Watch out, the Liberals’ federal budget is shutting down two favourable tax rules for investors
Investors who own shares of mutual fund corporations or linked notes have only six months left to take advantage of favourable tax rules that this week’s federal budget has shut down as of Oct. 1, 2016.
Canadian mutual funds can be structured as either trusts or corporations. Many mutual fund corporations are organized as “switch funds” and offer different types of asset exposure, such as Canadian equities, U.S. bonds or global infrastructure, in different funds. Each fund, however, is structured as a separate class of shares within the same mutual fund corporation.
The primary benefit of the switch fund structure is that investors are able to exchange shares of one class of the mutual fund corporation for shares of another class, in order to switch their economic exposure among the mutual fund corporation’s different funds, without triggering a disposition for tax purposes. This allows investors to rebalance their portfolios on a tax-deferred basis, something that is not available to taxpayers investing in mutual fund trusts or investing directly in a portfolio of securities.
Tuesday’s budget is changing the tax rules such that a switch within the mutual fund corporation from one class of shares to another will be a taxable disposition. This measure, however, will only apply to switches after September 2016, meaning that until then, you may wish to take advantage the current rules and rebalance your mutual fund corporation portfolios on a tax-deferred basis.
Another investment product hit by the budget are linked notes, which are debt obligations issued by financial institutions that provide a rate of return that is “linked” to the performance of one or more assets or indices over the term of the note. The underlying linked asset or index is often a basket of stocks, a stock index, a commodity, a currency or even units of an investment fund.
The current tax rules governing linked notes require an investor to accrue the maximum amount of interest that could be payable on the note each year. Investors, however, have generally taken the position that there is no deemed accrual of interest on a linked note prior to the maximum amount of interest becoming determinable. Rather, the full amount of the return on the note is only included in the investor’s income in the year in which it becomes determinable, which is generally at, or shortly before, maturity. This date is known as the “determination date.”
When a note is sold prior to maturity, a specific tax rule requires interest accrued to the date of sale to be included in the income of the vendor for the year of sale; however, some investors selling linked notes on the secondary market prior to maturity take the position that no amount received is accrued interest as the determination date has not yet occurred. As a result, these investors include the full amount of return on the note as proceeds of disposition used to calculate the capital gain on sale, effectively converting the return from ordinary income to a capital gain, which is only 50 per cent taxable.
Starting Oct. 1, 2016, the budget proposes to change the tax laws governing these notes to treat a gain realized on the sale of a linked note as interest income, giving investors six more months to consider whether to dispose of their linked notes prior to the rule change in order to claim capital gains treatment.