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Investors holding linked notes, such as principal-protected notes, could see the elimination of tax planning benefits this fall, according to proposed changes in this year's federal budget.
A linked note is a debt obligation in which the return is linked to the performance of one or more reference assets or indexes over the term of the obligation. The underlying asset or index can be a basket of stocks, a stock index, a commodity, a currency or units of an investment fund.
There are two main types of linked notes: principal-protected notes (PPNs) and principal-at-risk notes.
These investments are typically sold by larger financial institutions and guarantee an investor's principal be returned at maturity. But unlike other investment vehicles that guarantee principal (i.e., a guaranteed investment certificate), the amount of interest earned for a PPN is not guaranteed and could potentially result in a zero return on investment.
Under a principal-at-risk note, there is a risk – depending on the performance of underlying asset/index – that the overall investment at maturity may be less than the principal amount invested.
The attractiveness of both kinds of securities is that they will often yield higher returns than, say, a GIC.
Now, as part of the 2016 federal budget, proposed changes will alter the tax treatment on the sale of both types of linked notes as of Oct. 1.
The government is looking to introduce a new rule that would deny capital gains treatment on secondary-market sales of linked notes, and treat the portion of any gain realized over the principal amount of the note as ordinary income.
For investors, this means they would not be able to write off gains made from the notes against any losses incurred in that year.
The total amount of assets held in both PPNs and principal-at-risk notes is approximately $34.8-billion at the end of June, 2015, according to Investor Economics.
Despite the investment industry knowing for a number of years that the CRA was reviewing the tax rules surrounding these notes, it was unexpected in the budget announcement, says Jamie Golombek, managing director of tax and estate planning with CIBC Wealth Strategies Group.
"The proposed changes by the federal government to these products will result in a major tax change for investors and produce double the amount of tax for non-registered holders of structured notes who choose to sell prior to maturity," Mr. Golombek says.
(There is no impact to linked notes held in non-taxable accounts.)
Previously, an investor who held a linked note in a taxable account and held the note to maturity would be required to include any positive return in ordinary income, according to a research note by RBC Dominion Securities. For an investor who held a linked note in a taxable account and sold it in the secondary market prior to maturity, the general practice was to treat any gain as a capital gain.
As a result, investors holding linked notes with accrued gains in taxable accounts should consider whether it would be advantageous to sell their linked notes – and claim capital gains treatment – prior to the deadline.
RBC says the proposed changes do not affect other benefits of investing in linked notes, including: varying degrees of principal protection, enhanced upside market participation, access to underlying assets that investors cannot efficiently access themselves, and customization.
RBC says it is currently consulting with other issuers, as well as the Canadian Bankers Association, to see whether they should approach the Department of Finance to clarify or challenge the proposed changes.
CIBC is also in industry discussions. One issue being discussed is whether or not all linked notes should be treated in the same manner, Mr. Golombek says.
"I would argue that some products, such as principal-at-risk notes, are more akin to an underlying equity investment than that of a bond product and therefore, due to the significant risk of capital, any profit or loss should receive capital gain or loss tax treatment," he says. "This would be a scenario where perhaps the Department of Finance might want to reconsider the proposed changes."
Clare O’Hara