A tax loophole can sometimes make a fundamentally unappealing investment more popular than it would be otherwise.
This is the story behind linked notes, which were quietly targeted in last month's federal budget. Linked notes produce returns based on a particular basket of stocks, an index, commodities or other investments. If you hold them to maturity, your gain is taxed as interest. If you sell at a profit before maturity, you may be able to claim a capital gain. The budget ends that benefit for linked notes after September.
Once that change takes effect, linked notes lose one of the few attractions they offered. Being able to sell before maturity through a secondary market means a lighter tax hit because only 50 per cent of capital gains are taxable.
Linked notes are typically issued with terms of five or seven years. There are two types of these notes, principal protected (you get your principal back at worst) and principal at risk. A common feature with most linked notes is that there's a complex formula used to determine your actual return. You may get a percentage of the returns generated by the investments on which the notes are based, or your gains may be capped. In any case, these notes are largely a gimmick designed to appeal to risk-averse investors who feel traditional asset allocation cannot meet their needs.
Following the 2001-2002 stock market crash, principal protected notes became a minor force in the Canadian investing world and even attracted the attention of the federal Department of Finance for their lack of disclosure. Rising stock markets and bad word of mouth over high fees and a lack of transparency pushed these investments to the margins. But there's still enough assets in them that the federal government projects it will generate $45-million in revenue from 2016 through 2018 by shutting down the early redemption loophole.
In fact, you could argue that this budget measure strikes a blow for sound investing by making linked notes less appealing. Most anything linked notes can do, a basic mix of stocks, bonds and cash can do better.