
Finance also confirmed that it will allow for increases in the
size of a forward as a result of the merger of two investment
funds, provided that the surviving forward's notional amount
does not exceed the combined notional amounts of the two
predecessor forwards (presumably subject to the growth limits
described above) and its term does not exceed the term of either
Draft legislation implementing these proposed changes is not yet
available. We will provide an update once draft legislation has
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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