On July 11, 2013, the Department of Finance issued a long awaited News Release and Backgrounder announcing changes to the grandfathering rules for “character conversion  transactions”.

The 2013 Federal Budget eliminated the tax benefits associated with character conversion transactions – forward sale and forward purchase agreements used by many mutual funds and other investment funds to convert the return on a portfolio of investments from fully taxable ordinary income into capital gains. Only 50% of capital gains must be included in income  for tax purposes. Grandfathering was available for a “derivative forward agreement” entered into before March 21, 2013. However, many investment funds used a series of 30-day or 90-day forward agreements to implement  their character conversion strategies. A series of “derivative forward agreements” was not grandfathered under the original Budget proposal. However, a series of agreements had a transition period of approximately 180 days before tax benefits would be eliminated.

To provide additional transition time for short-term forwards, Finance is now proposing to extend grandfathering to including a continuous series of short-term forward agreements first entered into before March 21, 2013. Grandfathering for long- term forward agreements will end on March 21, 2018. All grandfathered forward agreements will be subject to “growth limits”, as described below.

Short-Term Forwards

For a “derivative forward agreement” – a forward sale or purchase agreement (or a series of agreements) with a duration exceeding 180 days that was entered into before March 21, 2013 and the terms of which provide for final settlement of the agreement before 2015 (or that is part of a series of agreements that concludes before 2015) — Finance proposes to extend grandfathering until the end of 2014 for investment funds that stay within the specified growth limits. Also, the grandfathering rules will be amended to make it clear that agreements entered into before March 21, 2013 will be considered when determining whether a series of agreements  has a term of more than 180 days. However, it is proposed that this change will apply prospectively, so that an investment fund that exceeded the growth limits before July 11, 2013 will have a 180-day transition period. Finance provided the following example: if a taxpayer entered into a 180-day derivative forward agreement on April 1, 2013 as a continuation of a series of derivative forward agreements that were entered into before March 21, 2013 and the new derivative forward agreement exceeded the growth limits described below, the taxpayer would still be entitled to 180 days of grandfathering after April 1, 2013.

Long-Term Forwards

For a grandfathered “derivative forward agreement” that was scheduled to finally settle after 2014, grandfathering will now end on March 21, 2018, and will be subject to the growth limits described below.

Growth Limits

To qualify for grandfathering, the notional amount of the derivative forward agreement after March 20, 2013 cannot exceed the total of:

  • the notional amount of the forward immediately before March 21, 2013;
  • any net increase in the notional amount of the forward after March 20, 2013 resulting from a net increase in the value of the reference assets (i.e., excluding new investments in the forward);
  • any forward settlement amounts after March 20, 2013 that are reinvested in either the forward or a replacement forward;
  • any cash on hand immediately before March 21, 2013 that can reasonably be considered to have been committed to the forward before March 21, 2013;
  • if the forward was entered into, and an over-allotment option in respect of an offering of securities was granted, before March 21, 2013, amounts invested in the forward using proceeds from the exercise of the over-allotment option after March 20, 2013; and
  • any other increases in the notional amount of the forward occurring after March 20, 2013 and before July 11, 2013, that do not exceed 5% of the notional amount of the forward immediately before March 20, 2013.

Finance also confirmed that it will allow for increases in the size of a forward as a result of the merger of two investment funds, provided that the surviving forward’s notional amount does not exceed the combined notional amounts of the two predecessor forwards (presumably subject to the growth limits described above) and its term does not exceed the term of either predecessor agreement.

Draft legislation implementing these proposed changes is not yet available. We will provide an update once draft legislation has been released.

If you have any questions about this bulletin, please contact the authors or any other member of BLG’s Tax Group.