Character Conversion Transactions Get a Reprieve

The federal government gave character conversion transactions a mid-summer reprieve on July 11, making the transition process somewhat easier for companies that use derivative forward agreements to change the character of income transactions to capital transactions.

You may recall that the March 21, 2013 federal budget targeted these tax arrangements. Essentially, forward agreements were used to buy or sell a capital property at a specified future date. The problem is that the purchase or sale price of the capital property under a derivative forward agreement is not based on the performance of the capital property but instead by reference to some other measure. Often this measure is the performance of a portfolio of investments which typically contains investments that produce fully taxable ordinary income.

Rather than challenging such arrangements in court, which the Income Tax Act allowed the government to do, legislation was changed in the budget to ensure ordinary income transactions in these arrangements will be taxed as such – with a 100% rather than 50% income inclusion. In order to prevent double taxation, the budget proposals also provided rules for an adjustment to the cost base of the capital property.

Originally the budget proposed that this new tax treatment will apply after budget date to derivative forward agreements that have a duration of more than 180 days. Now, for transactions entered into before March 21, 2013, there is transitional relief until the end of 2014 if the terms of these agreements provide for final settlement before 2015. Investment funds that use a series of rolling 30-day agreements will be allowed to continue to do so as a continuation of the series, as long as the series of agreements ends before 2015. 

However, in these cases, certain limits on growth must be followed. Investment funds that stay within those growth limits will have until the end of 2014. Derivative forward agreements entered into after March 20, 2013 and before July 11, 2013 will have at least 180 days of grandfathering if they exceed the growth limits. In addition, in the case of longer term agreements, grandfathering could continue past 2014, if growth limits are met. Increases in the size of a derivative forward agreement resulting from the merger of two funds will be exempt in certain cases.