Tax Insights: Finance releases draft legislative proposals ─ Asset wealth management industry measures

Issue 2022-05

In brief

On February 4, 2022, the Department of Finance released draft legislative proposals (the proposals) to implement 2021 and previous years’ federal budget measures. The proposals include measures that impact investment funds, including “exchange traded funds” (ETFs), and their investors, by:

• introducing a formulaic codification of the “allocation to redeemers” (ATR) methodology that can be used by mutual fund trusts (MFTs) that are ETFs
• in respect of “in-kind” redemptions of MFT units, eliminating a beneficiary’s reduction to its proceeds of disposition by the gain realized by the trust (from the “in‑kind” distribution of trust property to satisfy the redemption)
• exempting trusts that have all of their units listed on a designated stock exchange from the additional trust reporting requirements that were proposed in the 2018 federal budget
• prorating the tax applicable to registered investments under Part X.2 of the Income Tax Act (ITA), based on the proportion of registered plan investors that hold the registered investment

This Tax Insights discusses these measures, for which the federal government has launched public consultations, with comments to be submitted to the Department of Finance by April 5, 2022.

In detail

Allocation to redeemers by ETFs

Background

It is generally understood that a redemption of MFT units may give rise to double taxation. The “capital gains refund” mechanism provided under the ITA is intended to mitigate double taxation, but it is formula-based and does not always work as intended. Accordingly, MFTs adopted the ATR methodology to allocate capital gains realized by the trust to the redeemer, which reduces the redeemer’s capital gain realized on redemption and allows the MFT a deduction for the allocated capital gain, and therefore mitigates the potential for double taxation.

The 2019 federal budget introduced measures (i.e. new subsection 132(5.3) of the ITA that limits the use of the ATR methodology) to combat certain arrangements that the federal government considered abusive. Specifically, subsection 132(5.3) denies the MFT a deduction in computing its income, when the ATR is paid out of:

• its income earned, or
• its taxable capital gains and the amount is greater than the taxable capital gain that the redeeming investor would otherwise have realized on the redemption

At that time, the investment fund industry raised concerns about the availability of investor information that was necessary to apply subsection 132(5.3) with respect to taxable capital gain allocations. To address these concerns, the government:

• introduced a reasonable efforts safe harbour for MFTs in computing a redeemer’s cost amount, and
• deferred the application of subsection 132(5.3) for ETFs to taxation years beginning after December 15, 2021

New subsection 132(5.31)

The proposals introduce new subsection 132(5.31), which expands the ATR rules to limit the deduction by ETFs of certain amounts allocated to its investors who have redeemed units. It also provides specific rules to MFTs that offer both listed and unlisted units. The proposed changes apply to taxation years that begin after December 15, 2021.

Subsection 132(5.31) would deny a deduction by the ETF of an ATR based on the following formula:

A – (B / (C + B) x D)

Where:

A = allocated taxable capital gains to redeemers for the taxation year

B = lesser of:

(i)   total amount paid for redemptions of the ETF units in the taxation year
(ii)  greater of:

a.  the amount determined for C, and
b.  the net asset value (NAV) of the trust at the end of the previous taxation year

C = NAV of the trust at the end of the taxation year

D = the amount of the trust’s net taxable capital gains for the taxation year

Generally, this formula is meant to deny an ETF an ATR that exceeds the portion of the ETF’s taxable capital gains considered not attributable to investors who redeemed in the year.

For an MFT that offers both ETF and non-ETF units:

• proposed subsection 132(5.31) would apply to the ETF units, and
• the current subsection 132(5.3) would apply to the non-ETF units

However, the amount of deduction by an MFT with respect to its non-ETF units, while limited by the non-ETF investor’s gain on redemption, is generally further limited to the portion of the MFT’s net taxable capital gain attributed to the non-ETF units.

Changes to proceeds of disposition for beneficiaries redeeming in-kind

The proposals amend paragraph 107(2.1)(c), which would otherwise reduce a beneficiary’s proceeds of disposition by the gain the trust realizes on the distribution of property to satisfy the redemption, so that it does not apply when the trust is an MFT. This change ensures there are no adverse consequences from the ETF ATR changes discussed above. This also fixes the fairness concern that MFT providers have with the calculation of redemptions for purposes of the capital gains refund mechanism when there was a redemption-in-kind. The amendment applies to taxation years that begin after December 15, 2021.

Additional trust reporting rules

The proposals include the 2018 federal budget measure that introduces new tax return filing and information reporting requirements for trusts. The proposals modify the proposed additional trust reporting rules by:

• excluding a trust, all the units of which are listed on a designated stock exchange, from these additional reporting rules
• extending the application date of the rules to taxation years that end after December 30, 2022

Investment trusts that are not MFTs (e.g. pooled fund trusts) continue to be subject to the enhanced reporting requirements.

Taxes applicable to registered investments

Trust units and shares of corporations that satisfy certain requirements and receive Ministerial approval to be registered investments (RIs) are qualified investments for registered plans such as registered retirement savings plans, registered retirement income funds, registered education savings plans and tax-free savings accounts.

Investment funds that are not MFTs or mutual fund corporations, but are RIs, are limited to holding investments that would be qualified investments for registered plans. When an RI holds property that is not a qualified investment, it is liable to pay tax under Part X.2 of the ITA. If trust units or shares of a corporation that are RIs are held by registered plans as well as non-registered investors, this tax can be disproportionate, because the tax applies at the RI level.   

The proposals amend subsection 204.6(1) to prorate the tax based on the proportion of shares or units of the RI held by investors that are registered plans.

This measure applies to Part X.2 taxes calculated in respect of months after 2020. It also applies for taxpayers whose Part X.2 liability in respect of months before 2021 has not been finally determined by the CRA and accepted by the taxpayer as of April 19, 2021.

The takeaway

The new proposals provide welcome and long-awaited certainty and relief on some issues for the asset wealth management industry. However, with respect to the ATR for ETFs, because Finance took a formulaic approach similar to the capital gains refund mechanism, it may not, depending on the facts, be beneficial for investors.

The asset wealth management industry should take this opportunity to provide feedback on the proposed measures by April 5, 2022, to help ensure the Canadian fund industry remains globally competitive.