General provisions in the ITA applicable to corporations and their shareholders provide that, in certain circumstances, an exchange of shares of a corporation by a taxpayer is deemed not to be a disposition or is deemed to be a disposition that occurs at the taxpayer's adjusted cost base of its original shares. In either case, this results in the deferral of tax under the ITA until the shares received by the taxpayer on the exchange are disposed of in a taxable transaction. Many "mutual fund corporations" or "investment corporations" (both as defined for the purposes of the ITA) have, for many years, offered multiple classes of shares to investors. Each class of shares provides exposure to distinct portfolios of investments held by the corporation (for example, a Canadian equities portfolio or a corporate bond portfolio). The corporations allow an investor to invest in a different portfolio by switching between different classes of shares of the corporation, and relying on the general provisions of the ITA, the exchange can be completed on a tax-deferred basis. Such funds are often referred to as 'switch funds'.
Budget 2016 proposed to amend the ITA so that taxpayers exchanging classes of shares in "mutual fund corporations" (or "investment corporations") would no longer be able to rely on the relevant tax deferral provisions of the ITA and would be considered to have disposed of their original shares at fair market value. It was indicated in Budget 2016 that the proposed amendments would not apply where the shares received on an exchange only differ in respect of management fees or expenses to be borne by the investors and otherwise derive their value from the same portfolio or fund within the mutual fund corporation (i.e., the switch is between different series of shares within the same class).
Unlike many of the tax proposals in Budget 2016, specific proposed language to implement the switch fund change was not included in the NWMM. Instead the NWMM simply provided that:
- The Act is modified to give effect to the proposals relating to Taxation of Switch Fund Shares described in the budget documents tabled by the Minister of Finance in the House of Commons on Budget Day.
Accordingly, the 2016 Legislative Proposals are the first time that the proposed rules have been set out in significant detail. It appears that the proposed rules largely conform to the general statements in Budget 2016. However, they do differ in that the proposed rules cover a potentially broader array of tax deferral provisions than some taxpayers may have expected, provide a slightly enhanced exception, and limited transitional relief for certain newly formed corporations.
The main provision of the rules is proposed subsection 131(4.1) of the ITA. It provides that, subject to certain exceptions, the tax deferral provisions in sections 51 (convertible property), 85 (transfers of property by a shareholder to a corporation), 85.1 (share for share exchange), 86 (exchange of shares in the course of a reorganization), and 87 (exchange of shares on amalgamation) do not apply to taxpayers exchanging shares of a class of a "mutual fund corporation" for another share of a "mutual fund corporation" where the original shares are recognized as an investment fund under securities legislation. By virtue of a proposed amendment to existing subsection 130(2) of the ITA, shareholders of "investment corporations" that are not "mutual fund corporations" will also be subject to proposed subsection 131(14.1).
Budget 2016 contemplated an exception to the general rule to cover exchanges solely undertaken in relation to management fees and expenses. Proposed paragraphs 131(4.1)(a) and (b) to the ITA provide two exceptions that are somewhat broader than the very limited exception described in Budget 2016.
First, if a share exchange or disposition occurs in the course of a capital reorganization covered by section 86 or an amalgamation covered by section 87, then a shareholder will remain entitled to a tax deferral provided that:
- All shares of the particular class are exchanged;
- The original shares and the exchanged shares derive their value from the same underlying property and in the same proportion; and
- The exchange was undertaken for solely for bona fide reasons and not to obtain the exemption.
The technical notes included with the 2016 Legislative Proposals provide an example where such an exchange would be considered to be bona fide if it was undertaken to reallocate voting rights in a section 86 reorganization in order to reduce compliance costs and administrative complexity.
The second exception covers certain exchanges of shares of different series of the same class. In particular, a tax deferral will be available where shares of a class of a "mutual fund corporation" are exchanged for shares of the same class (ignoring the rule in subsection 248(6) that would otherwise treat shares of different series as a separate class), provided that:
- The original shares and the exchanged shares derive their value from the same underlying property and in the same proportion; and
- The class of shares is recognized as a single investment fund under securities legislation.
All of the foregoing rules will apply to dispositions of shares that occur after 2016. This leaves several months for taxpayers to switch shares they may currently own in a "mutual fund corporation" on a tax deferred basis. This application date is extended from the October 1, 2016 date proposed in Budget 2016 and is understood to be in response to stakeholder representations for an extended transition period, as well as implementation at the start of a calendar year to facilitate tax reporting.
In addition, the 2016 Legislative Proposals provide a new relieving rule in relation to "mutual fund corporation" status under the ITA. This appears to be a response to potential problems caused to new corporate funds that had commenced sales prior to budget date and were impacted by the uncertainty caused by the Budget 2016 Proposal. Specifically, subject to certain conditions, proposed subsection 131(8.01) allows a corporation that was incorporated after 2014 but before the budget date to elect to be deemed to be a "mutual fund corporation" from the date it was incorporated until the earlier of the days it otherwise qualifies as a "mutual fund corporation" or Dec. 31, 2017. This change comes into force after Jan. 1, 2017.