Proposed tax on index units casts too wide a net
Rob Carrick The Globe and Mail Tuesday, August 15, 2000

One of the cheapest, most effective and versatile investment vehicles soon will be rendered useless to many Canadians if the Finance Department has its way.

Exchange-traded mutual funds, also called index participation units, have been around for years, but they've suddenly become hot thanks to the recent introduction of dozens of new varieties in the United States and, to a lesser extent, Canada. These funds work pretty much like regular index mutual funds, except that they trade on a stock exchange and generally charge far less in management fees.

The U.S. exchange-traded funds, listed on the American Stock Exchange, are available now to Canadians through most any broker. Unless the proposed new legislation is changed, though, no sane investor is going to want them unless it's for the foreign content portion of a registered retirement savings plan.

Here's why. As part of an effort to go after people who duck taxes by investing abroad, the Finance Department has said it wants to treat gains from foreign investment funds in a way that makes them utterly unattractive. The new rules are open for comment until Sept. 1, after which they'll be fine-tuned and then passed into law in early 2001.

Under the proposal, investors would have to tally up the gains or losses from their U.S. exchange-traded funds each year, a process called marking to market. The gains would then have to be declared annually as ordinary income, which means you won't get the benefit of the 66-per-cent tax inclusion rate for capital gains.

In short, owning an exchange-traded fund originating in the United States in a non-RRSP account (retirement accounts are tax-sheltered, remember) would mean a tax bill in every year the fund made money. At present, there's tax owing only when you sell a U.S.-listed exchange-traded fund for a profit, and when you receive a distribution of dividends or capital gains.

The point of the legislation -- curbing tax avoidance by stashing money abroad -- is entirely legitimate. But including exchange-traded funds would be overkill.

One reason is that people who hold these funds outside RRSPs already pay taxes on distributions. Exchange-traded funds don't generate much in the way of distributions every year (that's part of their attraction), but investors will still find themselves owing taxes in most cases.

The legislation is designed to target high-net-worth investors, but it will hurt plenty of small investors who are simply buying exchange-traded funds to build a low-cost but well-diversified fund.

"The net cast by the legislation is very, very wide," said Gina Katz, a tax expert and principal at Ernst & Young in Toronto. "Needless to say, when you cast a net wide, you end up with unintended results."

Ms. Katz said the proposals will be time-consuming and expensive for wealthy investors to comply with. The Finance Department wants the new rules to apply to investment funds and trusts in which 50 per cent or more of the assets are in securities. Deciding whether a particular fund has crossed this threshold promises to be very lucrative for the accounting profession.

The department is inviting comments on its proposed rules until Sept. 1, which isn't much time. To help the department see the light, you can send a letter to the Finance Department's tax legislation division, 17th floor, East Tower, 140 O'Connor St., Ottawa, K1A 0G5.

Remember, the new proposal would have no impact on the popular i60s (XIU-TSE), an exchange-traded fund that mimics the returns of the S&P/TSE 60 index of big, blue-chip stocks; nor would it affect four similar products that will be introduced shortly in Canada.

Two of these new funds will try to deliver the returns of five- and 10-year government bonds, while the others will offer 100-per-cent RRSP eligibility while tracking the S&P 500 and the Morgan Stanley Capital International-Europe, Australasia and Far East Index.

There's bound to be a bit of tax confusion about the latter two funds, although it has nothing to do with what the Finance Department is doing.

Gains from both funds will be treated as interest income, which is fully taxable. The reason is that the funds hold most of their assets in treasury bills while using derivatives to replicate the performance of their respective indexes.

U.S.-listed exchange-traded funds include Spiders (SPY-Amex) and Qubes (QQQ-Amex), which track the S&P 500 and Nasdaq 100 indexes, respectively, as well as a new Barlcays product called iShares.

There are 56 iShare varieties and they let you invest in broad indexes, as well as in specific economic sectors, such as technology, telecommunications or real estate, and in a variety of regions and countries.

If you want to window shop for iShares, try the Web site http://www.ishares.com. Just don't buy anything until we see if the Finance Department does the right thing.

 

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