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Ottawa targets mutual funds using low-tax strategy

The federal government is cracking down on a broad swath of the investment-fund business, including some of the hottest-selling products, by curbing the use of manoeuvres that boost returns by minimizing taxes.

As part of a fight to close loopholes, Thursday's budget contained notice that Ottawa would sharply limit the use of "character conversion transactions." These complex strategies use derivatives to turn income into capital gains, which are taxed at a lower rate.

Fund sellers, lawyers and accountants are scrambling to understand the government's intentions, but the early impression is that the curbs will have big implications for mutual fund investors and banks. Industry experts were unable to say exactly how many funds will be affected, but the consensus is that it will be many.

Investors in funds employing the tactics may face higher taxes and lower returns, while banks that have offered the derivatives as a way to raise money cheaply may face higher costs.

One group of funds that may run afoul of the new rules are popular "advantaged" exchange traded funds (ETFs) that advertise their ability to lower investors' tax hits. Other mutual funds that don't advertise an advantaged structure often still use it to minimize taxes.

"A significant amount of both the mutual fund industry as well as the ETF and closed-end fund industry of TSX-listed products have been using this character conversion structure for years, and this will be a significant change which will start to require these products to be unwound almost immediately," said Chris Pitts, a partner at PricewaterhouseCoopers who specializes in asset managers.

The move came as a surprise. The structure has been used for years without drawing the ire of the Canada Revenue Agency (CRA), though some in the fund industry suspected that one day regulators might halt the practice. Even so, there was little warning other than vague rumours in the days leading up to the budget that something might be afoot.

Fund companies and their advisers are now waiting to see the actual legislation to determine the scope of the effects, said Janice Russell, head of the banking and securities tax practice at Deloitte.

"We've got a notice of ways and means, but certainly there will be a need for clarity and interpretation as it evolves," she said. However, Ms. Russell said the strategy is a common one and the number of funds affected would be "quite a few."

So-called "advantaged" funds that use the structure have become popular. They offer regular payouts for investors seeking income; the capital gains treatment helps maximize the yields.

As a result, there has been a steady stream of initial public offerings of advantaged ETFs in recent years.

It appears the move "will have a significant impact on many investment funds" including iShares Advantaged funds, said Jeffrey Logan, head of iShares products at BlackRock Asset Management Canada Ltd.

One result may be the end of the hot streak for advantaged structures. "Perhaps this will really halt the growth," said Howard Atkinson, chief executive officer of Horizons Exchange Traded Funds. His firm has generally avoided advantaged structures, only offering one fund with about $10-million in assets, a fraction of the $4.2-billion Horizons funds have under management.

"We were afraid, to be be honest, that with the income recharacterization that the CRA would possibly look at that," he said.

The "character conversion" transactions use a derivative structure. For example, a bank might sell an asset such as a stock to a fund manager, and agree to buy it back at a set time in the future for a price that generates the agreed return.

That return has in past been reported as a capital gain. But there is an argument that it is not a true capital gain because there is no risk of loss, and because there is no link to the open-market value of such assets.

The budget singled out purchase or sale agreements for assets "using a pricing formula that is not based on the performance of the particular property but on some other measure."

© 2007 The Globe and Mail. All rights reserved.

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