Canada: Tax Changes Of Interest To Canada’s Investment Management Industry

On June 5, 2000 the Canadian federal government tabled a Notice of Ways and Means Motion ("NWMM") with amending legislation to implement a variety of income tax measures previously announced. The following comments highlight those items of prime interest to the investment management industry.

The so-called trust proposals contained in the NWMM are the most relevant to the investment management industry. They were initially released on December 23, 1998, and subsequently revised on December 17, 1999. Further modifications and additions have been made in the June 5, 2000 NWMM. Finance Canada has stated that the trust proposals are intended to clarify existing legislation, and to codify current administrative policies. However, the amending legislation goes well beyond this simple goal.

The changes, which are wide-ranging and in many cases subtle, affect all types of trusts. Some of the highlights are outlined below:

• Capitalized distributions of foreign property funds: When distributions from a fund are reinvested in additional units, the cost amount of the investor’s units increases. When distributions are capitalized, it does not. The foreign property limit is measured at cost. A pension plan’s foreign property "room" can be increased if distributions from its foreign-content funds are capitalized and distributions from its Canadian-content funds are reinvested. This technique is commonly used by pooled funds. The amending legislation eliminates the capitalization advantage for distributions that become payable after 2000.

The cost amount of units of a foreign-content fund will increase by the amount of capitalized distributions, but only for the purposes of calculating foreign property. The increase will occur 61 days after the end of the year in which the distribution became payable. These new rules will not apply to Canadian-content funds.

Funds that capitalize distributions may wish to reconsider their approach and the implications of these new rules on record keeping and client statements.

• Dispositions: The amending legislation introduces a new definition of "disposition" which details the circumstances that will and will not result in a disposition. Generally, a transfer that constitutes a disposition will result in a taxable event, unless one of the newly-introduced rollover provisions applies.

The new definition of "disposition" applies to transactions and events occurring after December 23, 1998. These proposed amendments affect transactions that have commonly been considered not to be dispositions, including those involving no change in beneficial interest. Any transfer or reorganization involving a trust should be evaluated in context.

• Transfers between registered plans: The amending legislation makes it clear that a transfer of securities:

- between RRSPs;

- between RRIFs; or

- between an RRSP and an RRIF,

after 1999 is not a disposition (or occurs on a rollover basis) if certain conditions are met. In brief, the annuitant of both plans must be the same person, the transferee plan may only hold property with nominal value before the transfer and the transfer plan must be collapsed after the transfer. This rule affects the cost amount of securities held by an RRSP or RRIF, and thus its foreign property holdings. The amending legislation not only codifies but extends the administrative policy of the Canadian Customs and Revenue Agency (CCRA – formerly Revenue Canada) described in paragraph 12 of Interpretation Bulletin IT-412R2.

• Trust butterflies – divisive reorganizations: The amending legislation introduces a concept of "qualifying disposition" as well as detailed rules that permit the transfer of assets between trusts on a rollover basis when there has been no change in beneficial interest. These rules could be used to transfer selected assets of a fund to a new fund on a rollover basis provided the unitholders of both funds are the same.

• In-kind redemptions of units: The amending legislation modifies the rules in subsection 107(2.1) of the Income Tax Act ("ITA") dealing with the distribution of property from a trust in satisfaction of all or part of the beneficiary’s capital interest in the trust. This rule applies when a beneficiary redeems units and receives property rather than cash. As before, the trust will be deemed to have disposed of the transferred property at fair market value (FMV), and the beneficiary will be deemed to have acquired the transferred property at a cost equal to FMV. Previously, the beneficiary’s proceeds of redemption for his or her units would be deemed to be the FMV of property received.

Under the amended legislation, after working through a convoluted formula, the beneficiary’s proceeds will generally be equal to the adjusted cost base (ACB) to the trust of the transferred property (less any assumed debt). In other words, the beneficiary will not realize a gain on the redemption of units to the extent that the trust realizes a gain as a result of the distribution of property.

While the amended rule is intended to eliminate double taxation, it is a rather dramatic departure from what investors would expect, and has the effect of imposing increased reporting obligations on the trust.

• The existence of a trust: The CCRA takes the position that the taxation year of a trust is generally not affected by the termination of a trust. Several tax provisions require a trust to be a mutual fund trust or Canadian-resident throughout the year. To avoid unintended consequences when a trust ceases to exist at any time in a calendar year, the amending legislation includes two deeming rules. One, in subsection 132(6.2), ensures that the status of the trust as a mutual fund trust status continues throughout the year. The other, in subsection 250(6.1), ensures its status as a Canadian resident continues.

• Retaining mutual fund trust status: As mentioned above, new subsection 132(6.2) is intended to address the unintentional disqualification of a trust as a mutual fund trust by virtue of its dissolution in a year. As currently drafted, subsection 132(6.2) could apply to any situation where a mutual fund trust fell below the 150-unitholder requirement during a year in which, at the beginning of the year, it was a mutual fund trust (even should the trust not be subsequently wound-up). This does not appear to be Finance’s intention, however. The new rule will apply to 1990 and subsequent taxation years.

• The definition of "unit trust": The amending legislation modifies the meaning of the term "unit trust" in two ways. First, it modifies the definition itself to ensure that a fund will not lose its status as a unit trust only because it converts from a closed-ended fund to an open-ended one (or vice versa) during a year. The amendment will apply after 1997. Second, it modifies the definition of "personal trust" to exclude unit trusts. Previously, in limited circumstances, a unit trust could qualify as a personal trust and take advantage of the beneficial tax rules available only to personal trusts. The amendment will apply after 1999.

• Share-for-share exchanges: As originally announced by Finance on April 15, 1999, the amending legislation introduces subsection 85.1(5) to extend the rollover provisions available for domestic share-for-share exchanges to those involving foreign corporations. Subsection 85.1(6) sets out the circumstances when the rollover will not be available. The rollover is optional, and is available for exchanges that occur after 1995. Taxpayers may request a reassessment for 1996, 1997 and 1998 if they have disposed of shares and the new subsection 85.1(5) would have applied.

• Foreign mergers: As originally announced by Finance on April 15, 1999, the amending legislation modifies the foreign merger rules in subsection 87(8) and (8.1) to permit a rollover, whether or not the predecessor corporations and the merged corporation are resident in the same foreign jurisdiction. The rollover is optional and is available for transactions that occur after 1995. Taxpayers may request a reassessment for 1996, 1997 and 1998, if they have disposed of shares and the revised foreign merger rules would have applied.

The amending legislation includes new section 253.1, which ensures that holding a limited partnership interest will constitute "investing" and will not jeopardize a trust or corporation’s status as a unit trust, mutual fund trust, mutual fund corporation, mortgage investment corporation, private holding corporation, small business investment corporation or master trust. The amendment will apply after 1992.