Parliament Hill, Ottawa, Canada

Editor’s note, Mar. 20: This story has been updated to include comments from Horizons ETFs.

The federal government is taking aim at certain character conversion transactions used in some investment funds that attempt to reduce taxes by converting, through the use of derivative contracts, the returns of an investment that would otherwise be treated as ordinary income into tax-preferred capital gain.

The proposed changes were part of the 2019 federal budget introduced Tuesday.

“They’re just tightening the screws a bit more,” said Ian Russell, president and CEO of the Investment Industry Association of Canada, noting that the federal government had introduced rules targeting character conversion transactions in the 2013 budget. At the time, the changes affected bond capital yield funds that used forward contracts to convert interest income to capital gains, as well as certain corporate-class funds that used forward contracts.

Fund companies had to unwind such arrangements. At the time, Investment Executive reported that about 70 investment funds with a combined $20 billion in assets under management (AUM) – as well as at least $1 billion in ETF AUM – were affected by the 2013 budget measures.

The rules from 2013 treat any gain arising from a derivative forward agreement as ordinary income rather than a capital gain. However, a commercial transaction exception to those rules, intended to exclude mergers and acquisition deals, exists.

According to the 2019 budget, a character conversion transaction has been developed in the marketplace that “attempts to misuse this commercial exception as it applies to purchase agreements.”

In this transaction, an “investor” mutual fund enters into a forward contract with a counterparty in which it agrees to buy units of a second “reference” mutual fund for a price equal to the value of the units on the date the agreement is made. The reference funds holds investments that produce ordinary income.

On the settlement of the purchase agreement, the investor fund acquires the units of the reference fund and treats the cost of those units as equal to the purchase price under the forward agreement. The investor fund immediately sells the units of the reference fund and realizes a gain, which the investor fund treats as a capital gain by making use of an election.

The government is proposing an amendment that introduces an additional qualification for the commercial transaction exception in the definition “derivative forward agreement” as the exception applies to purchase agreements.

In general, this amendment provides that the commercial transaction exception is unavailable if it can reasonably be considered that one of the main purposes of the series of transactions, of which an agreement to purchase a security in the future is part, is for a taxpayer to convert into a capital gain an amount paid on the security, by the issuer, during the period that the security is subject to the agreement.

This measure will apply to transactions entered into on or after budget day and will also apply after Dec. 2019 to transactions that were entered into before that day including those that extended or renewed the terms of the agreement.

Just as it did in 2013, the government says that while it could challenge the transaction under the rules in the Income Tax Act, doing so might be “time consuming and costly.” Instead, it is proposing the legislative change.

In a press release, Horizons ETFs Management (Canada) Inc. indicated that it was assessing the potential impact of the proposed changes on its family of funds. The Toronto-based firm indicated that 45 its funds – including its Horizons S&P/TSX 60 Index ETF, which had $1.9 billion in assets as of Feb. 28 – could be affected by the changes.

“If the ETFs were to continue to carry on operations after their 2019 taxation years in the same manner as they do currently, the proposed legislative changes could potentially result in taxable distributions to the unitholders of the ETFs in respect of periods after their 2019 taxation years,” the firm indicated in the release.

Horizons ETFs said that it was consulting with legal and tax advisors, as well as other industry players, about the proposed changes, and said it would pursue “alternatives to mitigate any potential future tax impact on the ETFs or their unitholders.”

With files from Melissa Shin