Federal finance minister Jim Flaherty is cracking down on the use of derivatives strategies that allow investors in mutual funds that hold interest-paying securities to enjoy the lower tax rate levied on capital gains.

Representatives of the mutual fund and exchange-traded fund (ETF) sectors had no inkling of the surprising budget proposal, which would put an end to the use of derivatives instruments for “character-conversion transactions” that magically transform ordinary income to capital gains, only 50% of which are taxable.

“It is absolutely a surprise,” says Jon Cockerline, director of policy and research with the Toronto-based Investment Funds Institute of Canada. “We had no indication this was coming. Obviously, it will have an impact on many funds.”

Adds Laurie Munro, president of NexGen Financial Corp. of Toronto, a mutual fund company that specializes in tax-efficient strategies: “The government is looking under every possible rock to raise income. This is not good news for the fund industry.”

The measure will apply to derivatives-based forward agreements entered into on or after Budget Day (March 21). Derivatives contracts arranged before March 21 will be grandfathered. As these contracts expire, interest income will become fully taxable. There are no fund sector estimates on the value of assets affected by the change, but most major fund companies offer tax-advantaged income funds that employ derivatives strategies to reduce investor taxes. And they are popular.

Rudy Luukko, editor of investment funds and personal finance with Morningstar Canada in Toronto, estimates the value of mutual fund assets under management (AUM) that will be affected is in the many billions of dollars. As well, at least $1 billion of ETF AUM will be affected.

Among the larger mutual funds employing derivatives strategies to convert income to capital gains are the $3.2-billion Renaissance Corporate Bond Capital Yield Fund, sponsored by CIBC Asset Management Inc., and the $1.1-billion Fidelity Canadian Bond Capital Yield Fund, sponsored by Fidelity Investments Canada ULC. Derivatives strategies for purposes other than the conversion of income to capital gains still are allowed in funds.

“The derivatives strategies have enabled some [fund portfolio] managers to give investors more in the way of after-tax returns,” Luukko says, “which is all the more important in the low interest rate environment that we’re in. The strategy is now in the process of being eliminated.”

The measure applies primarily to investment funds that are held in non-registered accounts, as the tax benefit is not useful in funds held in RRSPs or tax-free savings accounts. The proposal will, therefore, hit hardest the pocketbooks of high net-worth investors who have sizable assets outside of their registered plans and are in the highest tax bracket.

As the derivatives contracts unwind, the returns of the investment funds employing such strategies will become fully taxable. Many such funds are clones of funds in the same family that did not offer the tax advantages, and this will lead to redundancies in product lineups.

“We can expect some moves on the part of the affected companies,” Luukko says, “to revise fund objectives or seek approval for fund mergers or even terminations in the case of smaller funds.”

Typically, the cost of using derivatives to convert interest income to capital gains ranges between 30 and 50 basis points, as a percentage of fund AUM.

The “slight silver lining,” says Jamie Golombek, managing director, tax and estate planning, with Canadian Imperial Bank of Commerce‘s private wealth-management division in Toronto, is that as forward contracts expire, the costs of using derivatives will disappear. But the savings won’t come close to offsetting the lost tax-related advantage.

“A theme in this year’s budget,” Golombek says, “is closing loopholes. And the term that the government has used is ‘improving the integrity’ of the system.”

He adds that there is nothing specific in the budget that would change how corporate-class funds work. This product allows investors to hold units in several funds from the same family in a corporate structure, enabling tax-free switching among the funds and cost offsets for funds providing interest income, which results in reduced taxation. However, to the extent that derivatives contracts are used to convert interest to capital gains within the corporate-class structure, such techniques will no longer be allowed.

“Funds within the corporate-class structure may find they are now generating more taxable income within the corporation, and that could be challenging to mop up,” says Dan Hallett, vice president and director of asset management with HighView Financial Group of Oakville, Ont. “Fund managers will lose one tool that they are using to minimize income, and they could become stricter about how much they allow into the income-generating classes within these structures.”

While the budget proposal removes one tool, Munro says, there still are other tools available. He estimates that less than 25% of NexGen’s fixed-income AUM is covered by income-conversion derivatives. Other firms, he says, might make greater or lesser use of derivatives.

Although existing derivatives contracts will be grandfathered, they all face varying expiry dates. For example, Munro says, NexGen Corporate Bond Fund uses only one derivative, a five-year contract that covers $9 million of its $45 million in AUM. By contrast, NexGen Canadian Bond Fund has about 12 months’ coverage with its derivatives contracts.

“We’re in dialogue with our tax advisors, trying to get an accurate read on what’s coming down the pipe,” Munro says. “The whole industry is waiting for more details from the government. The devil is in the details.”

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