Proposed federal legislation aimed at combatting offshore tax evasion has triggered a protest from legitimate investors in U.S.-based mutual funds and a popular new alternative called exchange-traded funds (ETFs).

Sophisticated Canadian do-it-yourself investors have been gravitating to passively managed baskets of foreign stocks that trade on stock exchanges like individual stocks. They do so because management fees are much lower than the actively managed foreign equity funds sold by the Canadian mutual funds industry, but also because turnover and capital gains taxes are low if they aren’t frequently traded.

The federal Department of Finance announced draft Legislation on the Taxation of Non-Resident Trusts and Foreign Investment Entities on June 22. In a move that just happens to be in the mutual fund industry’s interests, the ministry proposed to levy capital gains taxes once a year even if the ETFs weren’t sold (or the gains "realized") — using a "mark to market" approach.

This would preclude what investors in ordinary mutual funds or individual stocks currently enjoy: they pay no capital gains tax as long as they do not sell the securities and realize the gains. Instead, they pay tax on dividends payable and defer realizing (and consuming) their gains. Under the proposed legislation, investors would suffer a double whammy — not only paying annual tax on unrealized gains but would be taxed as income on 100% of gain, rather than the 67% inclusion rate normally levied on capital gains.

Critics say it’s ludicrous that an investor who directly bought 20 individual Internet stocks would not have to pay capital gains taxes on unrealized gains. But that would happen to an investor holding an ETF basket of the same 20.

Tax lawyer Blair Dwyer of Victoria., B.C., says the legislation is also inconsistent with the department’s earlier decision to permit certain ETF products like SPDRs to be held within Canadian registered pension plans and retirement accounts.

A campaign to get Paul Martin, the Finance Minister, to modify the government’s stance has been orchestrated by do-it-yourself investor advocate Bylo Selhi, through a page on his Web site: http://www.bylo.org/usmfetftax.html

Investors have until Sept. 1 to comment on the proposed legislation.

The seeds of the problem were sown in the February, 1999, budget, which had proposals to tighten up regulations on the taxation of non-resident family trusts and foreign investment funds. Under the proposed changes, U.S. equity mutual funds and products like SPYs, QQQs, DIAs, WEBs, HOLDRs and iShares are included in the definition of FIFs. By requiring Canadian investors to pay income tax on the amount by which these securities increase each year, "this will effectively make the ownership of such securities impractical," says Mr. Selhi.

A ministry official confirmed the proposed legislation would cover such products.

Originally, U.S.-based mutual funds were to have been exempted but that concession was lost when the department issued a press release last November. But the dominant ETF providers in Canada say they intend to fight. Gerry Rocchi, president of Barclays Global Investors Canada Ltd. says it will be submitting a proposal to Finance outlining its concerns.

Here's what Richard Croft had to say [that was editted out of Jon's piece due to space limitations]:

"If we understand the intent of the legislation, the government will once again be penalizing the Canadian investor who wants to hold a diversified globally diversified portfolio for the long term. A portfolio I might add, that was purchased with after tax dollars."

"This type of legislation will encourage frequent trading, which goes against the government's own plans for the Canada Pension Plan, where they intend to tap the financial markets using a passive investment approach."

"Once again the government has found a way to force Canadians to pay higher management fees in order to escape what amounts to disciplinary taxation."

"If we are not able to persuade the government to put this legislation back where they found it - presumably buried under some large rock that was overturned by lobbyists - we will have allowed our elected officials to introduce a tax that discriminates against the small investor and that cannot be supported by any fairness standard."

"How can the government justify a tax that treats index based securities as an interest bearing asset, but will allow large institutional or individual investors the right to hold all of the securities that are in the index based security, and then tax that portfolio only when gains are realized, and then only as a capital gain or loss. We are dealing with apples and apples, with different tax treatments."

Richard Croft is President of Toronto based Croft Financial Group, An Investment Counsel Portfolio Management firm.