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Mutual funds and ETFs will no longer be able to use a methodology to allocate income and capital gains realized by redeeming unitholders — at least in its current form — if proposals from the 2019 federal budget are implemented. This could potentially result in increased tax bills for clients.

The proposals appear to affect ETFs more than they do mutual funds. “The entire Canadian ETF industry could be disadvantaged against mutual funds if what is proposed goes through,” Horizons ETFs said in a statement emailed to Investment Executive.

The 2019 budget is looking to constrain the ability for mutual fund trusts, which include ETFs, to reduce or defer taxes paid when unitholders make redemptions. The proposals affect all mutual fund trusts that use the allocation to redeemers methodology.

What’s allowed now, and what won’t be

When unitholders redeem units, mutual fund trusts (including ETFs) could incur income and gains. To avoid double taxation, mutual fund trusts must flow income and capital gains, including any that arise due to redemptions, to unitholders by the end of each tax year.

The budget targets two structures: those involving allocations of income to redeeming unitholders, and those involving allocations of capital gains to redeemers. A fund could use one or both.

Let’s tackle income first. The budget proposes to disallow allocations of ordinary income to redeemers if the unitholder’s redemption proceeds are reduced by the allocation.

The allocation to redeemers methodology can be used here because some unitholders hold their units on account of income and others on account of capital. Examples of unitholders who hold on account of income are banks, brokers and day traders — essentially, any entity that carries on a business in securities. Retail investors typically hold mutual funds and ETFs on account of capital.

When an entity holding units on income account redeems, the fund could allocate that redeemer income and reduce the redeemer’s proceeds, creating a loss on the redemption of the units. This loss would then offset the income allocation. The remaining unitholders would not receive a distribution of income and, if they hold on account of capital, would only pay capital gains tax when redeeming or selling their units. This maneuver appears to no longer be allowed if the budget proposals go through.

“With the right parties at the table, the fund could pay no tax on income and nobody would be paying tax,” said Nigel Johnston, partner at McCarthy Tétrault LLP in Toronto.

Certain synthetic ETF structures that use swaps, such as total return swaps, also use this methodology. With total return ETFs, the funds do not hold the underlying index and instead use a swap. An institutional counterparty delivers the total return of the underlying index, including compounded dividends and capital appreciation. Unlike with a physical ETF, the unitholders do not receive distributions and therefore do not pay tax on them. Instead, the counterparty — who holds on account of income — is allocated the income upon redeeming the units thanks to the allocation to redeemers methodology. Again, if the budget proposals go through as is, this allocation will no longer be allowed in its current format.

Now let’s look at capital gain allocations. Current rules allow mutual fund trusts to allocate capital gains to redeeming unitholders in excess of the gains they would otherwise have realized upon redemption. The mutual fund trust can deduct this allocation, and the allocation reduces the unitholder’s proceeds so the unitholder pays the same tax he or she would have paid if there had been no allocation. Further, because the excess portion does not need to be allocated to the remaining unitholders, it is reflected as an unrealized gain in their units. The remaining unitholders only pay tax on this unrealized gain when they redeem their units.

The budget proposes to deny mutual fund trusts this ability to allocate excess capital gains to redeeming unitholders. Instead, it would require that only appropriate gains be assigned to those unitholders.

“What the budget measure is trying to do is cap the individual investor’s capital gains in terms of what you allocate to them,” said Minal Upadhyaya, vice president, policy and general counsel at the Investment Funds Institute of Canada (IFIC).

In principle, this seems fair: unitholders should only be allocated the gains that apply to their situations. The trouble is, doing so “is a difficult if not impossible exercise,” Upadhyaya said.

For a manufacturer to appropriately allocate gains, it must know the adjusted cost base (ACB) for each unitholder. This can be challenging because some unitholders hold funds in nominee name while others do so in client name.

Another potential issue comes up, Upadhyaya noted, if a client holds the same units of the same fund across multiple dealerships. In that case, “it’s up to me [as the client] to figure out what my ACB is because I’ve got to pool all of those together.” She added that the taxpayer holds ultimate responsibility for knowing his or her ACB.

As a result, tracking each unitholder’s true ACB “is a difficult exercise from a fund company perspective because of all the permutations,” she said.

If you think that’s bad, ETFs have it worse. “The manufacturer doesn’t trade directly with the individual unitholder, and doesn’t have direct line of sight to the individual investor,” she said. As a result, it is impossible for ETF manufacturers to know their investors’ identities and cost bases, and thus impossible to accurately assign capital gains upon redemption.

Being unable to appropriately allocate gains when unitholders redeem means that any capital gains resulting from that redemption may be borne by the remaining unitholders. Practically speaking, unitholders may receive taxable distributions while they still hold units, rather than only when they sell them.

A March 27 report by Alex Perel, director and head of ETF Trading at Scotiabank, called “The Federal Budget and its Impact on ETF Investors,” summarized the problem. “Investors holding ETF shares over year-end can find themselves receiving a tax bill even though they did not hold the shares at the time the gains were realized within the fund,” Perel wrote. “[T]his tax impact on remaining holders is caused by investors who have exited the fund and not the investors that remain.”

Instead of the allocation to redeemers methodology, the budget suggested using the capital gains refund mechanism — despite noting that “it does not always fully relieve double taxation.”

Johnston explained that the mechanism “can give rise to situations where you don’t get a full refund of the tax that would otherwise be payable.” For this reason, he said, fund manufacturers have used the allocation to redeemers methodology instead of or in concert with the capital gains refund mechanism.

The volume of the problem

The federal government estimated that closing this so-called tax loophole would create $350 million in revenue from fiscal 2019 to fiscal 2024 — more than the amount created from efforts to increase tax compliance. Some of this revenue may be new taxes paid on ordinary income that can no longer be allocated, and some may be taxes that will be incurred earlier than under existing rules, since allocating gains to redeemers creates a tax deferral rather than a tax elimination. (The Department of Finance did not return a request for comment by press time.)

Industry experts hesitated to estimate the number of mutual funds and ETFs affected. The 2019 budget documents said that “many” mutual fund trusts use the allocation to redeemers methodology. However, Johnston said, “many mutual fund trusts’ governing documents contemplate them using the allocation to redeemers methodology, but in practice they may not use it at all.”

On March 20, Horizons ETFs released a list of 45 of its ETFs that may be affected by the proposals related to the allocation methodology. On March 22, National Bank Financial released a report noting that those ETFs and an Auspice Capital ETF could also be affected. However, any mutual fund or ETF that uses the allocation to redeemers methodology for income, capital gains or both is also affected.

Perel’s Scotiabank report provided a nuanced look at the situation.

“We do not believe this effect will be uniformly felt by the ETF investment community,” he wrote. “The most liquid and actively traded products will typically have the greatest turnover and hence relatively high distributions of capital gains at year-end. Conversely, funds with low turnover (and therefore lower realized capital gains) should see less capital gains distributions to unitholders at year-end.” He pointed out that investors may then gravitate toward “newer, smaller, less-turned-over funds simply because they may distribute fewer gains.”

A post-budget analysis by McCarthy Tétrault’s tax group notes: “The denial of the deduction for income allocable to a redeeming unitholder may itself lead to arbitrage opportunities: unitholders with large positions on capital account may redeem units before the end of a year to avoid large income distributions at the end of the year.”

Implications for advisors

Many in the industry perceive the sweeping changes implied by the 2019 budget proposals to be broader than what the government intended. IFIC and other organizations want to open up dialogue with the Department of Finance “to help them understand the industry’s concerns. And that’s typical of our process,” Upadhyaya said. Finance “had a specific type of scenario in mind” when writing the budget proposal, she added, and “we’ll work very closely with [them] to help achieve their goal.”

“I wouldn’t panic at the moment. There is going to be industry lobbying, and there will probably be some changes,” said Johnston, who is a member of the Portfolio Management Association of Canada’s Industry Regulation and Taxation Committee and IFIC’s Taxation Working Group.

Further, the status quo remains for this year, since the existing proposals take effect for tax years beginning after March 20.

“We expect that the ETFs will continue to function as is, with all of their current tax advantages, for the remainder of the 2019 tax year,” Horizons said in its statement. “The only way to ensure a taxable event occurs to unitholders would be for them to sell their units. If unitholders sell their units, this will not trigger a taxable distribution from the ETF to other non-redeeming unitholders.”

Horizons also said that it does not anticipate needing to close any of its ETFs as a result of the budget proposals, even if they are implemented as is. “The operational structure could change if the legislation goes through as proposed,” Horizons said.

The National Bank report offers similar counsel. “For investors who currently hold these ETFs or considering a purchase, we believe there is not enough information to do anything other than wait for fund issuers’ further comments on impact assessment before taking action,” wrote authors Daniel Straus and Ling Zhang. “Investors still have a few months to take action before the budget gets approved and the changes take effect.”