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The federal government is moving to close a loophole that allows investors in certain exchange-traded funds to defer taxes, but the main provider of the products says it’s too early to know what the eventual impact of the proposed legislation will be.

Citing “unfair tax advantages,” this week’s federal budget said the proposed changes would “prevent the use by mutual fund trusts of a method of allocating capital gains or income to their redeeming unitholders where the use of that method inappropriately defers tax or converts fully taxable ordinary income into capital gains taxed at a lower rate.” (ETFs are a type of mutual fund trust.)

One of the government’s main targets is believed to be swap-based ETFs – also known as total return ETFs. These complex products don’t hold any securities directly but deliver the same performance as an index through an agreement – called a total return swap – with a financial institution. The structure is popular in non-registered accounts because no dividends or interest are received and no income taxes are payable until the units are sold, at which time the investor’s total return is taxed advantageously as capital gains.

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In recent years, the federal government has cracked down on other tax-friendly investment structures, including a 2013 decision to curtail the use of “character conversion transactions” that used derivatives to turn income into capital gains, and 2016 legislation to eliminate tax-free switching between corporate-class funds. Given these recent moves, the government’s decision to target swap-based ETFs didn’t come as a surprise to the industry.

“I’m not a tax expert but my read of the budget document suggests that this structure works today because the swap-based funds rely on an exemption, which the budget indicates will no longer apply to these funds,” Dan Hallett, vice-president and principal of Highview Financial Group, said in an interview.

“At this point, it does appear as though these funds are being targeted directly. If my assessment is correct, the tax benefits of these funds will end,” Mr. Hallett said.

Horizons ETFs Management (Canada) Inc. says it is still trying to determine how the proposed legislation will affect its 15 index total return ETFs, as well as other products that use derivatives. The list of ETFs that could potentially be affected includes its largest ETF – the Horizons S&P/TSX 60 Index ETF, with assets of about $1.88-billion – and funds that use derivatives to track commodities such as oil, natural gas and gold. These include “bull” and “bear” ETFs that allow investors to make leveraged bets on underlying indexes and commodities.

The changes would not take effect until after the 2019 taxation year, Horizons said. “If the ETFs were to continue to carry on operations after their 2019 taxation years in the same manner as they do currently, the proposed legislative changes could potentially result in taxable distributions to the unitholders of the ETFs in respect of periods after their 2019 taxation years,” the company said.

Meanwhile, BMO Nesbitt Burns Inc. issued a statement late Wednesday saying it’s “assessing the impact on certain investment funds that it manages” that may be affected by the proposed budget changes. It listed six funds that would be affected, including four TACTIC-branded funds and two Q-Model-branded funds.

“In order to benefit from limited transitional relief, the manager has suspended the distribution of the funds until further notice and will not accept new purchase orders for the funds until it completes its assessment of the proposed legislative changes and determines what further actions might be advisable,” BMO stated. “If the proposed amendments were enacted as proposed, certain derivative agreements that the funds have entered into will likely be treated as ‘derivative forward agreements’ for tax purposes, which would increase the income of the funds and may result in non-refundable tax payable by the TACTIC Funds or an increase in the amount of taxable distributions to be made to unitholders of the Q-Model Funds.”

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It’s not clear if ETFs from other companies would be affected by the proposed legislation.

Still, investors who hold swap-based funds needn’t panic, said Dan Bortolotti, portfolio manager at PWL Capital.

“If they are forced to shut down these funds, I would expect Horizons will look for ways to minimize the tax impact to their investors. So if you hold these ETFs in a taxable account, it probably makes sense to just take a wait-and-see approach for now. You will be able to make a better decision once we have more information,” Mr. Bortolotti said.

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