Absurd tax a windfall for mutual funds
Jonathan Chevreau The National Post August 24, 2000
Investors will sell foreign holdings, buy high-cost funds

If the absurd proposed federal legislation to tax unrealized gains of foreign investment entities (FIEs) goes through, it's clear there will be one big group of net winners and one even larger group of net losers.

The losers: investors who buy U.S. or other foreign stocks for their non-registered investment portfolio. The winners: the Canadian mutual fund companies that sell the U.S. equity mutual funds those investors will have to flock to as a result of the tax implications of the legislation.

This is the conclusion of a senior executive of the Canadian mutual fund industry.

No one I talked to in the industry or the Department of Finance believes the fund industry actively lobbied for the change, although it benefits from it.

The industry has been understandably quiet, if hopeful, about the prospects of beating back competition from low-fee providers of exchange-traded fund (ETF) groups such as Barclays Global Investors Canada.

The official spokesperson for the Investment Funds Institute of Canada declined comment beyond saying IFIC is "looking into" the FIE taxation issue.

But at least one fund executive thinks the proposed legislation is ludicrous.

"We think it's a totally ridiculous bill and we don't think it will pass," says Bill Holland, chief executive officer of C.I. Fund Management Inc. Holland says this even though he knows his mutual fund company -- particularly its capital gains-minimizing C.I. Sector funds -- will be a beneficiary of the legislation, should it pass unamended.

"It will be beneficial to Canadian fund companies because they are the natural substitute for U.S. stocks," Holland says. C.I. lawyers believe that as many as 20% of all U.S. stocks will be considered by the Canadian government as FIEs.

Any foreign stock that has more than 50% of its assets in what the government defines as "investment property" -- including cash, real estate, many commodities, some derivative financial products, resource properties and a long list of other entities -- would be considered an FIE.

There's an exception for certain publicly traded companies, provided they're not mainly in the investment business, according to Allan Lanthier, the Montreal-based director of international tax with Ernst & Young.

Also, some investment activities are protected from the rules, such as foreign banks and insurance companies, says Gerry Rocchi, BGI Canada president.

Worse, certain hot sectors of the economy are more likely to be caught by the new rules: technology stocks, e-commerce companies and biotechnology stocks.

If your U.S. or other foreign stock is considered an FIE for tax purposes, then under the most likely scenario investors would have to pay tax on a "mark to market" basis once a year even if they hadn't sold the securities or "realized" the actual gain.

They will have to pay tax at their top marginal rate just as if the gain were interest or employment income, and on 100% of the gain, not the 67% inclusion rate that now prevails for other securities. The 100% rate applies to securities purchased after the June 22, 2000, announcement date. For those purchased before then, it's the 67% rate, but only for gains accrued before the end of 2000.

In many cases, the only way to come up with the tax payment would be to sell some of the holdings in the security.

Then there is the question of how losses would be treated and carried forward or backwards. Of limited comfort is that under mark to market, a loss is deductible against other sources of income, even though there's no disposition, Lanthier says.

The proposed legislation is punitive to anyone who holds such U.S. stocks in a taxable portfolio and to investors in foreign closed-end funds, U.S. mutual fund groups such as Vanguard, exchange-traded funds from Barclays Global and even investment trusts such as Warren Buffett's Berkshire Hathaway.

The proposal might have also created an administrative headache for the 25% foreign content limit in RRSPs by changing undertake. Mark to market thus becomes the default regime.

The alternative regime is the so-called "accrual approach," which involves calculating how Canadian accounting and tax rules would treat a foreign company if it was resident in Canada.

"Ideally everyone would report your income or a proportionate share of a fund's income year by year," says a Finance official.

The problem is that while Canadian fund companies are obliged to distribute all capital gains, dividends and income to investors each year, this is not usually the case with FIEs. Originally, it planned to exempt U.S. funds. Finance dropped this special treatment last November over concerns too many loopholes would be found.

What Finance should do is drop any notion of ramming this legislation through in time for the next tax year. The current legislation governing foreign investment funds has been in place since 1984, says Lanthier, and waiting till 2002 to get it right should have minimal impact on the public treasury.

 

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