A deadline passed Thursday that affects how allocations of capital gains are treated when ETF unitholders make redemptions, leaving fund providers in an uncertain position and potentially raising tax bills for ETF holders next year.
The financial industry has been awaiting additional guidance from the Department of Finance since it received a reprieve in June, when the 2021 budget implementation act received royal assent.
Provisions in the act make the capital gains refund mechanism the only reasonable option for ETFs to allocate gains to redeeming unitholders — a methodology that can result in double taxation.
The legislation that passed in June included an exception for tax years beginning before Dec. 16 for ETFs.
The intention of the carve-out was to give the government time to come up with specific allocation to redeemers (ATR) rules for ETFs, given that the legislation has drawn concerns from the industry about tax fairness since the rules were first proposed in the 2019 federal budget.
The Investment Funds Institute of Canada (IFIC), the Canadian ETF Association and other groups have lobbied for a revised ATR methodology that would avoid double taxation both within the fund and to the investor who redeemed.
But the clock has run out, for now.
“For the 2022 tax year, the rule now applies for ETFs,” said Matias Milet, partner, tax with Osler, Hoskin & Harcourt LLP in Toronto. Fund providers will “have to rely on the capital gains refund mechanism only, and they’ll live with the good and the bad of it.”
However, Milet, who has worked with industry groups on the allocation to redeemers issue, believes the government is still working on a rule for ETFs. “I don’t think we’ll end up with only the existing capital gains refund mechanism, but there is this period of uncertainty for the industry and for investors,” he said.
There are two ways for mutual fund trusts to allocate gains: the ATR methodology and the capital gains refund mechanism. But as mentioned, the capital gains refund mechanism “results in significant double taxation,” Milet said, especially in down or turbulent markets.
As a result, he said, “it’s helpful for funds to have [an] alternative way of dealing with gains realized by the fund in connection with redemptions, and that’s when they like to use allocation to redeemers,” which does a better job of preventing double taxation in down or turbulent markets.
But the legislation passed in June prohibits the traditional ATR methodology, denying ETFs (and all mutual fund trusts) the ability to allocate excess capital gains to redeeming unitholders.
Instead, only “appropriate” gains should be assigned to those unitholders. The legislation seeks to tie the amount of capital gains the fund can allocate to a redeemer to the end investor’s actual capital gain on the disposal of their units, which is nearly impossible to determine for ETFs. Due to several factors, an ETF does not have the information to figure out the actual capital gain — forcing the fund to use the capital gains refund mechanism instead to avoid running afoul of the legislation.
Experts have forecast more modest gains for equities markets next year, which means using the capital gains refund mechanism in 2022 could result in instances of double taxation.
In May, an IFIC representative said the organization was hoping for “an amended ATR methodology for ETFs that provides proportional allocation capabilities in both down and turbulent market conditions.”
Milet said the government could make any future amendments retroactive to tax years beginning Dec. 16. Proposed revisions would also be released for public comment, he added.
Nonetheless, Milet said fund providers wishing to keep their options open should track all data to use both the capital gains refund mechanism and the traditional ATR methodology during the coming tax year.
And fortunately, providers “won’t have to file a return or issue slips to investors showing the gains they’ve distributed and allocated until March of 2023 for the 2022 tax year, so there’s not an immediate urgency to figure out which rule applies,” he said. “But they should track as much data as they can.”
Milet added that if the government releases a rule requiring data that isn’t currently tracked, there would probably be sufficient lead time built in. “I don’t think they’d put people in a position where they have to report in March 2023 for information they weren’t collecting in 2022 because the rule didn’t exist yet.”
The 2021 act includes the same formula as the 2019 draft legislation to determine which deductions for capital gains will be denied.
Parliament rose Thursday and resumes sitting on Jan. 31, 2022, though the next time the ATR issue is likely to be addressed in legislation is the 2022 federal budget.
The federal government estimated in the 2019 budget that changing the ATR rules would create $350 million in revenue from fiscal 2019 to fiscal 2024.