The two big threats to wealth creation in Canada are taxation and high investment management fees. That's why knowledgeable investors trying to minimize fees and taxes are so upset over proposed federal legislation that would tax unrealized capital gains from foreign investment entities.

Unless the Department of Finance can be persuaded to come to its senses by Sept. 1, investors who in good faith bought certain baskets of foreign securities for their non-registered or taxable investment portfolios will find themselves not only facing a double tax whammy, but in a classic Catch-22 situation.

If draft legislation to tax non-resident trusts and foreign investment entities goes through, tax collectors would scoop capital gains taxes annually on stock market gains not even realized by the investor. What's proposed is to value new passive investment products like exchange traded funds on a "mark to market" basis. Investors would be driven back into the arms of Canadian fund companies whose global mutual funds charge almost 10 times the fees newer products like ETFs impose.

The double whammy is that the proposed capital gains taxes would apply not at the 67% "inclusion" rate normally prevalent in Canada, but would be taxed fully as income on 100% of the gains.

The Catch-22, says investor advocate Bylo Selhi, is that if you want to avoid the annual tax on appreciated gains and sell products like ETFs, this would incur tax on the capital gains that appreciated during the time you owned them. "Whether you submit to the new tax or bail out, you get hit with a potentially monstrous tax bill."

This affects far more than so-called "offshore" investors: The definition of "foreign investment entities" has been made broad enough to include Canadians who own closed-end mutual funds traded on stock exchanges, the low-cost index funds of U.S.-based Vanguard Group Inc. and possibly even Warren Buffett's famous Berkshire Hathaway Inc.

It gets worse. The rules may apply even to individual foreign or U.S. stocks like Microsoft Corp., says Robert Spindler, chair of the joint committee on taxation for the Canadian Institute of Chartered Accountants. The new rules may apply to stocks if at least half their assets are in investments -- including cash, of which Microsoft has plenty. It could apply to many technology startups and corporations divesting themselves of assets. And most individuals won't be in a position to figure out such complexities, Spindler says.

In Canada, Barclays Global Investors Canada Ltd. has announced a flurry of new ETFs that give do-it-yourselfers the two weapons they've needed: lower MERs and tax effectiveness. While its Canadian equity iUnits are not affected, BGI's foreign equity ETFs sold to Canadian investors would be, as would such popular rival products such as SPDRs and the many new single-sector funds sold on the American Stock Exchange. BGI stands to lose a lot of business and president Gerry Rocchi will be submitting its concerns. Curiously silent has been Montreal-based State Street.

In its zeal to crush offshore tax evasion, the Department of Finance appears to be wielding a sledgehammer rather than zapping offshore tax evaders with targeted slaps of a flyswatter.

The investors affected are not engaged in or advocating tax evasion. Like any sane citizen in this overtaxed nation, they seek to minimize taxation by the entirely logical strategy of placing fixed income investments in registered retirement savings plans.

Because the government limits the amount of tax-sheltered retirement savings to about half the level of the U.S. or U.K., investors have been forced to build tax-efficient equity portfolios outside their RRSPs. With ETFs, the plan is to add continually to the holdings without taking profits. They can do this with individual Canadian stocks and, before now, most foreign stocks. For example, those who held Nortel Networks Corp. over the years and never sold did not "realize" the capital gains and therefore suffered no tax liability. Same with people who own U.S. equity mutual funds or international funds sold by Canadian fund companies like Mackenzie or Trimark. Except for annual distributions and some dividend income, buy and holders in taxable plans largely minimized their capital gains taxes in a perfectly legal manner.

Richard Croft, president of Toronto-based Croft Financial Group, says the legislation discriminates against small investors and "cannot be supported by any fairness standard." The government is again penalizing the investor who wants to hold a diversified globally diversified portfolio for the long term, he says, "a portfolio, I might add, that was purchased with after-tax dollars."

Ironically, the Department of Finance has already blessed SPDRs and similar products as being eligible to be held in the foreign content portion of RRSPs and RRIFs.

The campaign to protest the legislation before a Sept. 1 comment deadline is taking place at investor advocate Bylo Selhi's Web site; it's also being discussed at the wealth forum I moderate at The Wealthy Boomer. Or e-mail your concerns to the department at consltcomm@fin.gc.ca.