As part of draft legislation released on July 30, the Department of Finance put forward revisions to address concerns over proposals in the federal budget that target a methodology used by certain mutual fund trusts (MFTs) and unit trusts.
The budget proposals focused on the so-called “allocation to redeemers” methodology, which the government said was being abused in some cases. As explained in notes accompanying the federal budget in March, some MFTs had been using the methodology to allocate capital gains to redeeming unitholders in excess of the capital gains that would be realized by said unitholders on their unit redemptions. The result was inappropriate tax deferral on the excess amount for remaining unitholders.
“Proposed subsection 132(5.3) of the Tax Act was Finance's answer to combat this perceived abuse,” noted Grace Pereira and Joelle Kabouchi of Borden Ladner Gervais LLP in a recent commentary. Under that provision, an MFT would not be allowed a deduction for the excess capital gain allocating to redeeming unitholders over the capital gains they would have otherwise realized if:
- the amount allocated to the redeeming unitholder is a capital gain; and
- the redeeming unitholder's redemption proceeds are reduced by the allocation
The measure, which the government said would be applied to taxation years of mutual fund trusts that begin after March 18, 2019, elicited reactions of concern from industry members. As Pereira and Kabouchi explained, MFTs seldom have precise information on individuals’ adjusted cost bases. That means many of those that were utilizing the allocation to redeemers methodology were making “best guesses” or using cost numbers to perform the allocation out of capital gains to redeeming unitholders.
Others said that the proposals, if enacted as proposed, would make the methodology impracticable for most listed MFTs; that’s especially true for ETFs, for which redemption requests are likely to come only from market makers whose cost amount is generally equal to the fair market value of their units. There were also “submissions on the well-known inadequacies of the capital gains refund mechanism” that the allocation to redeemers methodology is meant to address.
With the July 2019 revisions, the Ministry of Finance noted that an MFT is expected to keep records of initial subscription prices paid when units are acquired, along with information on transactions to which the MFT is a party that may affect the “cost amount” of the units.
In the absence of such information, a trustee of an MFT is only required to exert “reasonable efforts” — conducting inquiries to third parties or searching through relevant records, for example — to determine the cost amount of units held by a redeeming unitholder. If the MFT has reason to believe that there are external factors affecting the cost amount of units, such as transactions to which it was not a party, the Ministry of Finance said it is expected to make inquiries regarding those factors.
The July revisions also deferred the application of the proposed subsection 132(5.3)(b) to MFTs with units that are listed on a designated stock exchange in Canada and are in continuous distribution. Instead of taxation years that begin after March 18, 2019, it’s now proposed to apply to taxation years beginning after March 19, 2020.
“The deferral will give the ETF industry additional time to engage with Finance about … possible solutions that will ensure that Canadian ETF issuers remain competitive with their non-listed Canadian mutual fund trust counterparts,” Pereira and Kabouchi said.
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