May 22, 2013
Financial institutions, investment funds and certain general corporations may be affected by targeted tax measures introduced in the 2013 federal budget to address what the government considers “loopholes” in the Canadian tax system. These measures include anti-avoidance rules relating to “character conversion transactions” and “synthetic dispositions”. These new rules may have a broader reach than preventing the perceived abuse identified in the budget and thus may inadvertently affect normal commercial transactions.
This TaxNewsFlash-Canada summarizes the proposed anti-avoidance rules and their potential effects on taxpayers’ transactions. These rules affect certain financial arrangements used to convert ordinary income into capital gains (character conversion transactions) and transactions that are economically equivalent to a disposition of the property but the taxpayer retains legal ownership of the property (synthetic dispositions).
Character conversion transactions
According to Finance’s comments accompanying the budget, the proposals targeting character conversion transactions are aimed at stopping certain financial arrangements used to convert fully taxable ordinary income into capital gains, which are only 50% taxable.
As illustrated below, a character conversion transaction seeks to reduce tax by converting, through derivative contracts such as a forward agreement, the returns on an investment that would normally be considered ordinary income to capital gains.
Example — Character conversion using a forward agreement
Assume the following:
- The Investors in the Fund wish to get a pre-tax return based on the performance of the Reference Fund, which invests in high yield debt securities.
- The Fund enters into a forward agreement with the Counterparty giving it the right to sell Canadian securities in the future to the Counterparty based on the value of the securities held by the Reference Fund. (The counterparty usually invests in the reference fund to hedge its exposure under the forward agreement but it does not have to.)
- On Day 1, the Fund raises $100 million from the Investors and uses it to purchase a basket of non-dividend paying Canadian equity securities. The Reference Fund invests $100 million in a portfolio of high yield debt securities.
- After a few years, the Reference Fund has earned interest income of $40 million and is worth $140 million.
- Upon maturity of the forward agreement, the Fund sells its Canadian equity securities (that have a fair value of $105 million) to the Reference Fund for $140 million.
- The Investors receive a capital gains distribution from the Fund of $40 million. Because only 50% of capital gains are subject to tax, the Investors pay income tax of $9 million ($40 million capital gain × 50% × 45% assumed tax rate). If the Fund had held the debt securities, the Investors would have received an income distribution of $40 million from the Fund and would have paid tax of $18 million ($40 million × 45% tax rate).
The budget proposes that any return arising under a “derivative forward agreement” that is not determined by reference to the performance of the capital property being purchased or sold will be treated as being on income account if the term of the agreement exceeds 180 days. A series of shorter agreements with a total term that exceeds 180 days will also be caught.
The income (or loss) will be included (or deductible) in computing income at the time of acquisition/ disposition. The new rules will apply to derivative forward agreements entered into on or after March 21, 2013 as well as derivative forward agreements entered into before March 21, 2013 if the term of the agreement is extended on or after March 21, 2013.
|KPMG observations |
The proposals may already have had their desired effect in that a significant number of investment funds that offered “tax advantaged” fund classes have announced that they will not accept any additional investments in these funds pending further details on the proposed legislation.
However, the potential scope of the proposal is even more broad. The proposals do not contain a purpose test and accordingly, even transactions that are not designed to convert income into capital gains may be caught. For example, investment funds that would have realized capital gains if they held investments directly but instead have used derivatives to minimize non-tax related costs and achieve operational efficiencies will also be affected.
Further, the proposals’ reach extends beyond investment funds. For example, if the sale price of a subsidiary includes an earn-out based on retention of staff, the sale agreement may potentially be considered a derivative forward agreement and the earn-out would be taxed as regular income rather than as a capital gain.
Some other matters require clarification. For example, in a typical forward agreement, the size of the forward position can usually be increased or “upsized” from time to time, up to a predetermined aggregate amount.
It is unclear whether this upsizing or partial pre-settlements will taint the grandfathered status of a particular derivative forward agreement that is otherwise grandfathered because it was entered into before March 21, 2013. The grandfathering currently provided in the proposals could potentially affect some taxpayers sooner than others, such as those using rolling 30-day arrangements.
We understand that these issues have been brought to Finance’s attention and we await the draft legislation to see whether any changes will be made.
Finance proposes in the budget to treat certain transactions as dispositions for income tax purposes. In particular, the tax consequences of disposing of a property, such as realization of capital gains, cannot be avoided by a taxpayer who enters into a “synthetic disposition transaction” — a transaction that is economically equivalent to a disposition of the property but where legal ownership of the property is retained by the taxpayer.
Consider the following example of a simple monetization that involves a taxpayer who owns shares and wants to receive cash for those shares without actually selling them.
Example — Synthetic disposition
Assume the following:
On Day 1 of the transaction, Taxpayer enters into a forward sale agreement with a facilitator (such as a bank) to sell the shares at a certain value in five years.
Facilitator gives a loan to Taxpayer for the discounted fair market value of the five-year forward sale amount.
Facilitator enters into a forward sale for five years hence to sell the shares at a fixed price.
In five years, Taxpayer delivers the shares to Facilitator, realizes a taxable disposition and the loan is repaid.
Facilitator sells the shares.
Effectively, Taxpayer locks in a sale price for the shares on Day 1 and gets cash but does not have a disposition until year five.
Under the budget proposals, where a taxpayer enters into an agreement that has the effect of eliminating all or substantially all their risk of loss and opportunity for gain on a property for a period of more than one year, there will be a deemed disposition as well as a deemed repurchase of the property. Accordingly, any accrued gains will be immediately realized by the taxpayer. Finance notes that this measure could apply to:
A forward sale of property (whether or not combined with a secured loan)
A put-call collar on an underlying property
The issuance of certain indebtedness that is exchangeable for property
A total return swap on property
A securities borrowing to facilitate a short sale of property that is identical or economically similar to a property belonging to the taxpayer (or a non-arm’s length person).
Finance also notes that this measure will not generally apply to ordinary hedging transactions, which typically only involve managing the risk of loss. Also, this measure will not generally affect the tax treatment of ordinary course securities lending arrangements, nor apply to ordinary commercial leasing transactions.
To ensure that taxpayers cannot obtain tax benefits associated with continued ownership of a property after entering into a synthetic disposition transaction, Finance also proposes that if a taxpayer is deemed to have disposed of and reacquired a property, the taxpayer will be considered not to own the property for purposes of determining whether the taxpayer meets the holding-period tests for rules such as the dividend stop-loss rules and foreign tax credit rules.
The dividend stop-loss rules reduce the loss that may be deductible by a taxpayer on the disposition of shares of Canadian corporations in certain circumstances when the taxpayer received a dividend on the shares prior to disposition and held the shares for a period of less than one year. Similarly, the foreign tax credit rules reduce the foreign tax credit that a taxpayer may claim for dividends on a share that is held by the taxpayer for one year or less.
This measure applies to agreements and arrangements entered into on or after March 21, 2013. However, this measure will also apply to agreements and arrangements entered into before March 21, 2013 if their term is extended on or after March 21, 2013.
|KPMG observations |
Investment funds and financial institutions will need to carefully review their existing investments and hedging strategies to assess the potential impact of the budget proposals. Depending upon the volume of transactions, the necessary system changes to track all affected dispositions may be onerous to make.
Similar to the character conversion proposal, the potential scope of this proposal is broad. The proposals do not contain a purpose test and accordingly, even transactions that are not motivated by deferring the recognition of a gain may be caught.
For example, where the sale of a Canadian resource company provides for a prolonged closing period of more than one year in anticipation of potential delays in obtaining government approvals and environmental assessments, the vendors may still be deemed to have disposed of the company at the time the sale agreement is signed.
Status of the budget proposals
Finance has not yet released legislation to enact these budget proposals. This legislation is expected this summer.
We can help
Your KPMG adviser can help you assess the effect of the tax changes in this year’s federal budget on your personal finances or business affairs, and point out ways to take advantage of their benefits or ease their impact. We can also keep you abreast of the progress of these proposals as they make their way into law and help you bring any concerns you may have to the attention of the Ministry of Finance.
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Information is current to May 21, 2013. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
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