One of the "tax loopholes" targeted in Budget 2013 is a category of financial transactions dubbed "character conversion transactions" by the Government. The Ministry of Finance sees "character conversation transactions" as inappropriate attempts to convert investment returns that would be fully taxed as ordinary income into capital gains, only half of which is treated as taxable income.

Budget 2013 defines the offensive transactions as those using a form of derivative agreement known as a "forward contract". New provisions in the Income Tax Act (Canada) (the "Tax Act") will apply specifically to forward contracts of a taxpayer where the purchase or sale price is not based on the attributes of the property being sold but is instead determined by the performance or value of a reference asset.

In recent years, a number of mutual fund trust and mutual fund corporation investment vehicles have been established, which entered into forward contracts with commercial banks. One typical structure involves the fund holding a portfolio of Canadian corporation shares that will be sold at a future date to a bank for a price (determined at the time of sale) that is calculated by reference to the performance or value of another indentified asset or managed portfolio. These arrangements are sometimes called "conventional forwards transactions". A second type of transaction (known as a "prepaid forward transaction") involves the investment fund paying a fixed purchase price at the start of the contract to buy a basket of Canadian corporation shares from the bank that have a value determined by reference to the future performance or value of another identified asset or managed portfolio.

Because the investment income of such funds arises from the purchase or sale of Canadian corporation shares, the profits are treated as capital gains. Investment funds would typically make the election under subsection 39(4) of the Tax Act to have all dispositions of Canadian securities treated as capital account transactions.

The proposed new character conversion transaction rules will apply to forward contracts that meet the new statutory definition of a "derivative forward agreement". The essential elements of the definition are:

  • The term of the agreement (or a series of agreements of which the relevant agreement is a part) is greater than 180 days.
  • The price of the property to be sold (in the case of a forward sale agreement) or the amount of property to be delivered on settlement (in the case of a forward purchase agreement) is determined, in whole or in part, by reference to something other than (i) the value of the property being purchased or sold, (ii) income or gains on such property, or (iii) returns of capital in respect of such property.
  • The agreement is entered into (or the term of a contract entered into prior to March 21, 2013 ("Budget Day") is extended) on or after Budget Day.

To ensure that the profits from a character conversion transaction are fully taxable, a new paragraph is proposed to be added to section 12 of the Tax Act, which itemizes amounts required to be included in a taxpayer's income from business or property in respect of a derivative forward agreement. If a derivative forward agreement is a contract to purchase property (a prepaid forward), the income inclusion will be the amount by which the value of the property acquired exceeds the taxpayer's cost of the property. If the derivative forward agreement is a contract to sell property (a conventional forward), the income inclusion will be the amount by which the sale price exceeds the taxpayer's adjusted cost base of the property. The income inclusion is required in the taxation year in which the derivative forward agreement is settled and the property is purchased or sold.

Budget 2013 also proposes to allow a deduction for any loss in respect of a derivative forward agreement that is "under water."

The Tax Act will also be amended to add a provision to recalculate a taxpayer's adjusted cost base of the capital property that is purchased or sold under a derivative forward agreement. This will have the effect of producing a nil gain or loss on the actual disposition of the property arising under a conventional forward. There will also be a nil gain or loss under a prepaid forward if the acquired shares (or other property) is disposed of at its value at the time of settlement of the derivative forward agreement.

Investors in such funds with forward contracts entered into before Budget Day will generally be "grandfathered" from the effect of the new character conversion transaction proposals unless the term of the relevant forward contract is extended after Budget Day. Typical terms for forward contracts range between 3 to 7 years.

There are a number of noteworthy aspects of this Budget 2013 proposal:

  • The new rules do not require that a taxpayer have a character conversion purpose in connection with a derivative forward agreement.
  • It appears that the Government does not have confidence that character conversion transactions could be successfully challenged on the basis of the general anti-avoidance rule in the Tax Act.
  • Investment funds with "grandfathered" forwards will be anxious to know what position the Government will take with respect to "upsizing" the existing forward agreement in connection with new issuances of units (which is a standard practice of funds the units of which are continuously offered).
  • The new rules will apply to a forward agreement if any element in the pricing formula is not related to the value of, income or capital gains in respect of, or capital returned in respect of, the property being purchased or sold.

The Government estimates that the additional revenue to be generated from the proposed character conversion transaction rules is not large: $175 million between 2013 and 2018. However, the numbers do not disclose the loss of what must be a significant amount of additional revenue that will result from the forced extinction of many investment funds that have previously utilized forward contracts or as an element of their investment approach.