In each of its previous three budgets, the federal Liberal Government has acted to close certain tax loopholes. The budget released on March 19, 2019 ("Budget 2019") continues that trend by focusing on the technical tax rules for the mutual fund industry, which has been a focus in previous years (e.g., changes to switch funds). Here are three things that asset managers need to know about Budget 2019:
1. Allocation to Redeeming Unitholders: Deferral
One way a mutual fund trust ("MFT") is a tax-efficient structure is due to the capital gains refund mechanism. This mechanism is designed to ensure there is no double taxation when an MFT realizes a gain on a sale of investments to fund a redemption of units. The mechanism provides a refund to the MFT in respect of tax that the MFT has paid on its capital gains attributable to redeeming unitholders. Generally, an MFT allocates capital gains realized by it to a redeeming unitholder and claims a corresponding deduction. Budget 2019 refers to this as the "allocation to redeemers methodology."
Budget 2019 notes that certain MFTs use the allocation to redeemers methodology to allocate capital gains to redeeming unitholders in excess of the capital gains that would otherwise have been realized by these unitholders on the redemption of their units. This effectively allows the MFT a deduction in respect of the full allocated amount and a deferral of the taxation of the excess amount for the remaining unitholders. Budget 2019 includes a new rule that would deny an MFT a deduction in respect of the portion of an allocation made to a unitholder on a redemption of a unit that is greater than the capital gain that would otherwise have been realized on the redemption. The proposal will apply to taxation years of MFTs that begin on or after March 19, 2019 ("Budget Day").
2. Allocation Continued: Character Conversion
Budget 2019 notes that certain MFTs have been using the allocation to redeemers methodology to convert the returns on an investment that would have been characterized as ordinary income to capital gains. This planning is possible when redeeming unitholders hold their units on income account, but other unitholders hold their units on capital account.
Budget 2019 introduces a new rule that will deny an MFT a deduction in respect of an allocation made to a unitholder on a redemption, if (i) the allocated amount is ordinary income, and (ii) the unitholder's redemption proceeds are reduced by the allocation. This measure will apply to taxation years of MFTs that begin on or after Budget Day.
3. Derivative Forward Agreements
Recall that the federal Conservative Government's 2013 budget eliminated a common investment structure whereby an MFT converted ordinary income into capital gains by utilizing a derivative forward agreement. A derivative forward agreement is defined to include any agreement to purchase a capital property where the difference between the fair market value of the property delivered on settlement and the amount paid for the property is derivative in nature (i.e., attributable to an underlying asset). At the time those rules were introduced, the tax community expressed concern that the rules caught certain types of transactions that were never intended to be caught. One exception to these rules, when implemented, was to exclude certain commercial transactions, like merger and acquisition transactions, from the scope of the derivative forward agreement rules. However, an alternative transaction strategy has been developed to misuse this exception by technically complying with the rules, but essentially converting returns of income into capital gains.
Budget 2019 will amend the existing rules to provide that this exception is not available if one of the main purposes of the series of transactions is to convert an amount paid into a capital gain. This measure will apply to transactions entered into on or after Budget Day and will provide for transitional relief for agreements concluded prior to Budget Day until December 2019.
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