After a two-year break, the federal government is pressing forward with proposed changes to how mutual fund trusts allocate income and capital gains when unitholders make redemptions.
The 2021 budget implementation bill tabled on April 30 contains legislation nearly identical to what was tabled in July 2019, except the new bill does not apply to tax years beginning before Dec. 16 for any exchange-traded mutual fund trusts — i.e., ETFs.
The Department of Finance “hasn’t managed to sort out what the appropriate rules should be with respect to ETFs, and want to give themselves more time to work it out,” said Nigel Johnston, partner at McCarthy Tétrault LLP in Toronto. “In the meantime, ETFs can continue on as they were.”
“We are pleased with the revised legislation proposal, because it gives more time for the government to consult with stakeholders and propose amended legislation that can provide ETFs with an ‘allocation to redeemers’ solution they can use permanently,” said James Carman, senior policy advisor, taxation, with the Investment Funds Institute of Canada (IFIC).
Back in the 2019 federal budget, the government proposed to constrain mutual fund trusts’ ability to deduct income or capital gains when unitholders redeem units. The proposals affected all mutual fund trusts (including ETFs) that use what’s known as the “allocation to redeemers” (ATR) methodology.
Following industry consultations, the government tabled legislation to enact amended proposals in July 2019, but an election was called before the bill could pass. Those July amendments loosened an obligation related to calculating mutual fund unitholders’ cost bases and gave ETFs an extra year to implement a controversial provision related to capital gains.
In the 2021 bill (C-30), the amendment relating to ETFs now has an effective date of Dec. 16. Carman said IFIC and the Canadian ETF Association lobbied for the change made to the April 30 legislation.
Furthermore, Bill C-30 “broadened the application of the deferral to include mutual fund trust ETFs created after Budget Day 2019,” Carman said. “The previous legislation that was proposed in 2019 only provided a deferral of the provision for any ETF mutual fund trust that had been created before the budget.”
Allocations of income
If passed, Bill C-30 will disallow allocations of ordinary income to redeemers if the unitholder’s redemption proceeds are reduced by the allocation. This would apply to all mutual fund trusts for tax years beginning after March 18, 2019.
While that change is retroactive, “the convention is that tax changes generally take effect when they’re announced in the budget,” said Johnston, a member of the Portfolio Management Association of Canada’s Industry Regulation and Taxation Committee and IFIC’s Taxation Working Group. “Everybody knows the legislation, when it’s passed, will be retroactive to the date specified in the budget.”
Allocations of capital gains
The proposals related to capital gains have drawn concerns about tax fairness from the industry since they were introduced in 2019.
“If you can’t properly allocate [capital gains], those capital gains that couldn’t be allocated to the redeeming investors end up being paid by those remaining in fund,” Carman said. “We want the tax result for redeeming and remaining investors to be fair.”
If passed, Bill C-30 would deny mutual fund trusts the ability to allocate excess capital gains to redeeming unitholders. Instead, only “appropriate” gains should be assigned to those unitholders.
C-30 includes the same formula as the 2019 draft legislation to determine which deductions for capital gains will be denied. A mutual fund trust wouldn’t be able to allocate any gains to a unitholder upon redemption above what would be actually realized by the unitholder.
Carman said IFIC has been lobbying for a revised ATR methodology that would “avoid double taxation both within the fund and to the investor who redeemed.”
There are two ways for mutual fund trusts to allocate gains: the ATR methodology and the capital gains refund mechanism.
“Both of these were enacted by previous governments with the intent of preventing the same economic gain from being taxed twice in connection with the redemption of mutual fund trust units,” Carman explained. “Right now, ETFs can’t use the current [proposed] ATR legislation because the legislation seeks to tie the amount of capital gains the fund can allocate to a redeemer to the investor’s actual capital gain on the disposal of their units.”
Due to several factors, an ETF “does not have the information needed to make a determination of what the investor’s capital gains were for the redemption,” Carman said.
Unfortunately, the capital gains refund mechanism won’t solve the problem, Carman added. The mechanism tends to work well in years when markets have risen, he said, but in down or turbulent market conditions, the mechanism can lead to instances of double taxation.
Carman said IFIC is hoping for “an amended ATR methodology for ETFs that provides proportional allocation capabilities in both down and turbulent market conditions.”
Johnston said follow-up legislation detailing an amended ATR methodology could appear in a second budget implementation bill or in a technical amendments package.
Carman said he’s optimistic about how the Department of Finance’s consultations will proceed.
“Finance has been fair with us throughout this entire process,” he said. “Government and industry have been working together in good faith to come up with a solution.”
Bill C-30 has passed first reading.