Ottawa backed off yesterday in its overly broad attempt to tax phantom capital gains on foreign investment entities (FIEs).

Bowing to multiple protests, the Department of Finance granted a year's reprieve to investors in the affected securities. It extended the Sept. 1 commentary deadline to Dec. 31 and carved out a number of U.S.-based exceptions.

While controversial legislation to impose annual tax on a so-called "mark to market" basis remains in place, Finance has returned to its year-earlier stance of exempting many U.S. based "regulated investment companies." Included in its updated definition of RICs are exchange-traded funds (ETFs) and U.S. based mutual funds.

These were the focus of a grassroots campaign by small investors. Draft legislation designed to catch offshore tax evaders was released in June, but it was apparent Finance had cast far too wide a net. Several hundred protests were lodged by individuals and practitioners.

Stephen Rive, principal with Barclays Global Investors Canada Ltd. said "we are very happy" its iShares and rival ETFs such as Diamonds, SPDRs and QQQs are now considered to be RICs and therefore excluded from the mark-to-market tax regime.

While not explicitly stated in the release, the Investment Dealers Association believes the exemption will apply to ETFs whether sold directly or through Canadian brokerages, said IDA senior vice-president Ian Russel.

But closed-end funds and many investments trading on non North American stock exchanges will continue to be taxed as per the original proposals.

Robert Spindler, a partner with Arthur Anderson, said the accounting industry got 80% of what it was looking for. But the legislation is still extensive enough to catch the original target: Those who use offshore investments to avoid or evade tax.

Finance said it was not its intention to capture individual companies with significant liquid assets, such as Microsoft.

Victoria-based tax lawyer Blair Dwyer says it will still be necessary for tax professionals to understand the U.S. tax code. It is "disconcerting to have Canadian tax law depend on the provisions of U.S. tax law, because now Canadian taxpayers will have to check U.S. tax law in order to determine whether an investment qualifies for exemption under Canadian tax law," he said.

Finance did not address the status of investment corporations such as Warren Buffett's Berkshire Hathaway. "My suspicion is Berkshire would not be a 'regulated investment company' for U.S. purposes," Mr. Dwyer said, "There will still be a significant difference in tax treatment between owning shares of Brascan and owning shares of a foreign version of Brascan."

There's nothing wrong with Canadians investing in shares of any corporation listed on a regulated stock exchange in the United States or any other industrialized country, Mr. Dwyer said. "RRSP foreign property levels are being raised, which indicates the government wants Canadians to have the freedom to invest outside of Canada ... The FIE rules impose restrictions on that freedom and seem inconsistent."

Paul Hickey, national tax partner with KPMG LLP says Finance showed its willingness to listen to criticism. "It seems to have pulled in considerably the wide net which would have caught many types of otherwise innocuous investments in the FIE definition and tax regime."

Changes to the definition of "investment property" should narrow the scope of investments caught by the FIE rules, he said. High-tech companies should be relieved to see the definition exclude purchasing or developing of computer software or films for sale or licensing, Mr. Hickey said.

One aspect of the change of heart was the mobilization of small investors by the Internet. A Finance official said 300 letters were generated just by the Web site www.bylo.org, organized by anonymous investor advocate Bylo Selhi. He was not available for comment.

Terry Greene of Vancouver-