Individual investors and enthusiasts of low-cost exchange-traded funds celebrated last week when the government exempted them and some other foreign investment entities from a proposed annual tax on unrealized capital gains.

But the exemption granted on certain U.S. securities appears to be a pyrrhic victory at best, when you consider the reaction of corporate taxation experts.

Allan Lanthier, Montreal-based director of international tax for Ernst & Young (Canada), doesn't mince his words in calling for the Department of Finance to go back to the drawing board. This comment was made after last week's modifications to June's version of the proposed legislation:

"I find the package fundamentally flawed, and in need of a complete revisit, both from a policy standpoint and to address the hundreds of errors and anomalies in the draft legislation itself," said Lanthier. "This patchwork approach of identifying a few, isolated issues in a package rife with others just does not cut it."

He took exception to a comment in Friday's column, attributed to Robert Spindler, that the accounting profession was 80% happy with the exemptions and changes.

Spindler, a partner with Arthur Anderson and chair of the taxation committee for the Canadian Institute of Chartered Accountants, clarifies that the 80% comment was directed at the impact on individual investors in U.S. ETFs and mutual funds.

Since many such funds will qualify as RICs, they will be spared the "phantom" tax treatment of the mark to market approach to capital gains. While closed-end funds trading in non-North American stock exchanges and companies like Berkshire Hathaway may not qualify for the exemption, small investors got a lot of what they were looking for.

But the situation is far less rosy in the field of corporate taxation, and Spindler agrees with Lanthier on that point. "The collateral damage caused by this legislation in the corporate world is massive and [Lanthier] is quite right. It's completely unacceptable."

An example is exchangeable shares, where Canadian shares can be exchanged for the stock of a foreign company, often a U.S. company. Even with the revised legislation, financial officers will have to figure out if that U.S. company will be considered a foreign investment entity for tax purposes, even though the rules may not be effective for another year.

"It is hugely problematic in that context," Spindler says. "The one thing capital markets need is certainty and stability. If Canada is trying to make itself competitive to appeal internationally ... the more turmoil and uncertainty, the less attractive the market and your country."

Ottawa's "incredibly broad" attack on offshore tax havens initially would have caught all foreign investments, Spindler says, and the effect of last week's changes was simply to pluck out certain things from that net.

"When they try to capture everything and pluck out those that deserve to be exempted you will always leave massive amounts of things that should not have been caught because you don't have perfect knowledge," Spindler says.

Spindler thinks Finance should focus on the evil it's attacking. Instead, it's trying to take the easy way out and as a consequence changing fundamental tax principles. "To tax value as it accrues as opposed to when it's realized throws the whole realization principle out the window."

One danger is that it could open the door to such scary prospects as taxing Canadian investments on the same basis, something considered in the 1980s.

Lanthier says that for almost 30 years, Canada has had a comprehensive set of rules for taxing foreign investment income. The foreign affiliate rules, introduced in 1972, included the concept of foreign accrual property income (FAPI), under which individual and corporate taxpayers are subject to annual accrual taxation on various forms of investment income.

Rules regarding taxation of offshore investment funds (OIF) were introduced in 1984 as a backstop to the FAPI rule interfering with international corporate investment and the Finance release does little to address that issue."