Bill C-32, tabled last week, includes the revised “allocation to redeemers” (ATR) formula introduced in draft legislation from February. The ATR formula directs how allocations of capital gains are treated when ETF unitholders make redemptions.
The 2019 budget proposed preventing ETFs from allocating excess capital gains to redeeming unitholders, but until this past February, a workable ATR formula to facilitate that did not exist. The new formula will take effect for tax years beginning after Dec. 15, 2021 — a.k.a. the current tax year.
Matias Milet, tax partner with Osler, Hoskin & Harcourt LLP in Toronto, said the new ATR formula will generally result in higher year-end distributions of capital gains to investors than under the previous ATR formula, which allocated gains to redeeming unitholders as they redeemed throughout the year.
The change is theoretically tax-neutral because a reinvested year-end distribution also increases the investor’s adjusted cost base, but Milet pointed out that those investors will be “allocated gains without receiving a commensurate cash distribution.”
As a result, ETF investors should know that their tax bill could be higher than if their distributions had been calculated under the old methodology, and plan accordingly.
Milet, who has been involved in discussions with both fund manufacturers and government officials, said the new formula is not exactly what the investment industry wanted, but that keeping the formula consistent between February and Bill C-32 is “the lesser of two evils,” given that the implementation date has not moved.
“The ETF providers and their service providers have to apply these rules in January and February when prepping tax slips to send out to investors. They also have to apply them in December because they’re doing public announcements of what their year-end distributions are expected to look like,” he said.
Due to the November release of Bill C-32, complying with the new ATR rules will be difficult, “but it would have been multiple times harder had [the government] changed the rules,” he added, especially since some manufacturers may have begun updating their systems based on the draft legislation from February.
The new ATR formula in Bill C-32 requires that the ETF know its net asset values as of the end of the current and preceding tax year; the amount that was redeemed by unitholders; and the capital gain for the entire ETF (not for each unitholder). The ATR formula for mutual fund trusts, which appears in legislation passed in June 2021, is unusable by ETFs due to several factors and includes a specific carve-out for ETFs.
The June 2021 legislation seeks to tie the amount of capital gains a fund can allocate to a redeemer to that redeemer’s actual capital gain on the disposal of their units, which is nearly impossible to determine for ETFs. An ETF does not have the information to figure out the actual capital gain.
Without the revised ATR formula in Bill C-32, the ETF would need to use the capital gains refund mechanism instead to avoid running afoul of the legislation.
However, the capital gains refund mechanism can result in double taxation, especially in down markets like the one experienced in 2022.
The government estimated in the 2019 federal budget that changing the ATR rules would create $350 million in revenue from fiscal 2019 to fiscal 2024. A revised estimate has not been released.
Bill C-32 is at second reading in the House of Commons. The House of Commons sits until Dec. 16 and the Senate until Dec. 22, before breaking until the end of January.