Canada takes aim at tax-advantaged bond funds that use derivatives strategies

Finance minister Jim Flaherty targets funds popular with ordinary investors in tax crackdown. Is this the way forward in the international battle against tax evasion? Yakob Peterseil reports

Canadian finance minister Jim Flaherty has announced that his government will shutter approximately 70 fixed-income funds that have been marketed to ordinary Canadians as "tax-advantaged". It turns out that over the past 20 years, investors in Canada may have unwittingly poured C$20 billion into mutual funds set up for the express purpose of reducing taxes.

The funds got their name from the way they cut investors' taxes in half. The trick is achieved through a derivative. On the heels of the announcement, most of the funds have closed to new investors, and after an as-yet-to-be-defined transition period, the funds will cease to exist.

The funny thing is, before Jim Flaherty mentioned it in his budget speech, many investors in these funds probably didn't even know they were benefiting from something called a "character conversion transaction". It is likely that not a single one could tell you how it worked.

The funds had managed to operate in plain sight for 20 years without attracting the attention of the Canadian Department of Finance or the revenue authorities. But as the billions kept pouring in, and the tax breaks became ever starker, tax-advantaged bond funds became classic victims of their own success. "I think every structure has a life cycle," says Tim Hughes, Toronto-based partner at Osler, Hoskin & Harcourt. "Over time, the funds become more voluminous and the structure starts to be applied to different scenarios." It was only a matter of time, Hughes suggests, before the authorities came in to break up the party.

 

We are taking additional actions to close tax loopholes... with strange names like ‘synthetic dispositions' and ‘character conversion transactions'

Almost like magic

The story will sound familiar enough to anyone who has encountered a tax loophole before.

During the financial crisis, it was stock markets in the US that got all the attention, but in the space of nine months between 2008 and 2009, the S&P/TSX Composite Index, a broad measure of Canadian equities, dropped by nearly 50%. Almost overnight, investor euphoria over equities turned into a mad dash for safety.

Most investors, on the advice of their brokers, turned quite reasonably to bonds. But as more people piled into fixed-income funds, yields fell, making solid returns difficult to achieve. The challenge for funds became finding that extra bit of yield to lure investors to their funds. In the ruthlessly competitive mutual fund world, they were willing to look just about anywhere to find it.

They found it, finally, in a derivative. Years before, the Canadian authorities had blessed a clever structure dreamt up to get around a ban on owning foreign (non-Canadian) securities. Funds were limited in the amount of foreign securities they could hold, but investors looking for the exposure discovered a way to get it while staying within the purview of the rules. That way was to enter into what is known as a ‘forward contract'.

The contracts are simple enough - one party agrees to sell something to another party at some point in the future. Let us say it is a basket of blue-chip Canadian stocks. The parties might agree to make the sale in 30 days', or in a year's, time. The twist comes when they fix the price. Typically, you would determine the price of a basket of stocks by looking at the value of the stocks in the basket. But what if you didn't actually care about those stocks? In fact, what if you were really interested in a basket of Japanese stocks?

The way it worked was that one party would buy $1 million of Canadian stocks and essentially pretend it had made an identical investment in a basket of Japanese stocks. Then, in 30 days, it would sell the Canadian stocks to the counterparty for whatever the $1 million investment in Japanese stocks would be worth. Say the Japanese securities rose 10% in those 30 days. The party would sell its $1 million investment for $1.1 million, pocketing a $100,000 return. And the Canadian stocks? It is irrelevant what has happened to the Canadian stocks. The Canadian stocks were just placeholders for the real investment.

The reason this worked is because the forward contract was considered a Canadian instrument. So the fund hadn't bought or sold any Japanese securities. It had played by the rules all along. Yet, through the derivative, it achieved direct exposure to Japanese stocks, allowing the fund to gain or lose on the price movements of those securities.

The dangers in this approach are plenty, but the practice was seen as largely benign by the authorities, says John Tobin, Toronto-based partner at law firm Torys. Probably because there were no blow-ups - that is, funds making large bets that turned sour. But someone figured out another use for the structure, one that appeared considerably less benign to the Canadian regulator.

One thing that remains remarkably consistent across jurisdictions is that holders of bonds are taxed differently from holders of equities. The reasons for this are probably myriad - part policy reasons, part historical accident. In Canada, for instance, returns earned on bonds are 100% taxable at ordinary income rates. In contrast, only 50% of returns earned on equities are taxable. It is a persistent and confounding problem - how to achieve diversity in a portfolio in the most tax efficient way? Higher taxes are a considerable drawback to investing in bonds. But what if you could somehow turn a bond into a stock?

The technology already existed - it was just a matter of applying it in a new way. Someone eventually figured out that in the same way you could transform foreign securities into Canadian securities through a forward contract, you could turn securities taxed at a higher rate into ones taxed at a lower rate. You could effectively turn bonds into stocks. As in the example above, the fund entered into a forward contract to buy and sell a basket of Canadian stocks, but the fund did not care about the stocks. All it cared about was receiving exposure to a portfolio of bonds. Any interest or appreciation coming from the bonds was reflected in the price the fund received when it sold the Canadian stocks. Through the use of derivatives, the fund never touched the bonds. During the life of the investment, it did nothing but deal in Canadian stocks.

Almost like magic, investors in the funds paid 50% less in tax than investors in so-called ‘direct hold' bond funds. The popularity of tax-advantaged fixed-income funds soared. And investors were not the only ones to benefit. In order to write the forward contract, funds needed someone to stand on the other side of the contract, to hold the underlying bond portfolio and pay out the returns when the contract settled. They turned to big Canadian banks, often affiliates of the fund manager. Banks reportedly charged between 25 and 75 basis points per contract.

Money that had been earmarked for the department of revenue was therefore passing not just to ordinary investors, but to big banks.

 

'Loopholes with strange names'

Despite the cleverness of the structure and its undeniable appeal, however, the timing could not have been worse.

In a televised speech last spring, Flaherty delivered the Department of Finance's annual budget proposals for 2013. The Ottawa Citizen characterised this year's speech as a "modest" and "cautious" affair, but for members of the investment community, it did not lack for drama. Near the end of the speech, Flaherty abruptly came out swinging against tax-advantaged bond funds and the elite investors who allegedly benefit from them.

"Today," the finance minister announced to the House of Commons, "we are taking additional actions to close tax loopholes. Loopholes with strange names like ‘synthetic dispositions' and ‘character conversion transactions'... complex structured transactions that have allowed a select few to avoid paying their fair share of taxes."

The announcement may have been dramatic, but it is doubtful that it came as a total surprise. In the wake of the financial crisis, governments around the world have been taking long, hard looks at shoring up their bottom lines through closing so-called tax leaks. Canada is no different. A Department of Finance official boasted in an email to Structured Products that the government has introduced more than 75 such measures since 2006. Early targets were corporations converting into tax-friendly income trusts. Some feared at the time that real estate investment trusts (Reits) might be targeted next.

In the space of a few minutes, a C$20 billion corner of the fund world found itself without a leg to stand on. The funds - wildly popular a moment before - were suddenly obsolete. Though the bulk of funds that use the structure are mutual funds, exchange-traded funds (ETFs) and closed-end funds are also affected. Curiously, sources say Flaherty's government is not out to get the financial services industry or demonise derivatives. "It's come from policy technocrats in the Department of Finance who have identified that people had been using derivatives to convert income into capital gains," says Tobin. "I don't think Flaherty is anti-business. I think he's just trying to protect the tax base."

Even the lobbyists at the Investment Funds Institute of Canada (Ific) agree. "I don't get the impression that [Flaherty] is singling out the fund industry," says Ralf Hensel, Toronto-based director of policy at Ific. "The insurance industry is also facing major changes," he says, referencing tax reforms introduced by Flaherty that could negatively affect that sector.

Nevertheless, lobbying is in full swing. Since most everyone agrees that the loophole has been closed for good, Ific's efforts are focused on ensuring the smoothest transition possible for affected investors. There is some uncertainty about how grandfathering provisions will work, for example. Lawyers say the proposed rules are "so broad as to be unworkable," so there is an expectation that they will be whittled down.

And then? Once any relevant grandfathering provisions expire, Tobin suspects that managers will encourage investors to migrate to ‘direct hold' funds, where the bonds are held by the fund, or stay in funds that have been converted. In today's low-yield environment, when you take into account the fees that were paid to counterparty banks, investors' after-tax returns likely will not decrease by much. "Managers probably expect brokers to tell their clients: ‘You need exposure to a bond fund, you like this manager - why don't you just stay in this bond fund?' I doubt most mom-and-pop investors were highly motivated by the tax benefits in the first place," he says.

The government estimates that the revenue to be generated from closing the character conversion loophole is C$175 million over the next five years. With total revenues of C$264 billion expected in 2013-2014, the figure seems paltry. But perhaps that is beside the point.

What is striking about the events in Canada is that, in Ific's estimation, investors in these funds were not the "select few" singled out by Flaherty, but likely to be elderly, short-term-horizon investors saving for retirement. They hardly seem the most politically palatable examples to hold up as tax cheats, but that does not seem to have stopped Flaherty.

Across the Atlantic, the French have so far managed to produce the most irresistible symbol of tax evasion in the figure of Jérôme Cahuzac, the former finance minister charged with tax fraud for concealing an undeclared Swiss bank account worth roughly €600,000.

In Canada, by contrast, investors in the tax-advantaged funds were likely to be ordinary, income-seeking Canadians saving for retirement. Can it be that the latest international symbols of tax evasion are ‘moms and pops' with money stacked away in mutual funds?