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The federal government plans to tweak tax laws to remove the breaks given to big financial institutions that are benefiting from complicated hedging strategies on dividend-paying stocks.

The budget released Thursday calls it the “double-deduction loophole,” which allows some Canadian financial institutions to use “hedging and short selling arrangements in aggressive tax planning strategies.” By closing the loophole, the government says, it can add $635-million to federal coffers over five years starting in 2022-23, and $150-million annually afterward.

Here’s what happens: A financial institution shorts a stock, which means they borrow it, sell the shares, and keep the proceeds with a promise to repay the shares later. At the same time, the financial institution owns the same number of shares and collects the dividends.

An entity that shorts a stock can deduct the interest it pays for borrowing as an expense. And a corporation that collects dividends from another corporation can offset its income with those dividends.

Budget 2022 proposes to amend the Income Tax Act to deny the deduction for a dividend received where the taxpayer has entered into these paired short-sale transactions.

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The Canadian government’s view appears to be that financial institutions that engage in this combined short-long strategy are collecting two tax benefits in one economically neutral transaction, said Joseph Micallef, KPMG’s national tax leader in its financial services practice.

”I think in their view these types of transactions are inconsistent with the spirit of the tax policy that exists currently in the act,” he said. “You have a long position and a short position, and effectively, they eliminate [each other]. And so the ability to recognize [deductions on] both legs of that transaction, they don’t like it.”

Tara Benham, national tax leader for Grant Thornton LLP, said this proposal and others in the federal budget “are not wealth taxes. But they kind of are, where they looked to the industries or the entities that are making a lot of money and have the wherewithal to really plan for taxes.”

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