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CRA / Government of Canada

Former Emerge ETFs unitholders who held the securities in registered accounts face yet another headache: a potential penalty for holding non-qualified investments.

Last month, online brokerage CIBC Investor’s Edge sent letters to clients whose registered accounts still hold units of several Emerge ARK ETFs — even though the securities were delisted on Oct. 23, 2023, and liquidated about a week later. The ETFs were terminated on Dec. 29 and proceeds paid out to former unitholders.

CIBC’s letter warned the Emerge ARK ETFs were non-qualified investments and gave several options for correcting the issue. The letter also informed the investors they must remit penalty taxes to the Canada Revenue Agency (CRA) for holding non-qualified investments in a registered account.

The ETFs appear in the investors’ accounts because “the ETFs still have proceeds owing to the unitholders,” a CIBC spokesperson stated in an email.

Those proceeds are the $4.7-million receivable owed by Emerge Canada Inc. to five of the six Emerge ARK ETFs. Emerge Canada announced on Jan. 5 that former unitholders are now unsecured creditors of the company.

This situation is “like a kick in the pants after a slap in the face,” said Dan Hallett, vice-president of research and principal with HighView Asset Management Ltd. in Oakville, Ont. “The ETFs didn’t perform well; they got delisted when they were off their highs; they [liquidated] before the upswing — it’s the perfect storm of everything that could go wrong.”

Last April, the Ontario Securities Commission (OSC) placed Emerge Canada’s 11 ETFs under an unprecedented cease-trade order, which lasted until the ETFs were delisted in October. Unitholders remained trapped in the ETFs until the funds were terminated in December.

A month after the cease-trade order, the OSC suspended Emerge Canada’s registration for capital deficiency. The OSC continues to oversee Emerge Canada and require that its activities be monitored by a law firm, though it suspended the registrations of Emerge Canada on Feb. 12. On Monday, the OSC confirmed that it continues to investigate Emerge.

What investors need to know

Investments allowed in registered accounts, including TFSAs and first home savings accounts (FHSAs), include securities, such as ETFs, listed on a designated stock exchange. However, once a security becomes delisted, it becomes non-qualified unless it is qualified for other reasons.

“The reasons behind a delisting have no bearing on the determination of whether the units of the ETF remain a qualified investment,” said Nina Ioussoupova, spokesperson for the CRA, in an emailed statement.

Holding non-qualified investments in a registered account can lead to severe tax consequences: the plan incurs a 50% tax on the fair market value of the non-qualified investment at the time it was acquired or changed status, and the investment’s income also is taxable.

The taxpayer must remit the 50% tax, along with Form RC243 (for TFSAs) or Form RC339 (for other registered plans), by June 30 “of the year following the year of acquisition or change to non-qualified status,” CIBC’s letter said.

Based strictly on the delisting criteria, the Emerge ETFs would have become non-qualified after close of business on Oct. 23, 2023. In that case, the deadline for the forms would be June 30 of this year.

The penalty for late-filing the relevant form is 5% of the balance owing plus 1% of the balance for every full month the return is late, to a maximum of 12 months. The CRA also will charge interest on the balance, compounded daily, starting July 1 of the year following the end of the calendar year after the tax arose.

The form requires the investor to report the fair market value of the investment on the date it became non-qualified. “The price at the close of business on the day it was delisted is the most sensible and reasonable basis for valuing the ETF,” Hallett said. (See bottom of article for prices of the Emerge ARK ETFs on Oct. 23.)

The 50% tax is refundable under certain circumstances. But Jason Rosen, managing partner with Rosen and Associates Tax Law in Toronto, recommends investors be proactive and pay the tax even if they believe they are entitled to a refund. The CRA will charge 9% interest on late payments in the third quarter.

“To qualify for the refund, the investment must be disposed of before the end of the calendar year after the year in which the tax arose (or such later time as is permitted by the Minister of National Revenue),” Ioussoupova said. “However, no refund is available if it is reasonable to consider that the holder of the registered plan knew or ought to have known that the investment was or would become a non-qualified investment.”

Based on the delisting date of Oct. 23, 2023, investors would have until the last trading day in 2024 to dispose of the security and potentially receive relief, Hallett said, since the CRA deems the settlement date to be the effective date.

Dec. 30 is the last trading day for settlement in 2024. However, best practice is to avoid waiting until the last minute, as unexpected issues can delay the settlement process.

Another penalty for holding a non-qualified investment is that the investment’s income becomes taxable. Those taxes would be non-refundable. However, none of the Emerge ARK ETFs distributed income after delisting. According to 2023 T3 filings for the six Emerge ARK ETFs (Canadian- and U.S.-dollar versions), the funds allocated only return of capital to their investors in the year.

Hallett warned, however, that if the receivable is fully repaid with interest, the interest income could be taxable if paid into the registered plan.

Getting a refund of the 50% penalty tax requires filling out Form RC4288, Rosen said. “Make sure you have documentation supporting your investment,” he said. He also suggested indicating any extenuating circumstances, such as death or disasters, that caused the investor not to realize that their investment became non-qualified.

Rosen warned that requests for relief can take several months to review, and aren’t always granted.

“Get ahead of it,” he said. “That [might] include getting advice from an accountant, investment advisor or tax lawyer — or all three. It’s never harmful to have too much information.”

How to dispose of the security

An investor could remove a non-qualified investment from their account by selling or withdrawing it; they could also swap the position for cash from a non-registered account. However, these options are difficult or impossible when a position has a zero balance and/or is no longer a tradeable security, as in the case of the Emerge ETFs.

One option, which CIBC offered to its customers, is to direct the brokerage to remove the delisted security and assign ownership to the brokerage. In doing so, the former unitholder also assigns away any rights to the outstanding receivable.

Hallett said former unitholders must weigh the 50% penalty tax against the repayment of the receivable, which ranged from 0.55% to 5.6% of each ETF’s net asset value as of Dec. 15.

“The lesser of the evils is getting rid of the security to avoid the [50%] penalty, and the trade-off is you give up the potential of receiving that receivable with interest,” Hallett said. “But I think the likelihood of receiving it is pretty low.”

According to a May 14 ruling by the Ontario Superior Court of Justice, which approved the discontinuation of a proposed class action against Emerge Canada, a lawyer advised in January that “Emerge is no longer a going concern and has no assets that could be used to satisfy any judgment that might be obtained against it.”

Emerge Canada stated in a Jan. 5 release that it “continues to work towards payment to unitholders.”

A lawyer for Emerge did not respond to a request for comment.

Hallett said the onus is on investors and their financial advisors to monitor and understand their holdings.

He said any former unitholder who sees the Emerge ETFs still appearing on their statement should call their broker to ask why. He also urged former unitholders to read and act upon letters sent from their brokerages, such as the one from CIBC.

Former unitholders may be affected even if they have not received a warning letter.

“Where the ETF units are not disposed of by the registered plan, it is likely that the registered plan is considered to continue to own/hold the ETF units,” Ioussoupova said, noting that whether the units are still held or owned is “a question of fact and law.”

Lessons learned

The tax challenges facing the former Emerge unitholders are yet another consequence of a fund manager building up a large receivable owing to its funds and failing to repay it prior to termination.

The practice isn’t common. In April 2023, Investment Executive reviewed the financial statements of 10 other small ETF families with similar AUM to Emerge (under $500 million). The analysis found most managers absorbed the operating expenses of their ETFs and paid the expenses directly each year. Only two of the 10 ETF families had a “receivable from investment manager” in fiscal 2021, but both were zeroed out in fiscal 2022.

Based on his nearly 30 years in the industry, Hallett agrees large receivables are uncommon: “Every receivable I’ve seen of this nature was much smaller proportionately, and by the next set of financials, it was zeroed out.”

Emerge’s practice was disclosed in its financial statements beginning in 2019. “You have to look through the financial statements as part of due diligence, including the notes,” Hallett said.

“Usually it’s very plain vanilla stuff; there’s nothing to see here. Until there is.”

Per-unit prices of the Emerge ETFs on Oct. 23, 2023

  • EARK: $7.69
  • EAGB: $8.80
  • EAUT: $13.36
  • EAFT: $7.61
  • EAAI: $9.08

Each ETF continues to have a receivable owing as of press time.