The Liberal government is proposing changes that would eliminate a tax-planning opportunity associated with linked notes, such as principal-protected and principal-at-risk notes, in this year’s federal budget. The proposed measure will apply to sales of linked notes that occur after September.

The feds propose to make changes to the Income Tax Act so that the return on a linked note retains the same character whether it’s earned at maturity or reflected in a secondary market sale.

Under current legislation, some investors who hold their linked notes as capital property sell them prior to the determination date effectively to convert the return on the notes from ordinary income to capital gains, only 50% of which is included in their income. To facilitate this, issuers of linked notes often establish a secondary market in which investors can sell their linked notes prior to maturity to an affiliate of the issuer.

“Linked notes pay interest based on the return of an underlying index,” says Jamie Golombek, managing director of tax and estate planning with Toronto-based Canadian Imperial Bank of Commerce’s wealth strategies division. “Some investors will sell the note days before the note matures and realize a capital gain rather than wait until the note matures and earn interest, which is taxable as ordinary income.”

The federal government proposes that a deeming rule will apply for the purposes of the rule relating to accrued interest on sales of debt obligations. This deeming rule will treat any gain realized on the sale of a linked note as interest that accrued on the debt obligation for a period commencing before the time of the sale and ending at that time.

“After Sept. 30, you can no longer get cap gains treatment simply by selling prior to maturity,” Golombek says.

The budget is also proposing that when a linked note is denominated in a foreign currency, foreign currency fluctuations will be ignored for the purposes of calculating gain. An exception will also be provided where a portion of the return on a linked note is based on a fixed rate of interest. In that case, any portion of the gain that is reasonably attributable to market interest rate fluctuations will be excluded.

A linked note is a debt obligation the return on which is linked to the performance of a reference asset or index over the term of the obligation. The reference asset or index can be a basket of stocks, an index, a commodity, a currency or units of an investment fund and is generally unrelated to the operations of the issuer.