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6 | INVESTMENT EXECUTIVE NEWS January 2020 Ontario is concerned that DSC ban would hurt smaller investors
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ostensibly for advice those brok-
ers can’t provide. Unlike the planned DSC ban, this policy has the support of Ontario.
The announcement on DSCs comes after more than a year of uncertainty. The CSA first declared its intention to ban DSCs in 2018, but Ontario’s Progressive Conservative gov- ernment immediately declared its opposition to the idea after being elected in 2018, throwing the DSC initiative into doubt. Although the government initially prom- ised to explore alternatives to a ban with the other members of the CSA, the regulator decided to go ahead with the ban with- out the country’s biggest, most important market.
That might not matter.
Investor advocates say that even if Ontario doesn’t partici- pate in the CSA’s planned ban on DSCs, the ban still will be nationwide.
“DSC funds are now a pariah product,” says Neil Gross, chair of the Investor Advisory Panel (IAP), the Ontario Securities Commission’s (OSC) independ- ent investor advocacy group.
“[DSC] use has been largely impossible to justify ever since many mutual funds became purchasable on a zero upfront commission basis,” Gross says. “So, even if Ontario doesn’t join in the ban, any Canadian dealer or [financial] advisor will just be courting liability risk by con- tinuing to sell DSC funds from
this point forward.”
The Canadian Foundation for
the Advancement of Investor Rights (FAIR Canada) also antici- pates that even if the DSC ban happens without Ontario, DSCs will eventually vanish through- out the country.
“Leading financial [services] institutions have already decided to stop selling DSC mutual funds, and more will come on board over time,” FAIR Canada states. “We believe that in time the elimina- tion of DSCs will encompass all of Canada, including Ontario.”
Both FAIR Canada and the IAP have long supported the elimina- tion of DSCs. The groups advocate an outright ban on embedded fees in general, including mutual fund trailers. The CSA’s approach of scrapping DSCs and discount brokers’ trailer fees reflects a more modest approach than the comprehensive ban it initially considered.
Yet, the CSA maintains that these measures will address its investor protection concerns with current sales structures.
“These expected rule changes, together with new conflict-of-interest rules that are being implemented under our client-focused reforms, will bring greater transparency to the fees paid by investors when they buy mutual funds,” said Louis Morisset, chair of the CSA and president and CEO of the Autorité des marchés financiers, when announcing the CSA’s policy plans.
Investor advocates are
pleased that the CSA is taking action at all. While they would have preferred a comprehen- sive ban on embedded compen- sation structures, FAIR Canada states that DSC funds are “rife with conflicts of interest, target the most vulnerable investors and there is strong evidence of mis-selling.”
FAIR Canada further states that eliminating the DSC struc- ture will be good for both inves- tors and the investment industry.
“The move away from DSCs is an important step forward in simplifying the mutual fund fee structures that consumers simply do not understand. We believe that [a ban] will enhance the professionalism of the finan- cial services industry,” says Douglas Walker, senior policy counsel with FAIR Canada.
Despite the contention that the industry will ultimately benefit from the CSA’s action, some in the industry would pre- fer to maintain the status quo.
The Investment Funds Institute of Canada states that although it will closely review the CSA’s policy propos- als when they are released, the fund industry “would have pre- ferred a nationally harmonized approach that preserved pay- ment choices for investors with full fee transparency.”
The Ontario government refers to the same preference — citing a belief that eliminating DSCs will hamper access to mutual funds for smaller investors — in explain- ing the government’s decision not
to go along with the CSA.
Says Scott Blodgett, senior
media relations advisor for the provincial Ministry of Finance: “The ban on the DSC option imposed by the CSA in the rest of the country will discontinue a payment option for purchasing mutual funds that has enabled Ontario families to save toward retirement and other financial goals.”
Instead of a ban, Blodgett adds, Ontario will consider intro- ducing restrictions on the use of DSC funds, a move that aims to address the regulators’ concerns over investor protection “while allowing for the continuation of a viable investment option for families.”
The OSC indicates that it will consider a variety of possible curbs on DSC sales — such as banning the use of DSCs with senior-age investors, outlawing the use of leverage in DSC transactions and mandating shorter redemption schedules — with an eye to pre- venting investor harm while con- tinuing to allow DSC sales.
Which, if any, of these restric- tions the OSC decides to adopt — and when that will happen — remains in question.
The CSA states it’s planning to
introduce its final rule changes outlawing DSCs in “early 2020.” The ban on paying trailers to dis- count brokers will be introduced later in the year.
The OSC indicates that its focus will be on working with the other members of the CSA to finalize the planned trailer- fee ban.
The one concession the CSA is promising is a longer transition period. The regulator’s initial proposal contemplated phasing in a DSC ban over just one year. Now, the proposals will include a phase-in period of “at least two years.”
New sales under the DSC option will be prohibited immediately once the ban takes effect, the CSA states. But the regulator expects to allow exist- ing DSC redemption schedules to run their course.
Similarly, the CSA indicates that the ban on paying trailers to discount brokers will include a two-year transition period.
Nevertheless, the writing’s on the wall for DSCs and discount- ers collecting trailer fees. Neither practice has much of a future in the decade ahead, and Ontario’s resistance ultimately may prove futile. IE
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mutual fund corporation called Horizons ETF Corp., with each individual ETF keeping its exist- ing mandate, ticker symbol and fee structure as a series within the corporate-class fund.
“If [clients] are in an unreal- ized capital gains position, then there’s no sense in realizing those capital gains and paying tax on them if [clients] don’t have to,” says Steve Hawkins, president and CEO of Horizons.
Section 85 of the ITA permits a taxpayer to transfer eligible cap- ital property, and that property’s adjusted cost base (ACB), into a corporation in exchange for shares and to defer taxes on the capital gain until the shares are sold — as long as the taxpayer and the cor- poration file a joint election.
With the Horizons restructur- ing, unitholders traded trust units for shares in a series in the corpor- ate-classfund.Ifaninvestorholds the units in a taxable account and doesn’t make the Section 85 elec- tion by the time they file their 2019 tax return, the transfer of their ETFs into the corporation will con- sidered be a deemed disposition.
Horizons converted 15 total- return index ETFs and 29 BetaPro ETFs — all of its funds that pri- marily use derivatives-based structures to achieve tax effi- ciency — into Horizons ETF Corp. This occurred after the federal
government proposed certain changes to the taxation of mutual fund trusts, which include ETFs, in the 2019 federal budget. Those changes to the so-called “alloca- tion to redeemers” methodology increase the likelihood that ETFs using derivatives-based struc- tures, such as the 44 Horizons ETFs, are forced to make taxable distributions.
Horizons has been actively helping unitholders make the joint election. To date, more than 2,000 unitholders have processed their Section 85 election through the company’s dedicated website.
“The reorganization itself is complicated,” Hawkins says, “but Section 85 rollovers are something retail advisors have been using for years [on behalf of clients] with respect to other corporate reorganizations.”
Hawkins says Horizons is assessing whether it will con- vert any of its other ETFs into corporate-class funds. “We have otherETFsthatareactivelyusing futures, as an example, [as part of those ETFs’] investment strat- egy,” he says. “Managing those products inside a corporate-class [fund] makes a lot more sense from a tax perspective.”
Section 85 rollover elections can be employed in both corporate reorganizations and mutual fund mergers. For example, Toronto- based Mackenzie Investments decided last year to merge some of its funds into a corporate-class
structure and helped unitholders make the election.
Separate from the reorgan- ization of its 44 funds, Horizons states it will consider allowing clients to use the special election to transfer a third-party invest- ment fund into its mutual fund corporation.
“We would consider a trans- fer for similarly indexed prod- ucts,” wrote Jonathan McGuire, external communications man- ager with Horizons in an email to Investment Executive (IE). He cited an example of an exchange of units in iShares’ S&P/TSX 60 index ETF for shares of Horizons’ S&P/TSX 60 index ETF.
In such a transaction, Horizons would become owner of the third-party fund in con- sideration for shares of a series in the corporation.
“Horizons, in most cases, will turn around and redeem the third-party ETF immediately in exchange for the underlying securitiesofthatthird-partyETF,” wrote McGuire. “The competi- tor ETF’s underlying securities received would become part of the Horizons ETF going forward.”
Tax experts say it’s uncom- mon for a corporate-class fund to allow such transactions, but that those transactions are per- missible under the ITA.
“[Such a transaction] would have to fall within the object- ives of the [corporate-class] fund and [take into account] its
investment restrictions,” says Jim Witty, vice president of tax, retire- ment and estate planning with CI Investments Inc. in Toronto.
Says Carol Bezaire, sen- ior vice president of tax, estate and strategic philanthropy with Mackenzie Investments: “It would have to be the same kind of index [as the ETF, and] there would be a lot of [issues to consider]: What kind of index does [the fund] trade on? Does it have a mandate that we want in our corporate structure? So, [the transfer process] would get complicated.”
Toronto-based Purpose Investments Inc. has been allow- ing Section 85 rollover trans- actions on a selective basis into an in-kind transfer fund. For example, an investor could exchange shares of a publicly traded company for shares of a Purpose corporate-class fund. If those company shares had a large unrealized gain, that would allow the investor to diversify without triggeringanimmediatetaxevent.
“It’s a specific-use case for specific clients,” says Vlad Tasevski, head of product with Purpose, about the in-kind trans- fer fund. Since 2015, Purpose has had an active patent application with the federal government for a “method of exchanging an asset for shares of an investment fund held in an investment fund cor- poration.” The patent includes methodology for tracking the ACB of the shares being transferred
into the corporate-class fund “during all the time the client is invested in the [corporation].”
Purpose offers almost 25 ETFs and mutual funds in Purpose Fund Corp., as well as individual funds set up as trusts.
CI Investments, which has corporate-class funds in its product lineup, “does not offer in-kind subscriptions at this time,” wrote a spokesperson for the firm in an email to IE.
Corporate-class funds, because of their structure, offer potential tax advantages for investors. One key advantage is that income and foreign divi- dends generated within one ser- ies of the corporation can be offset with expenses and losses incurred in other series, which allows for tax efficiency. In addi- tion, corporations can distribute only capital gains and dividends, which are more tax-efficient than income and foreign dividends.
Bezaire says she expects interest in corporate-class funds to increase, especially for small-business owners. Recent changes to the taxation of pri- vate corporations limit access to the small-business deduction tax rate when a small business gen- erates more than $50,000 in pas- sive investment income in a year.
“With corporate-class struc- tures, the passive investment income gets reduced because it [generates] fewer taxable distri- butions,” Bezaire says. IE
Horizons facilitating tax-deferral election for clients
Investor advocates say even if Ontario doesn’t participate in the DSC ban, the ban still will be nationwide