It’s going to be more difficult to save tax.
The 2013 Budget took aim at investments that use derivatives to convert income into capital gains, also known as character conversion transactions.
As of March 21, fund managers wouldn’t be able to use forward agreements longer than 180 days to convert interest and dividend income to capital gains. Existing forward agreements wouldn’t be penalized.
While the industry awaits further guidance, experts agree synthetic bond mutual funds (also known as capital yield funds), certain corporate-class funds and some synthetic ETFs would be affected.
To find out if your clients have anything to worry about, look at their fund prospectuses. Forward contracts may appear within the Top 10 holdings, as well as within the risk or financial instrument disclosure sections. You can also call your wholesalers.
As for ETFs, National Bank Financial’s Pat Chiefalo has put together a list of all Canadian forward-based ETFs, which are a subset of synthetic ETFs. There are 56, representing $2.7 billion in AUM and 4.6% of the market.
He says forward-based fixed-income, equity and commodity ETFs that pay distributions would likely be affected. In Canada, there are 12 such funds, representing $1.27 billion in AUM.
Levered and inverse funds, which use forward contracts for ease of operation rather than tax advantages and don’t pay distributions, would probably not be affected, he adds.
Bond capital yield funds that rely heavily on forward contracts to convert interest income to capital gains will likely be affected most.
But forward contracts are also used within some corporate-class funds.
IPC advisor Jason Pereira isn’t concerned. “This strategy was just one of many that corporate-class funds used to convert income.”
The other tax-saving strategies are still viable:
- Losses in some funds can be used to offset gains in other funds, so only the net amount is taxable.
- The capital gains refund mechanism lets the fund retain some gains for future taxation years rather than distribute them to investors.
- Income and dividend income are used to pay for expenses; any excess is distributed to unitholders.
And, while corporate-class structures used to carry higher MERs, “For the majority of the bigger players, there are zero additional costs,” says Pereira.
Since the Budget only targeted forward contracts of more than 180 days, funds can still use them, but “it’s going to be more cumbersome and that increases the cost,” he adds. “Without scale, it’ll be hard to bury that.”
As a result, Pereira predicts, “Smaller players will not offer fixed income or cap it,” because their funds won’t be able to absorb the interest income within expenses.
Certain mutual funds that currently use forward contracts are structured to redistribute interest and dividend income to investors with RRSPs, so they should also be able to stay tax-efficient under new rules, he says.
Don’t panic. Pereira says it’s unlikely there will be much impact on corporate-class funds this year due to grandfathering.
And the government still offers other avenues for tax savings, especially for the mass affluent.
“For average people, the TFSA is the only tax-efficient fund they’ll ever need,” says Pereira. “Now it’s small, but 20 years from now, and if Harper keeps his promise to double contribution room after the budget is balanced, people could have lifetime carry-forwards of more than $100,000.”
Demographics may also cause governments to keep some tax incentives alive.
“There’s no indication the capital gains tax rate will increase,” says John Campbell, a tax partner at Hilborn. “The lower tax rate encourages Canadians to invest. As the government realizes a large number of retiring baby boomers [will start divesting] and sees the struggle that private pensions are having, they’ll want to encourage people to invest.”
Still, this Budget reiterates that advisors need to be careful about what they’re recommending.
“What this budget really tells us is you need to know what you’re buying, and do so for the value of the investment, not for the tax advantage,” says Campbell. “Focus on rates of return and investment risk.”