One of the most absurd tax laws in recent memory is coming under heavy pressure from a concerted grassroots campaign. Legislation proposed by the Department of Finance that would force investors to pay tax on foreign stock market winnings they haven’t even banked is being met with widespread derision from major investment opinion leaders and the country’s mutual fund industry, which stands to benefit big-time from the new law.

Adding their voices to the protest are the following heavyweights: former securities regulator Glorianne Stromberg; mutual fund gurus Gordon Pape, Duff Young, Dan Hallett and Stephen Kangas; University of Toronto business professor Eric Kirzner; Walter Robinson, president of the Canadian Taxpayers Federation; personal finance author Bruce Cohen; the Investment Counsel Association of Canada; the Canadian Association of Retired Persons; and many, many more.

This growing army of small investor advocates is pitted against the twin goliaths of Ottawa and the $400-billion domestic mutual fund industry. Acting as the point man in this battle is Bylo Selhi, the anonymous advocate of low-fee, do-it-yourself investing. Selhi says that traffic at his Web site, www.bylo.org, has tripled in the past two weeks, and most of it is attributed to Ottawa’s moronic tax initiative.

And what’s all the fuss about? As Selhi explains on his Web site, Ottawa wants to annually tax, as income, unrealized capital gains on certain foreign investments — even if the securities haven’t been sold.

When the Finance department first unveiled proposed legislation in late June to combat offshore tax evasion, few people picked up on how extensive a sledgehammer the department planned to use to quash offshore tax evaders — and the many law-abiding innocent investors who will suffer from the department’s broadly aimed blows.

Only in the past few weeks has it become apparent that, far from targeting only wealthy users of offshore tax havens such as the Cayman Islands, the legislation affects anyone who owns closed-end mutual funds that generally trade in New York or London; foreign investment trusts such as Berkshire Hathaway; the ever popular exchange-traded funds, offered by houses such as Barclays Global Investors or State Street; and even certain foreign stocks.

Malcolm Hamilton, an actuary with William M. Mercer Ltd., says Ottawa "shouldn’t be slaughtering 99 innocents to catch the one guilty party."

Hamilton says he hopes the Finance Department has inadvertently cast its net too widely. Otherwise, he adds, it would appear Ottawa really wants to punish high-income earners — and encourage consumption rather than retirement saving. "Investors get slaughtered at every step," Hamilton explains. "First, management expense ratios are higher in Canada. Second, capital gains taxes are higher.

"They paint you into this corner where you have high-cost funds and highly taxed capital gains. And now every time you find the smallest avenue of escape — not even a complete one — they cut that off," Hamilton says.

The proposed law is similar to how Ottawa treats strip bonds. Even though an investor doesn’t receive a penny of interest until the bond matures, Ottawa, under a "mark to market" provision, taxes you annually as if you had received interest. The result was to force all strip bonds inside RRSPs.

Worse, investors would not only pay for phantom capital gains on foreign investment entities, but be taxed on 100% of the profits — rather than the 67% rate normally allotted to capital gains on other securities. The result will be to force investors to hold these securities only in their already-limited RRSPs or — more likely — to drive them back into the arms of the traditional Canadian mutual fund industry, whose foreign funds are not affected by the proposed law. That, in turn, will hurt returns because Canadian fund fees are almost 10 times higher than, say, exchange-traded funds.

Stromberg, formerly of the Ontario Securities Commission, says she is "astounded" by the proposed law, "because it denies to the individual investor the ability to use modern portfolio management techniques at a reasonable cost."

What’s infuriating is this law attacks the minority of knowledgeable investors who are trying to build a self-sufficient retirement nest egg in the face of the twin assaults of taxes and high investment management fees.

They realize they need more than the RRSP contribution room permitted (tax-assisted retirement saving, whether through pension plans or RRSPs, is less than half that of what Britain and the United States offer) and have therefore created low-fee, tax-efficient portfolios for their non-registered savings. Note that these taxable portfolios are created with income that is already net of tax deducted at source.

The legislation further discourages Canadians from accessing higher-yielding foreign markets, which account for about 97% of the world’s stock market capitalization. It is especially punitive to those building non-registered retirement portfolios and, in effect, forces investors to choose between individual [foreign] stocks and U.S. mutual funds sold by Canadian fund companies.

But at least one chief executive at a national mutual fund manager believes the proposed change is preposterous, even though his industry stands to benefit. "We think it’s a totally ridiculous bill," says Bill Holland, CEO of C.I. Fund Management, a top 10 fund firm.

And there’s another killer: As the legislation stands, these phantom gains will also count in working out the foreign content inside RRSPs and registered retirement income funds, which in turn may well trigger penalties for going beyond the 25% limit — unless investors sell off some of their foreign winners. (A Finance official confirmed this interpretation after I contacted the department. But, he added, the legislation will be amended to ensure the foreign content limit is not affected.)

Pape, the fund expert, warns in his electronic newsletter, Internet Wealth Builder, of a looming "tax nightmare." Apart from the horrendous complexity of sorting out unrealized capital gains and losses, he questions the fairness of the proposals. "Most people do not regard it as fair ball to be taxed on income they do not receive," he says.

Pape says none of Ottawa’s "sophisms" for justifying this tax treatment hold water. "The U.S. is not the Cayman [Islands]. ... To put SPDRs, WEBS and Berkshire Hathaway in the same category as offshore tax havens is so far off the mark that it leaves one wondering which planet the Finance bureaucrats are living on."