War on taxing foreign content far from over
Rob Carrick The Globe and Mail Tuesday, August 29, 2000
There's reason to be optimistic the federal Finance Department will change a proposed law that would heap taxes on people holding foreign investment funds. The battle isn't won yet, but the department is making inquiries that suggest a positive outcome for the growing number of people investing in exchange-traded funds listed on U.S. stock exchanges.

There are a couple of other encouraging developments, too. One is that the department is considering whether to push back the deadline for submitting comments on the new rules past Friday. So far, hundreds of responses have been received from investors, brokers and financial advisers who are angry at the prospect of U.S. exchange-traded funds being heavily taxed if they're held outside a tax-sheltered retirement account.

Exchange-traded funds held within a retirement account are vulnerable to the new rules in a subtle way that could reduce an investor's foreign content holdings. However, a Finance Department official says the final version of the law will leave registered accounts alone.

The legislation, which will be finalized early in the fall for introduction in early 2001, is designed to go after high-net-worth individuals who stash money in foreign investment funds that allow them to avoid paying taxes.

As it stands now, investors would have to declare any gains they make from foreign investment entities each year, a process called marking to market. People would also have to pay tax on their gains as if they were ordinary income, which means no favourable capital gains treatment.

The question that Finance is asking about exchange-traded funds is whether the dividends and capital gains they generate are passed on to unitholders and thus taxable, or whether they're kept within the fund and thus sheltered from tax. The key issue, obviously, is the tax-sheltering.

In the United States, exchange-traded funds are considered to be regulated investment companies, which means they are obligated to distribute the vast majority of their gains to unitholders.

Barclays Global Investors confirms that the 56 exchange-traded funds it offers in the U.S. market are regulated investment companies. State Street Global Advisors says the same about its funds, which include Spiders (Standard & Poor's depositary receipts), an exchange-traded fund that tracks the Standard & Poor's 500-stock index.

The bottom line here is that exchange-traded funds are in no way a tax shelter, and that means they're irrelevant to the department's war on tax avoidance. Finance officials must still be convinced of this, but at least they're asking the right questions.

The department has already decided to act on another complaint about a component of its proposed new rules, one that would have had a nasty effect on the foreign content portion of registered retirement accounts.

Right now, the foreign content limit for retirement accounts is 25 per cent of the book value of the plan, which means purchase price plus continuing distributions of capital gains and dividends.

The new legislation as it's now written would require people to mark to market any exchange-traded funds in their retirement accounts. This would have the effect of raising the book value of these holdings from purchase price plus distributions to market value.

After a good year for your U.S. exchange-traded funds, you could find that your foreign content has soared way above the 25-per-cent limit if you marked the funds to market.

On this count at least, investors have nothing to worry about. A Finance official said the new tax laws will be adjusted so that foreign investment funds held in retirement accounts won't be subject to the mark-to-market rule.

The same official also tried to ease concerns that the new rules would cause some foreign stocks to be subject to the same punitive taxation as exchange-traded funds.

The legislation targets entities with 50 per cent or more of their assets in investment properties, which could include not only funds holding stocks and bonds but also corporations holding cash and other assets. Microsoft Corp. has been held out as an example of a company that could be caught, while Yahoo Inc. is another.

However, the Finance official says U.S. companies would be exempt from the new tax rules if they are actively traded, widely held and not in the investment business. Banks and insurance companies would also be exempt.

There's still some potential ambiguity here, though. Some observers have wondered whether a company with most of its assets in cash, securities or real estate may be considered an investment company, even if it's in another line of business entirely.

The best course of action for investors right now is to lay off exchange-traded funds for non-RRSP accounts until Finance decides what to do with the new tax rules.

Don't sell any funds you own, though. This game's far from over.


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