Planned tax protectionist for fund firms
Rob Carrick The Globe and Mail Tuesday, August 22, 2000

Aside from the mutual fund industry, it's hard to find anyone who would benefit from the federal Finance Department's plan to tax the living daylights out of U.S. exchange-traded funds.

Investors would lose access to one of the best products to come around in a long time. Think of exchange-traded funds, also known as index participation units, as a supercheap, ultraversatile kind of index mutual fund that's traded on a stock exchange. These funds are available in Canada, but the real action is in the U.S. market.

The federal government won't gain a thing, either, if it taxes exchange-traded funds as punitively as planned.

The point of the new legislation is to go after people who duck their Canadian tax obligations by stashing money in foreign investments. This would be accomplished by making investors pay tax every year on any profits they make from foreign investment funds, including regular U.S. mutual funds and exchange-traded funds.

Worse, people would have to pay tax at the same rate as ordinary income, which means no preferential capital gains rate.

You'd still be able to buy U.S. exchange-traded funds as foreign content in a tax-sheltered retirement account, but they'd be useless for regular investing. Net result: No extra taxes for Ottawa because no one wants to hold U.S. exchange-traded funds in a non-registered account.

The outlook would be quite a lot brighter from the fund industry's point of view if the new rules were put in place as they are.

Right now, the fund industry in Canada has about $420-billion in assets. If exchange-traded funds proliferate, fund companies are going to be in a tough fight to hold on to these assets, never mind increase them.

Exchange-traded funds are still unknown to the majority of investors, but in 10 years it's quite possible they'll rival the popularity of regular mutual funds.

Exchange-traded funds charge a lot less in continuing management fees than regular mutual funds, even index funds. With their lower fees, exchange-traded funds should be able to outperform the majority of regular mutual funds over time.

In Canada, the only exchange-traded fund now available is the i60 (XIU-TSE), which tracks the S&P/TSE 60 index of big blue chips. Four more funds are coming soon, two of which will hold bonds. The other two will be fully eligible for retirement accounts while tracking the S&P 500 stock index and the Morgan Stanley Capital International-Europe, Australasia and Far East index.

None of these products would be affected by the proposed new tax rules, but a far broader selection of U.S. funds would be.

There are 56 new exchange-traded funds called iShares that are listed on the American Stock Exchange and thus are easily available through Canadian brokers. Want more variety? Then consider HOLDRs, an Amex-traded product that stands for "holding company depositary receipts."

The proposed new law from the Finance Department would sure be a help for Canada's mutual fund industry in fending off the threat from these products, much like high tariffs helped protect uncompetitive industries from foreign competition in days gone by.

Conspiracy theorists have jumped on this point, but a Finance official laughed it off.

"I can't emphasize this enough," he said. "We aren't trying to do any industrial policy here to boost the fortunes of Canadian mutual funds."

Finance may not intend to protect the mutual fund industry, but that would be the net result.

Who suffers? Regular investors do. All because they were caught like dolphins in the Finance Department's tuna nets.

Finance will accept comments on its proposed new legislation until Sept. 1, which means there's still a little time left to argue for some kind of exemption for U.S. investment funds, including exchange-traded funds.

It's worth noting that Finance originally intended to make an exemption for U.S. investment vehicles when they announced the new tax regulations in the 1999 federal budget. The exemption disappeared last November, however.

According to the Finance official, the change came after the department lost confidence that U.S. tax laws were stringent enough to keep track of what Canadian investors were earning south of the border.

Finance should put the U.S. exemption back, and it's not just me who's saying so. Since the department's plans were mentioned in a Personal Finance column last week, readers have sent a steady flow of angry e-mails.

One reader, Ernie Jerome of Nanaimo, B.C., even took a moment to e-mail while vacationing in New Zealand.

"Aside from any doubtful effect on reducing tax evasion," he wrote, "the Finance Department's proposed tax measures will . . . help maintain the Canadian mutual fund industry's excessive management fees by using discriminatory tax rules to effectively block Canadians' access to index units which have much lower management fees."

Thanks, Mr. Jerome. That about sums it up.


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