From our Canadian Bureau: Tax Proposal in Canada Raises Questions

By Dan Hallett, Contributing Writer

A controversial Canadian tax proposal has been opened for comment until Sept. 1, and the impact on your portfolio could be hugely negative. Here's the gist of the proposal:

All non-resident trusts and foreign investment entities will lose their
capital-gains treatment, and be taxed on 100% of the "increase in value" each year.

Suppose you, as a Canadian citizen, invest $10,000 in a foreign investment entity (defined below) and it rises to $12,000 by year's end. Even though you haven't sold it, you'll have to include the full $2,000 in your taxable income under the proposed law.

Current tax laws wouldn't tax that $2,000 gain until the investment was sold. Even when it is sold, only $1,333, or two-thirds, of the $2,000 would be taxable under current rules. Other income such as dividends, interest and capital-gains distributions that flow through to investors - either in cash or in the form of additional units - each year is also taxed accordingly.

What is affected?

This law is being proposed to stop wealthy Canadians from moving funds offshore to avoid taxes. A few years ago, a very wealthy Canadian family moved a $2 billion family trust fund out of the country. Canada's tax authorities failed to collect a dime of taxes, thanks to a loophole in the tax laws.

So, the intent of the law seems genuine. However, in attempting to stop a recurrence of this type of wealth transfer, the Canadian Department of Finance is sticking a knife in the back of honest taxpayers that neither exploit loopholes nor fall into the higher echelon of Canada's net worth.

The proposal defines a foreign investment entity as any corporation or trust, or any business structure not governed by Canada, with at least 50% of the carrying value of its assets in investment properties.

How does it affect your portfolio if you are a Canadian citizen?

This all-encompassing definition catches, among other things, investment funds based in the U.S. that are both open-ended (i.e. regular U.S. mutual funds) and funds traded on stock exchanges (aka ETFs: exchange-traded funds). ETFs include index products like "Diamonds" (DIA - ETF that tracks the Dow Jones 30), "Spiders" (SPY - ETF that tracks the S&P 500) and "Cubes" (QQQ - ETF that tracks the Nasdaq).

Traded on the American Stock Exchange, these can be purchased from Canadian brokerage firms and appeal to a growing number of thrifty investors wanting to replicate market performance with razor thin fees of about 0.18% per year.

Regardless of one's opinion of the indexing versus active-management debate, the U.S. is the world's best example of the benefits of indexing. But this new legislation will put an end to Canadians' freedom of choice. Canadian indexers will be forced to buy more expensive Canadian-based index mutual funds, which range in cost from 0.29% to 1.34% per year.

But wait - it gets worse.

The definition runs the risk of also catching some foreign stocks. So, if you live in Canada, those shares of Microsoft in your taxable account may not be as attractive as you once thought.

Microsoft currently holds a warchest of about $23 billion in cash and cash equivalents. Microsoft also has substantial dealings in derivative securities like put options. Cash (i.e. T-bills and other short-term debt securities) and derivatives fall into the investment-property definition above. If this law affects foreign stocks, it will also impact Canadian-based mutual funds holding such stocks, rendering those funds less tax-efficient.

Fidelity Far East, because of its holdings, is one fund that would be adversely affected by this proposed law. It holds more than half of its assets in holding companies Hutchison Whampoa Ltd., HSBC Holdings, Cheung Kong Holdings Ltd., and Sun Hung Kai Properties Ltd. Since these companies all hold investments in other companies and real estate, they would be considered
"foreign-investment entities".

As of the end of 1999, the fund's accrued gains on these four holdings totalled 38% of the fund's net asset value. Current rules wouldn't tax that gain because the fund hasn't sold the stocks. If this proposal is passed into law, unitholders of Fidelity Far East could be hit with a huge income distribution in 2001. Knowing that ahead of time, Canadian unitholders will likely start a run of redemptions on this and other funds in similar situations.

This proposed law has such large "trickle-down" potential that nobody but the
Canadian Finance Department will benefit from it. Over a 20-year period, this difference in treatment will cost Canadian taxpayers anywhere from 1.4% to 2.8% each year in eroded after-tax returns. Those figures effectively render EFTs and other affected securities useless in taxable accounts and will do far more harm to those who have already invested in such funds and accrued big gains.

Further, not only does this law propose to make a dangerous precedent by revoking these securities' capital-gains treatment, the Finance Department has made no provisions for grandfathering those who actually hold affected securities.

What can be done to stop this proposal in Canada?

It is impossible to legally avoid taxes on income and gains arising from foreign-based mutual funds and ETFs, so there is no loophole being exploited by investors of these holdings. In fact, U.S.-based funds calculate net income and realized capital gains in a manner that does allow Canadians to report the required income each year.

Further, the U.S. Internal Revenue Service issues form 1042-S - like Canadian T3 and T5 slips - to report all investment income and capital gains, then shares information with the Canadian Customs and Revenue Agency (CCRA). Hence, it makes no sense whatsoever why the Canadian government would want to penalize Canada's honest middle class to thwart the tax avoidance efforts of a handful of wealthy residents.

While closing the loophole should be supported, the proposal as it stands is
ludicrous and dangerous. The Department of Finance needs to hear the opinions of Canadian taxpayers by September 1, the deadline for comments on the proposal. (While it seems like a short time frame, the proposal was released in June of this year. But the provisions mentioned above were buried in 180 pages of vague legal terms and definitions.)

If you don't have time to draft a well-thought letter, pay a visit to http://www.bylo.org/ for a form letter and instructions on how to send it to government officials through the Internet. Whether you use that form or draft your own letter, send it to the following people:

The Hon. Paul Martin, Minister of Finance,
Department of Finance Canada; 140
O'Connor Street, Ottawa ON, K1A OG5; fax:
(613) 992-4291; e-mail: martin.p@parl.gc.ca

Len Farber, General Director Legislation,
Tax Policy Branch, Department of Finance
Canada; 17th Floor, East Tower, 140
O'Connor Street, Ottawa ON, K1A 0G5; fax:
(613) 992-4450

Jason Kenney, Finance Critic for the
Canadian Alliance; fax: (403) 225-3504;
e-mail: kenneJ@Parl.gc.ca.

Dan Hallett, B.Comm., CFP, is Senior Investment Analyst with Sterling Mutuals Inc. Dan is also a mutual-fund analyst and commentator for MyBC.com.