Innocent may be caught in tax net
Richard Croft The National Post August 21, 2000
Exchange-traded funds: Ottawa's proposal makes it impractical to hold foreign ETFs

After having come so far over the last 20 years, along comes the Government of Canada with new taxes buried in the draft legislation pertaining to Taxation of Non-Resident Trusts and Foreign Investment Funds. The new regulation may effectively make it impractical for Canadian investors to own exchange-traded funds like Spiders, Diamonds, Nasdaq 100 tracking shares, and iShares inside their non-registered or taxable portfolios.

Like so many government initiatives, this one is justifiably designed to stop tax evasion by Canadians who use offshore trusts and related mechanisms. However, under its current format, the U.S.-based index securities are caught -- perhaps inadvertently -- in a punitive tax net that's intended to catch law-breakers.

If the federal government doesn't get the message from ordinary taxpayers about the impact of this draft legislation before the Sept. 1 deadline for comments, it may become law.

If so, a large number of individual Canadian investors who are simply trying to save for their retirement by employing a well-thought out, low-cost investment program will be thwarted by the misguided efforts of the Finance Department to close loopholes in an effort to catch a small number of tax evaders.

The use of exchange-traded funds is no tax dodge. It is the latest development in the evolution of risk management through proper diversification.

Diversification can reduce risk from a number of perspectives -- by virtually eliminating company-specific risk, and by reducing both market and country-specific risk -- all within the context of a low-cost global portfolio.

Twenty years ago, the only role for diversification was to remove company-specific risk from a portfolio. For example, an airline company has its profit margins squeezed when the price of jet fuel rises. That's a company-specific risk unique to a transportation company, and the determining factor is the price of crude oil.

An oil company, on the other hand, benefits from higher prices at the pump; again, a company-specific event, but in this case, favouring the company. By holding both companies in a portfolio, you would have removed at least one layer of company-specific risk.

Before mutual funds came about, you would have to hold at least 15 different stocks with businesses in a cross-section of industries to remove company-specific risk from your portfolio. Of course, to buy 15 different stocks in different industries could cost as much as $100,000. That's beyond the reach of most individual investors. And so mutual funds were born.

The next step was to attack market risk, or the risk of being invested. When the TSE 300 rises or falls, chances are the value of your equity mutual fund will rise or fall as well.

Investors learned first hand how significant an impact market risk could have after the stock market crash of October, 1987. Even well-diversified equity portfolios suffered large one-day losses, and the industry went about to find ways of reducing market risk from a portfolio.

That's about the time the concept of asset allocation came to the forefront. A number of studies in the mid -1980s and again in the 1990s confirmed that by constructing a portfolio that held a blend of stocks, bonds and cash, investors could significantly reduce market risk.

So the financial services industry began manufacturing asset-allocation funds that provided a one-stop solution for holding a diversified asset mix.

Geographic diversification was the next logical step in the process.

By diversifying their equity assets to also include U.S. and international funds, investors were able to build an optimal global portfolio that diversified away company-specific risk, market risk, and to some extent, country-specific risk.

Performance and the impact costs play on the process then became the issue. Think of it as a cost-benefit analysis that asked a basic question: Does professional money management add sufficient value to the process to support the higher costs associated follow up on this discussion by providing a more in-depth look at the legislation and how it will tax the index-based securities used in the FPX. In the meantime, if you want more information about the new legislation and what you can do about it, go to www.bylo.org/usmfetftax.html.

 

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