Character Conversion Transactions

What do the new federal budget changes mean to investors?

To generate a capital gain, an investor generally purchases an asset, waits for the value of the asset to increase in value and then sells the asset for more than its cost.

If the investor does a lot of trading, he or she may make an election to have all capital transactions treated as capital gains by filing Form T123 Election on Disposition of Canadian Securities. This manages the risk of CRA treating the trading activities as income – fully taxable—in nature.

Since capital gains are taxed at half the rate of ordinary income like interest, capital gains are much more tax efficient than interest income. For this reason, taxpayers with a high marginal tax rate may prefer to invest in mutual funds which yield capital gains rather than an equivalent amount in interest (or even slightly less). Unfortunately generating capital gains is more difficult as you need to select assets that will increase in value. On the other hand, contracts are available (such as bonds) which generate a guaranteed amount of income. Wouldn’t it be nice if you could get that guaranteed income but in the form of capital gains? Well, mutual fund companies did come up with a way – the so-called character conversion transaction.

Here’s a simplistic example of how the strategy works. Let’s say that Fund A has $100,000 to invest. ABC corporate bonds earning 3.5% annually look like a good investment, but they generate interest. Bank B has 10,000 shares of XYZ corp shares in its portfolio. Fund A and Bank B enter into an agreement. Fund A will buy the XYZ shares from the bank for $100,000. The bank will use the money to buy the ABC corporate bonds. Under the agreement, Fund A agrees to sell the shares back to Bank B after two years for $106,000, regardless of the value of the shares at that time. The fund gets a guaranteed 6% return on the investment and because they purchased and sold shares, they report the income as a capital gain and allocate the gain to their investors. The bank effectively maintains its investment in the shares and reaps the 3.5% return on the bonds (and $6,000 of it becomes an increase in the cost base of the shares).

This type of transaction is called a character conversion transaction because it takes the guaranteed income (which is really a portion of the interest on the bond) and converts it to a capital gain. Existing arrangements like this will continue to be taxed as capital gains. However, any transactions entered into after budget day, March 21, 2013, will be taxed as interest income instead of capital gains. This, of course, makes such transactions much less desirable.

So what does this mean for ordinary investors? It means that, because they can no longer use character conversion transactions, mutual funds will find it much more difficult to generate guaranteed capital gains for their investors as existing arrangements are completed. Already, some mutual funds have stopped accepting new investors and some fund companies have announced that certain funds will be closed. Funds that do not have the mandate to generate capital gains are unlikely to have entered into such transactions so will be unaffected by these rule changes. 

Within the corporate class structure, these types of transactions were used by fund managers to generate capital gains for their share classes which targeted capital gains, so such funds will have more difficulty generating capital gains in the future and may not be able to sustain those share classes. Existing investors may have to convert to another class of shares which do not pay capital gains.

Tax and financial advisors should discuss these budget changes with their clients to consider alternative ways to earn capital gains within their investment portfolios.