The ability to use special contracts to convert income from mutual funds into capital gains is coming to an end. Because of this, sponsors of mutual funds and exchange-traded funds (ETFs) are tiptoeing carefully through the maze of potential tax consequences for unitholders when it comes to winding down these products.
Most of these funds use so-called “character conversion” transactions to reduce the taxable investment income. “The goal is to create an orderly transition for investors,” says James Carman, senior policy advisor on taxation for the Toronto-based Investment Funds Institute of Canada, “and get them into suitable products after the transition relief period ends.”
Approximately 70 investment funds with a combined $20 billion in assets under management (AUM) – as well as at least $1 billion in ETF AUM – are affected by the 2013 budget measure that will put an end to the use of derivatives instruments for fund transactions that transform ordinary income into capital gains. Because only half of capital gains are taxable, these strategies had boosted after-tax investment returns.
Most fund companies are still investigating which option to choose in response: close the funds once they can no longer use derivatives; merge the funds into existing funds; change the funds’ investment strategies; or simply allow the returns on the funds to become fully taxable.
Although the federal government originally gave the fund firms 180 days from the March 21 budget to wind down these transactions, the transition period has been extended to Dec. 31, 2014. Until then, short-term derivative contracts, such as 30-day rolling contracts, can be continued and expanded to cover any natural growth in the funds’ AUM, but such contracts can’t be expanded to cover any increase in AUM due to new sales. No fund will be able to access any character-conversion benefits beyond March 21, 2018 – exactly five years after the budget announcement.
“Until 2018,” says Laurie Munro, president of mutual fund sponsor NexGen Financial Corp. of Toronto, “we can roll over existing contracts. And that puts everyone on equal footing.”
Most affected funds have shut their doors to new investors during the transition to enable existing unitholders to continue to reap the benefits of character conversion without dilution. And any derivatives contract in place at the time of the budget with a settlement date beyond 2014 will be grandfathered until it expires. For example, NexGen Corporate Bond Fund uses a five-year derivatives contract covering about $9 million of its $50 billion in AUM, and that contract expires in February 2018.
In the ETF arena, Toronto-based BlackRock Asset Management Canada Ltd.‘s iShares ETF family recently announced changes to its derivatives-based ETFs in response to the new rules. For example, iShares Advantaged Canadian Bond ETF, iShares Advantaged Convertible Bond ETF and iShares Broad Commodity ETF will terminate their forward agreements and invest directly in the underlying securities.
The derivatives contracts on these ETFs will be ended during the final quarter of 2013, prior to the scheduled expirations of the agreements. The funds’ tax advantage will be in effect until the termination. Until conversion in the fourth quarter, new subscriptions for these funds remain on hold.
“We believe these changes are the best course of action for investors,” says Pat Chiefalo, director of ETF research and strategy with Montreal-based National Bank Financial Ltd. in Toronto, “allowing these funds to reopen, ensuring maximum liquidity and good pricing.”
The $3.1-billion Renaissance Corporate Bond Capital Yield Fund, sponsored by CIBC Asset Management Inc. of Toronto, is one of the largest mutual funds employing derivatives contracts to convert income. That fund now is closed to new investors.
However, the sponsor now is offering Renaissance Corporate Bond Fund to investors who want to pursue the same focus on corporate bonds but without the income character-conversion advantage. Since 2009, Renaissance Corporate Bond Fund has been the underlying reference fund on which Renaissance Corporate Bond Capital Yield Fund has based its returns through the use of derivatives, although the underlying fund was previously unavailable to retail investors directly.
“We opened up another fund with the same characteristics other than the tax advantage,” says Jamie Golombek, managing director of tax and estate planning with Canadian Imperial Bank of Commerce’s private wealth-management division.
Investment funds will be affected to varying degrees, depending on the percentage of AUM covered by forward contracts. One of the thornier issues in the unwinding of character-conversion contracts is the effect on corporate-class structures that contain individual bonds or balanced funds within the corporate family.
“For mutual fund corporations, it’s a more complicated situation than a single mutual fund trust,” says Carman. “Not only is the fund using the derivatives affected, but so are all funds within the corporate structure, as they share the tax implications.”
Typically, corporate-class structures offer reduced taxation to all unitholders by matching taxable interest income from some funds with offsetting expenses from other funds within the same corporate structure.
Some funds in these structures may also convert income to capital gains with derivatives. Because interest income cannot be distributed from a corporate-class structure, companies want to avoid creating income – and this will be more difficult without character-conversion derivatives.
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