If your clients trade in linked notes, they’ve lost another tax advantage.

Linked notes are income-producing products that are tied to a security or basket or securities (e.g., equities, commodities, currency). There’s often a principal protection guarantee, usually achieved through a zero-coupon bond. Returns are linked to the underlying security or securities: when they go up (or down), the note’s return does too. The upside is typically a portion of the underlying’s return, or it may be capped.

If you hold a linked note to maturity, the return is treated as interest income. But currently, the notes have a significant tax advantage: if you sell the note before maturity on the secondary market, the return is taxed as a capital gain.

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The Department of Finance nixed this advantage in the 2016 Budget.

After September 2016, any return from selling the note prior to maturity will be taxed as interest income.

“A deeming rule will apply […] relating to accrued interest on sales of debt obligations [i.e., the notes],” says the 2016 Budget. “This deeming rule will treat any gain realized on the sale of a linked note as interest that accrued on the debt obligation for a period commencing before the time of the sale and ending at that time.”

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Who uses these notes?

“Because they’ve had so many variations of [note structures], it’s hard to say they’re right for everybody,” says Darren Coleman, senior vice-president and branch manager at Raymond James. “We don’t see them being applicable for a wide range of clients, and we like having a relatively tight shelf.”

He says linked notes only work for people who don’t need their capital for a long stretch. He’s used a linked note once, for a client who knew he wouldn’t need the cash for at least eight years, since it was for a company retirement plan and none of his employees were retiring over that period. The other reason the note was appropriate, Coleman says, is because “we could sell it the day before maturity and instead of receiving interest income, we’d receive a capital gain.”

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The secondary market had been flourishing, he adds, though it’s not as liquid as buying and selling stocks. “The guys who build [a note] will often buy it back. It’s become a pretty key feature of these things — the ability to sell prior to maturity without a big difference in valuation” and to trigger a capital gain.

That key feature will be gone after September 2016. The budget also says that foreign currency fluctuations will be ignored when calculating the gain. There will also be an exception to the deeming rule “if a portion of the return on a linked note is based on a fixed rate of interest. In that case, any portion of the gain that is reasonably attributable to market interest rate fluctuations will be excluded.”

Typical terms are five years and seven years. “If your view is I need the money back in a year, these probably don’t have the right formula,” says Coleman.

What to do now?

“If I had one that was in the money right now, I would do the math and see if we still like the structure in terms of the investment side,” Coleman says. “And if it becomes fully taxable, do we still like the investment? Or would we be better off to exit it and buy something else — because if we exit now, we at least have it as a capital gain.”The 2016 Budget says the tax treatment change will net the government $45 million from 2016 to 2018.

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