In the 2013 federal budget, the Canadian government announced its intention to extend the tax loss restriction rules to trusts. Previously, loss restriction rules applied only to corporations when control was acquired. The new trust loss restriction rules were enacted on December 12, 2013, with retroactive effect beginning after March 20, 2013. Investment funds (including pooled funds, mutual funds and exchange-traded funds) are not exempt from the application of the rules.
This bulletin describes the new trust loss restriction rules and identifies implications for the investment fund industry. The rules present some significant operational challenges.
Trust Loss Restriction Rules
The trust loss restriction rules will apply each time a trust is subject to a "loss restriction event", which will occur each time a person (including a partnership) becomes a "majority-interest beneficiary" of the trust and each time a group of persons becomes a "majority-interest group of beneficiaries" of the trust. The rules are found in new section 251.2 of the Income Tax Act (Canada) ("ITA").
A "majority-interest beneficiary" of a trust is a person whose beneficial interest in the income (or capital) of the trust, together with the beneficial interests of any affiliated persons in the income (or capital) of the trust, is greater than 50% of the fair market value of all the beneficial interests in the income (or capital) of the trust. A "majority-interest group of beneficiaries" is a group of persons each of whom has a beneficial interest in the trust such that (i) if one person held the beneficial interests of all of the members of the group, that person would be a majority-interest beneficiary of the trust, and (ii) if any member of the group were not a member of the group, the majority-interest beneficiary test in (i) would not be met. For this purpose, "person" includes a partnership.
The rules will not be triggered when a person ceases to be a majority interest beneficiary. Also, an acquisition of a beneficial interest in a trust by a person affiliated with a majority-interest beneficiary will not trigger the rules. There are a number of other special interpretive rules, deeming rules and anti-avoidance rules included in section 251.2 of the ITA. Some technical anomalies have been identified.
Consequences of Loss Restriction Rules
A loss restriction event triggers the following tax consequences for a trust:
- The current taxation year of the trust will generally be deemed to end at the beginning of the day on which the loss restriction event occurred.
- The trust will be deemed to dispose of any non- depreciable capital property with an accrued loss for its fair market value. The trust may elect in its tax return to realize capital gains on property with accrued gains.
- Any undeducted net capital losses and non-capital property losses of the trust for taxation years before the loss restriction event will be extinguished. Net capital losses and non-capital property losses of the trust realized after the loss restriction event cannot be carried back to before the loss restriction event.
- Any undeducted non-capital business losses of the trust for taxation years before the loss restriction event can be carried forward, subject to certain restrictions.
Implications for the Investment Fund Industry
The loss restriction rules can be expected to have a significant and adverse impact on investment trusts ("Funds") from an operational, compliance and tax perspective.
- Unexpected Event — Many times a loss restriction event will not be anticipated and cannot be controlled. The event can occur because of subscriptions, redemptions or trades (or a combination). Further, the deemed year-end effectively occurs on the day before the triggering subscriptions/redemptions/trades.
- Distributions for Deemed Year-End Required — To avoid a tax liability, a Fund must calculate and distribute its net income and net realized capital gains for the short (and potentially unexpected) taxation year. The declaration of trust for a Fund traditionally provides for an automatic distribution at the natural year-end of a Fund. It may (or may not) provide for the automatic distribution on a deemed year-end.
- Potential Pricing Error — If an automatic distribution and reinvestment on a deemed year-end is not immediately followed by an automatic consolidation of units, the net asset value per unit of the Fund will be overstated. There will be a pricing error.
- T3 Returns Required for Deemed Year-End — The Fund will be required to file a T3 return within 90 days of the deemed year-end. This will be important because of the need to elect to realize capital gains in order to use capital losses.
- T3 Slips Must be Issued for Deemed Year-End — The Fund will be required to issue T3 slips to investors within 90 days of the deemed year-end, unless administrative relief is obtained.
- Timeframe for Qualifying as a "Mutual Fund Trust" — The time frame for a Fund to qualify as a "mutual fund trust" under the ITA will be shortened if a loss restriction event occurs after the time the Fund is created and before the first natural year-end of the Fund. This will be a very real issue for exchange traded Funds and other Funds that are not seeded by the Fund's initial unitholder. The Fund will have 90 days after the deemed year-end to qualify. The Fund would have to ensure that the election to be regarded as a "mutual fund trust" since inception is included in the tax return for the deemed year-end.
- Taxable Mergers — In the context of a taxable merger, the rules will operate to extinguish losses of a continuing Fund that is smaller than the terminating Fund.
- Tax-Deferred Mergers — Some technical anomalies may exist between the qualifying exchange rules and the new loss restriction rules.
- Fund Structuring — Certain Fund structures will be prone to the serial application of the loss restriction rules with the resulting year-end compliance and repeated extinguishment of losses. These Fund structures include pooled Funds with a small number of investors, Funds that have a few large investors, certain fund-on- fund structures and reference Funds. These Fund structures may be less viable in the future.