Certain investment funds that are trusts may be subject to unexpected and potentially harsh tax consequences from a measure first introduced with the 2013 federal budget that extended the tax loss restriction rules to trusts. While it does not appear that these rules were intended to catch investments and redemptions related to these investment funds, fund managers and administrators should consider reviewing the structure of their fund clients and taking steps to minimize the potential effects of these rules.
The trust loss restriction rules are effective for transactions occurring after March 20, 2013 and are considered enacted as of December 12, 2013 (and substantially enacted on October 22, 2013). The following types of investment funds may be affected by these rules:
- Fund-on-fund structures
- Pooled funds with a few large investors
- Newly formed funds
- Funds that are being wound up or merged
- Exchange-traded funds.
Previously, the tax loss restriction rules applied only to corporations when there was an acquisition of control of the corporation. The new rules, which are intended to prevent arm's-length parties from engaging in tax loss trading transactions, are triggered by a “loss restriction event”. Generally, a “loss restriction event” will occur when a person (together with any affiliated persons), or a group of persons, acquires more than 50% of the fair market value of the income (or capital) interests in a trust.
The 2013 federal budget documents include an example of a typical loss trading transaction that apparently was not restricted by the existing rules. In particular, the documents describe a situation where a taxpayer acquires an ownership interest in an arm's-length trust that has unused losses and then transfers income producing assets to the trust so that any income produced is offset by the unused losses. For details on the 2013 federal budget, see TaxNewsFlash-Canada 2013-10 "2013 Federal Budget Highlights" .
If a loss restriction event occurs, an investment fund that is a trust may be subject to tax consequences, including:
- The trust will have a deemed tax year-end at the beginning of the day on which the loss restriction event occurs.
- The trust will be required to realize any accrued losses on capital property, which expire at the date of the loss restriction event. The trust may elect to realize accrued capital gains to offset the accrued losses.
- The trust will lose any unused losses carried forward before the loss restriction event (other than business losses which can be carried forward subject to certain restrictions).
- The trust will be unable to carry back any net capital losses and property losses realized after the loss restriction event to periods before the loss restriction event.
Impact to the investment fund industry
The investment fund industry has outlined its concerns to Finance regarding the extension of the trust loss restriction rules in several areas.
Unknown loss restriction events
In many cases, a loss restriction event could be triggered by subscriptions, redemptions or trades on the open market. Fund administrators and managers may not have access to information on the identity of investors and may not be able to determine if a loss restriction event has occurred. Where investor holding information is available, the deemed year-end may happen even before the investor transactions are processed and the loss restriction event is identified.
Many investment trusts have clauses in the declaration of trust that requires the trust to pay investors sufficient distributions at year-end to reduce the fund's taxes payable to nil. Unless the declaration of trust provides that the trust will make distributions payable to investors on deemed taxation year-ends, it may not be possible to reduce tax payable by the fund to nil where a loss restriction event has occurred.
Under these rules, a fund's Net Asset Value (NAV) will be incorrect if the fund has a tax liability as a result of a deemed tax year-end since the tax liability will not have been calculated and recorded at close of business on the day before the loss restriction event occurs. Where the declaration of trust provides for “automatic” distributions on all tax year-ends, the fund's NAV per unit may also be incorrect if the declaration of trust does not also provide for payment in kind of any necessary distributions and an automatic consolidation of units immediately thereafter since the amount of outstanding units used to calculate NAV will be incorrect.
Additional tax compliance
After a deemed year-end, a fund is required to file a T3 return and issue T3 slips within 90 days. The additional compliance burden could be higher where there are multiple deemed year-ends within any given year.
Mutual fund trust status
An investment trust has until 90 days after the end of its first taxation year end to meet the conditions required to qualify as a mutual fund trust, retroactive to the date the trust was created. A loss restriction event could easily happen during the first few weeks of the trust's existence as new investors are found. Hence, the fund may have less time to qualify as a mutual fund trust.
This reduced timeframe will affect whether the fund can use the capital gains refund mechanism, which is only available to mutual fund trusts, to reduce the amount of distributions it must make to eliminate taxes payable. In addition, mutual fund trust status is one of the most common ways that investment funds qualify as eligible investments for registered plans such as RRSPs. Hence, failure to qualify as a mutual fund trust could have adverse tax implications to investors.
Although it is not yet clear whether Finance will grant any relief, fund managers and administrators can start planning now. These individuals can:
- Review subscription and redemption records to identify whether the fund has had loss restriction events since March 20, 2013
- Assess whether a newly launched fund has attained mutual fund trust status within 90 days after a deemed year-end where there has been a loss restriction event
- Review the fund's declaration of trust to determine if it provides for automatic distributions, reinvestment, and consolidation of units on a deemed year-end
- Consider changes to financial statement note disclosures regarding losses available for carry forward.
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The extended tax loss restriction rules are expected to have a significant impact on the investment fund industry. Your KPMG adviser can help you assess the potential impact of the rules and outline all the necessary steps you should take. For more information, please contact your KPMG adviser.