It looks like the government just shut down a business that was allowing banks to fund a little more cheaply and corporations to earn a little more income.
There's long been a transaction where a bank will promise a client income, but deliver it in the form of capital gains. It's accomplished through a derivative transaction that involves the bank selling the client an asset, then buying it back later at a higher price that delivers the agreed return. There's no risk to the client, but because a purchase and sale is used, it can be structured as a capital gain.
Because of the tax advantage, banks have been able to promise a slightly lower return than they could just selling the client a short-term fixed-income note. Everybody wins – the client gets a little extra tax advantaged income, and the bank gets a lower cost of funding than they could get by funding in fixed income paper.
Everybody, that is, except the taxman.
Now, the government is coming after so-called "character conversion transactions," which it defines as "arrangements that seek to convert ordinary income into capital gains through the use of derivative contracts. These arrangements typically involve the use of a forward agreement to buy or sell a capital property using a pricing formula that is not based upon the performance of the particular property but on some other measure, such as the performance of other portfolio investments that produce fully taxable income."
Under the budget, the income will now be treated as ordinary income.
And that likely means the end of that business for banks and customers that have used it, said Doug Clark, managing director of research at brokerage ITG Canada.
It's also likely to cause a drop in trading volumes on Canadian stock markets. The asset that banks usually sell to clients then buy back is stock.