Loss Restriction Rule Update for Investment Funds

In a mostly "good news announcement" for the investment fund industry, the Department of Finance (Finance) announced proposals (Proposals) on October 20, 2014 that would temper the application of the loss restriction event rules (LRE Rules) under the Income Tax Act (Canada) (the Tax Act) for most National Instrument 81-102 investment funds, as well as a number of other pooled fund trusts. The Proposals, tabled in the House of Commons in a Notice of Ways and Means Motion, will have retroactive relieving effect if passed in their current form. The Proposals signal a significant exemption for newly defined "investment funds," but unfortunately, there are a number of circumstances in which the LRE Rules will continue to apply and investment fund managers will need to remain vigilant to ensure tax compliance. In addition, there are a number of technical issues that will continue to create uncertainty.

The LRE Rules announced in the 2013 Federal budget were enacted in 2013 and became effective from March 21, 2013. The rules deem a trust that is at any time subject to an LRE to have a deemed year end for tax purposes and to have to “stream” its losses similarly to the acquisition of control rules that apply to corporations. An LRE occurs where a person becomes a majority interest beneficiary or a group of persons becomes a majority interest group of beneficiaries of a trust. An LRE can occur not only upon an acquisition of securities but also as a result of redemptions of securities. The LRE Rules have had a pernicious effect on the investment fund industry by deeming unexpected taxation year ends for many funds, an effect especially challenging for funds that did not provide for automatic distributions of income on taxation year ends in their constating documents.

The Proposals provide a limited safe harbor from the LRE Rules for trusts that are mutual fund trust and trusts that would be mutual fund trusts if they had 150 unitholders (MFTs and quasi-MFTs).¹ The safe harbor applies to exempt an LRE that occurs due to the acquisition of equity of a MFT and quasi-MFT if two conditions are met: (i) the fund is immediately before the acquisition an "investment fund," and (ii) the acquisition is not part of a series of transactions or events that includes the particular trust becoming a "portfolio investment fund" or ceasing to be an "investment fund." A MFT or quasi-MFT will be an investment fund provided it is also a portfolio investment fund.

For this newly defined term "portfolio investment fund," the Proposals borrow from the definition of "portfolio investment entity" in the so called SIFT Rules. In particular, a portfolio investment fund is essentially a "portfolio investment entity" as defined in subsection 122.1(1), i.e., a person that does not hold any "non-portfolio property" as defined in subsection 122.1(1), except that the restrictions in the latter definition to Canadian investments are removed so that foreign investments can cause a trust not to qualify for the LRE safe harbor.

The Proposals appear aimed at providing a broad exception for ordinary course transactions for MFTs and quasi-MFTs but their principal exemption’s reliance on "acquisitions of equity" as the "trigger," if intended to be so narrow, may still create some uncertainty for LREs for funds where the LRE results from a redemption. This has been a particular concern for the investment fund industry. Preliminary discussions with Finance suggest that Finance intended that the safe harbor be read so that a redemption by the fund (on a basis that a redemption is an acquisition by the trust) is a sufficient trigger.  We doubt that Finance will clarify this in the short term and thus some risk may continue where an LRE results from a redemption of units. In the meantime, funds may need to remain vigilant when dealing with LREs that occur when unitholders redeem thus leaving a single investor or a group of investors that becomes a majority interest beneficiary or a majority interest group of beneficiaries.

A MFT or quasi-MFT will qualify as a "portfolio investment fund" provided it does not hold:

1. more than 10% of the equity value of any other entity;
    
2. investments within the fund that are concentrated in an investment that represents greater than 50% of the equity value of the fund;
    
3. a property that the fund uses at that time in the course of carrying on a business; or
    
4. real or immovable property or resource property that represents more than 50% of the equity value of the fund. For this purpose, certain real estate REITs may be a real or immovable property (but shares of a corporation that derives its value from real property would not be).

These tests create some issues:

1. Note that the term "equity value" is defined in subsection 122.1(1) to be the fair market value at any time. Thus the above tests need to be tested on a fair market value ongoing basis (and not at cost).
    
2. For National Instrument 81-102 investment funds, which have a limitation on their investments to holding not more than 10% of the securities of any one issuer, it is likely that such funds will at all times meet the definition of a portfolio investment fund. However, pooled fund trusts which are not subject to such limitations may not meet the LRE safe harbor.
    
3. It appears that Finance is not concerned that various derivatives that are treated on income account merely because they are "adventures or concerns in the nature of trade" and therefore included in the definition of business would cause loss of the LRE safe harbor. However, funds whose overall activities rise to a level of a business will continue to be subject to the LRE Rules.  Regarding isolated derivatives, the phrase "uses at that time in the course of carrying on a business" and the words "carry on business" arguably require that there be a business that is carried on as compared to a business that results merely from "an adventure or concern in the nature of trade." This is generally consistent with the case law that differentiates between a business (using the normal use of the word, which applies a “carry on business” standard and those activities that do not meet that test but are nonetheless a business because they are deemed to be a business as an “adventure or concern in the nature of trade”). Likely this is the position that many listed investment funds have used in their compliance with the SIFT rules. However, because there are some sporadic comments in the case law (see for example, the Reinders case ([1980] C.T.C. 2798) that blur the two issues; it may be helpful if Finance could clarify in the technical notes that derivatives held on income account were not intended to cause a loss of the LRE safe harbor.
    
4. In addition, during start-up periods, it is possible that a fund may hold non-portfolio property because its assets are congregated in a single issuer.

Funds will need to monitor these tests to ensure compliance, particularly in light of the above issues .

The LRE Rules will also continue to apply to special transactions—becoming a "portfolio investment fund" (creating a "fresh start" without losses) and ceasing to be an investment fund. It is not clear how the Proposals will work for start-ups. One way to interpret these restrictions to the LRE safe harbor is to prevent a fund that is holding non-portfolio property (e.g., a real estate investment fund) from converting to an investment fund for purposes of the Proposals or vice versa without being subject to the LRE Rules.

Another way to interpret them is that the formation of fund creates a fund that becomes a portfolio investment fund and so any acquisition of equity that is part of that start-up can create an LRE. With respect to funds during the start-up phase, the fresh start rules will continue to apply the LRE Rules if the acquisition is part of a series of transactions that includes the particular fund becoming a portfolio investment fund. This would occur either immediately upon the formation of a fund, where it initially becomes a portfolio investment fund, or where a fund is seeded and runs for the purposes of preparing it to become a portfolio investment fund in the future, or the fund is seeded with the expectation that it will sell securities to the public. Unfortunately, because the phrase “series of transactions” used elsewhere in the Tax Act has been interpreted to have an extremely broad meaning, there will be no bright-line test for this. In practice, however, once a fund has issued its initial tranche of securities to its targeted investors and the distribution of the fund has become normalized, we would anticipate that the trust will no longer view future sales of securities as being part of the series that included that particular trust becoming a portfolio investment fund. Care should be taken, therefore, that for the first investors that come into a fund, particularly those who had been identified during the formation or start-up phase of the fund, that there is no LRE created because a filing will be necessary. Similarly, once a fund determines that it will cease to be an investment fund, care will need to be taken to ensure that no LREs occur during the process of winding down the fund. Thus managers may need to be vigilant at the commencement of a fund or termination of a fund to ensure that no LRE occurs.

The Proposals will have a retroactive effect to March 22, 2013 unless a trust elects in writing and files the election with the Minster of National Revenue on or before the trust filing due date for the last taxation that ends before January 1, 2015, in which case the rules will only apply for the trust’s taxation years after January 1, 2014. Thus, to the extent that a trust did file returns for 2013 on the basis that it had an LRE and does not wish to refile, it can make the election.

Finally, the Proposals also include an exception that the deemed year end that occurs under the LRE Rules will not apply for the purposes of determining the time to (i) reach 150 unitholders in subsection 132(6.2), (ii) determine when a tax return is due, and (iii) determine the definition of balance due date for the taxpayer. It is not clear how this rule is intended to operate for tax returns and tax slip information reporting—whether it eliminates those filings or just delays them.  However, we understand that Finance intends the provisions should work to merely delay reporting.

Unfortunately, the Proposals do not have complete bright line-tests but, they are considerably better than the current law. We hope that Finance will move quickly to hone the provisions to avoid the technical concerns outlined above.

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¹ In the case of quasi-MFTs with 150 unitholders, all of their beneficiaries must be beneficiaries whose interests are fixed interests of the trust.