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ETF firms warn tax plan could cripple industry

Ontario and B.C. proposals would cost $500-million a year, industry claims, and drive investors to U.S. markets

FINANCIAL SERVICES REPORTER

Exchange-traded fund companies are warning higher taxes could wipe out the $25-billion industry, as cost-conscious investors take their money to the U.S and buy the same products for less.

Ontario and British Columbia plan to harmonize their provincial sales taxes with the federal goods and services tax on July 1, which fund industry executives say will cost investors another $500-million a year in fees. There is currently no provincial tax on mutual funds in any province, while the 5-per-cent GST is already included in fees. Harmonization would add 8 per cent to management fees in Ontario and 7 per cent in British Columbia.

Mutual funds are expected to pass on the increase to their investors, but in the low-margin ETF industry executives say any small increase could hobble funds because they all tend to charge the same fees for similar products.

"We're not just competing against other Canadian ETFs," said Som Seif, president of Claymore Investments, which has $3.2-billion under management. "The U.S. market is much more developed and not a single penny in taxes is charged at the fund level to investors. So any increase in our fees will be meaningful."

ETFs are baskets of stocks or commodities similar to mutual funds, but they trade like a stock on an exchange. They are not actively managed, typically, which allows companies to keep their management fees low. The Canadian industry has seen rapid growth in the last five years, growing to $27-billion under management from about $20-billion despite the turmoil in financial markets.

Mr. Seif used the example of Canadian and American S&P 500 index funds that each charge a 0.5-per-cent management fee. If the harmonized tax were implemented as planned, he would have to boost his fee to 0.57 per cent. It's a tiny difference - but there's no rational reason for an investor to pay more for the Canadian product.

"It may not sound like much, but we are competing on every single basis point," he said. "What you will end up with is billions of dollars leaving Canada, and that's revenue that is not flowing to the Canadian government."

CI Financial Corp. and Mackenzie Financial Corp., two of Canada's biggest fund companies, have said they would consider setting up funds in sales-tax-free Alberta in order to lower costs for customers. It's an option Horizons BetaPro chief executive officer Adam Felesky would also consider, if it meant keeping his funds' fees in line with U.S. competitors.

"If the tax comes out as it's laid out then there's a serious risk to our business," said Mr. Felesky, whose firm has about $3-billion under management. "Why wouldn't you set up your ETF in Alberta? We're supposed to be low-cost, which means we need to consider every option."

The fund industry has been lobbying the government for months to exempt their products from the blended tax, but the efforts took a turn this week after government officials threatened to launch a public relations campaign to show investors how much they are already paying in management fees if the funds don't back down.

"Any time you've got a government that is basically going to launch an offensive against your industry, it's bound to have negative consequences," independent fund analyst Dan Hallett said. "You have to think both sides will find a way to come together on this a bit."

He agreed a trickle-down effect could drive capital out of the country if the tax drove investors to seek lower fees. Mutual funds will undoubtedly tack on the extra levy to their fees, he said, which could lead investors to ETFs. Once they realize U.S. ETFs are marginally cheaper, the money will flow south.

"These funds cater to a very price-sensitive audience," he said. "

That's especially true when you start getting into more specialized products."

© 2007 The Globe and Mail. All rights reserved.

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