1999 Ruling 9903543 - TOTAL RETURN SWAPS & MUTUAL FUND TRUST

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

1. Will the matchable expenditure rules in section 18.1 apply to the swap payments made by the Trust to the Bank?

2. Can the Trust report its income under the Swap upon realization versus using a mark-to-market method?

3. Can XXXXXXXXXX deduct the sales commissions it pays as a current expense?

4 Where a mutual fund trust is exempted by Securities Commissions from section 11.5 of National Policy #39 and given approval for quarterly retractions, will the requirements of 108(2)(a)(i) be considered to be met?

Position:

1. Not as long as the Trust's investment in the Swap is not a tax shelter.

2. Yes, if it so chooses, but once it chooses this method it must continue to report using this method for all future years.

3. No position taken on this matter.

4 Yes.

Reasons:

1. The application of paragraph 18.1(15) (a) would preclude the application of section 18.1, so long as statements and representations are not made or proposed to be made which would result in the Trust's investment in the Swap being a tax shelter. We were satisfied that no such statements and representations were included in the revised preliminary prospectus provided to us.

2. Similar position as provided in Technical News No. 14 for "Reporting of Derivative Income by Mutual Funds".

3. In order to expedite the issuance of the ruling, the representatives withdrew this request. We expressed some concerns that section 18.1 may apply but did not reach a final conclusion.

4. The Securities Commissions of the various provinces are primarily responsible for policing the issue of mutual fund units. Accordingly, the Department will not, in general, view a particular unit that is issued under and in accordance with the rules and regulations of the Securities Commission responsible for the particular unit as failing to meet the requirements of subsection 108(2). The "conditions" referred to in subparagraph 108(2)(a)(i) generally acceptable to the Department will be those conditions that conform to the requirements of the appropriate Securities Commission. Additionally, it is reasonable under the circumstances to consider that some unit holders may seek retraction of their units. Consideration was also given to E9332223.

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Attention: XXXXXXXXXX

XXXXXXXXXX, 1999

Dear Sirs:

Re: XXXXXXXXXX
Advance Income Tax Ruling

This is in reply to your letter dated XXXXXXXXXX, as amended in your numerous letters and facsimiles sent to us in XXXXXXXXXX, wherein you requested advance income tax rulings on behalf of XXXXXXXXXX, in connection with the proposed transactions described below.

Our understanding of the facts, proposed transactions and purpose of the proposed transactions is as follows:

FACTS

1. XXXXXXXXXX is a Canadian investment dealer. It is an indirect wholly-owned subsidiary of the XXXXXXXXXX (the "Bank"), a Canadian chartered bank. The address of XXXXXXXXXX. Its business number is XXXXXXXXXX and its Tax Services Office is XXXXXXXXXX.

2.

XXXXXXXXXX

3. Each of XXXXXXXXXX is a resident of Canada for the purposes of the Income Tax Act R.S.C. 1985, 5th Supp., c. 1, as amended (“the Act”), and the Trust referred to below will be a resident of Canada.

4.

XXXXXXXXXX

5.

XXXXXXXXXX

6.

XXXXXXXXXX

7. XXXXXXXXXX principal business includes the provision of services in respect of the administration or management of shares or securities. XXXXXXXXXX also acts as manager for XXXXXXXXXX conventional mutual funds (the “XXXXXXXXXX Funds"). The XXXXXXXXXX Funds are structured so that investment management fees are not payable by the XXXXXXXXXX Funds, but are paid directly by investors to XXXXXXXXXX as part of the "XXXXXXXXXX Program" offered by XXXXXXXXXX. The XXXXXXXXXX Program is a fully-integrated investment management program offered to assist clients in creating a structured investment plan. Each investment plan is tailored to meet clients' investment objectives, risk tolerance and return expectations. The XXXXXXXXXX Program offers an analysis of each client's optimum portfolio mix and access to the XXXXXXXXXX Funds structured exclusively for XXXXXXXXXX Program clients. The XXXXXXXXXX Funds currently have XXXXXXXXXX of net assets. XXXXXXXXXX fees from the XXXXXXXXXX Program are running at an annualized rate of XXXXXXXXXX dollars. XXXXXXXXXX also acts as manager or administrator of a number of special-purpose mutual fund corporations and mutual fund trusts which purchased and hold a fixed portfolio of securities. These funds include XXXXXXXXXX. The total assets under administration of these funds exceed $XXXXXXXXXX and XXXXXXXXXX fees during XXXXXXXXXX were XXXXXXXXXX dollars.

8. As part of its business, the Bank enters into derivatives transactions, including swap contracts. The Bank currently owns a portfolio of Canadian bonds with a market value of approximately $XXXXXXXXXX. However, while the portfolio is intended to track the Index closely, the portfolio is only comprised of approximately XXXXXXXXXX of the XXXXXXXXXX issues comprised in the Index.

9. To the best of your knowledge and that of the taxpayers involved, none of the issues involved in this ruling

i) is in an earlier return of the taxpayer(s) or a related person,

ii) is being considered by a tax services office or taxation centre in connection with a previously filed tax return of the taxpayer(s) or a related person,

iii) is under objection by the taxpayer(s) or a related person,

iv) is before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has not expired, and

v) is the subject of a ruling previously issued by Revenue Canada.

PROPOSED TRANSACTIONS

1. A trust (the "Trust") will be established pursuant to a declaration of trust (the "Declaration of Trust") made by

XXXXXXXXXX. The name of the Trust will be "XXXXXXXXXX". XXXXXXXXXX will be the trustee (the “Trustee”) of the Trust. An individual will contribute $XXXXXXXXXX to the Trust and will be issued one unit of the Trust in order to constitute the Trust. The Trust will be a passive investment trust and will generally restrict its investment activities to acquiring the Note and entering into the Swap as described in paragraphs 16 and 17 below.

2. The interest of each beneficiary under the Trust (a "Unitholder") will be described by reference to units ("Units") of the Trust. There will be a single class of Units. The Units will be retractable (i.e., redeemable at the demand of the Unitholder) as described in paragraph 19 below.

3. (a) XXXXXXXXXX will be retained by the Trust to act as administrator of the Trust. XXXXXXXXXX will be responsible for arranging for the distribution of Units under the Offering (referred to below in paragraph 13), including the payment of commissions payable to registered dealers that sell Units, anticipated to be $XXXXXXXXXX per Unit, payment or arranging for the payment of the expenses of the Offering, and for the administration of the ongoing operations of the Trust. As administrator, XXXXXXXXXX will be responsible for the payment of the Trust's ongoing operating expenses (i.e., expenses that would otherwise be currently deductible by the Trust, such as transfer agent fees, costs of financial statement preparation, and mailings to Unitholders, but excluding extraordinary expenses). For all of its services as administrator, XXXXXXXXXX will receive a single administration fee from the Trust at an annual rate (including GST) anticipated to be XXXXXXXXXX% of the assets of the Trust, calculated and payable quarterly. XXXXXXXXXX will also be entitled to receive redemption fees as described below in paragraphs 19 and 21.

(b) If the Trust has extraordinary expenses (none of which are currently contemplated) that are not payable by XXXXXXXXXX as administrator (see paragraph 12(a), above), the Trust will fund the payment of such expenses by demanding payment of a portion of the Note (as described below in paragraph 16) and terminating a portion of the Swap (as described in paragraph 17 below).

4. Units will be offered to the public by the Trust pursuant to the terms of a prospectus (the "Prospectus") filed with the securities regulatory authorities of each province of Canada (the "Offering"). The price per Unit under the Offering will be $XXXXXXXXXX. As part of the cost for earning the $XXXXXXXXXX per Unit commission, referred to above in paragraph 12(a), the registered dealers retained to sell the Units will pay all of the expenses of the Offering. The Trust will receive from various provincial Securities Commissions an exemption from certain requirements of National Policy No. 39 of the Canadian Securities Administrators, including the requirements of section 11.05 thereof, and the Securities Commissions will therefore accept that Units may be retracted quarterly.

5. The Prospectus will state that the Trust will be liable for tax under Part I of the Act on its income for a taxation year, less the portion thereof that it claims in respect of amounts paid or payable to Unitholders in the year. The Prospectus will also contain statements substantially to the following effect:

(a) In each taxation year prior to the Trust's taxation year ending in XXXXXXXXXX, if no termination of the Swap occurs in the year, it is anticipated that the net income of the Trust will not be material.

(b) If retractions of Units occur in a taxation year and the Trust is entitled to receive payments on such early termination of a portion of the Swap in the year, the Trust may have net income in the year. However, an amount up to the net income arising due to early terminations of the Swap in the year will be payable to Unitholders who retract Units in such taxation year and therefore it is not anticipated that there will be any material net income payable to other Unitholders, other than in the Trust's taxation year ending in XXXXXXXXXX.

(c) In the Trust's taxation year ending in XXXXXXXXXX, the Trust will be required to include in income any amount received or receivable by it on termination of the Swap. If any such amount is received or receivable, the Trust will have net income in such taxation year, which will be made payable to Unitholders at the end of the taxation year.

(d) The Trust generally intends to deduct, in computing its income in each taxation year, the full amount available for deduction in the year in respect of distributions to Unitholders. Consequently, it is anticipated the Trust

will generally not be liable in any year for income tax under Part I of the Act.

The Prospectus will not contain statements with respect to the tax treatment of the administration fee, the Trust's Swap Payments, or the Trust Unwind Payments (i.e., that they are deductible in computing the Trust's income).

6. The Units will be listed on the XXXXXXXXXX Stock Exchange. However, registrations of interests in and transfers of Units will be made only through the book-based system administered by The Canadian Depository for Securities Limited ("CDS"). CDS is a book entry system for the recording of ownership of securities that facilitates the clearance and settlement of securities transactions. On or about the closing date of the Offering (the "Closing Date"), the Trustee will deliver to CDS a certificate evidencing the aggregate number of Units subscribed for under the Offering. Units must be transferred and surrendered for retraction by a Unitholder through a participant in CDS. The Trust will satisfy the public distribution requirements in paragraph 132(6)(c) of the Act to qualify as a mutual fund trust on closing.

7. The Trust will invest the proceeds of the Offering in a deposit certificate issued by the Bank (the "Note"). The Note will pay interest at a rate equal to the average rate payable on bankers' acceptances issued by major Canadian banks and will be repayable, in whole or in part, on demand. Such interest will be paid quarterly.

8. On the Closing Date, the Trust will enter into a swap contract with the Bank (the "Swap"). Under the Swap, the Trust will agree to make quarterly payments (the "Trust's Swap Payments"), to the Bank equal to the interest received on the Note, less an amount anticipated to be XXXXXXXXXX% of the assets of the Trust, on an annual basis. The Bank will agree to make a payment (the "Swap Termination Payment") to the Trust on or about XXXXXXXXXX (the "Swap Termination Date"), determined approximately by the following formula:

	[(I1	* (.998125)42)  -  1]  *  Y
        I0

where: I' = Index at Swap Termination Date
10 = Index at Closing Date
Y = Proceeds of Offering less any Early Termination

If the amount determined by the foregoing formula is negative, no payment will be made by the Bank and the Trust will not be required to make a payment to the Bank.

9. The Swap will provide that, at specified dates in advance of the Swap Termination Date, the Swap can be terminated in part by the Trust (an "Early Termination"). On an Early Termination, the Trust will determine the amount of notional principal in respect of which the Trust elects to terminate the Swap (such amount being an "Early Termination Reduction"). Following an Early Termination, the Trust will no longer be required to make Trust Swap Payments relating to the Early Termination Reduction. The Bank will be required to pay to the Trust, on an Early Termination, an amount (the "Early Termination Payment") determined approximately by the following formula:

	[(	It	 * (.998125)t)  -  1]  *  Z
			    I0
	where:		It = Index at quarter t
10 = Index at Closing Date
Z = Early Termination Reduction
          t = number of quarters since Closing Date

If the amount determined by the foregoing formula is negative, the Trust will be required to pay such amount to the Bank (a "Trust Unwind Payment"). The purpose of allowing Early Terminations is to facilitate retractions of Units.

1O. Retractions of Units will be implemented quarterly on the last business day of March, June, September and December (each a "Retraction Date") in order to take into account the timing of interest payments under the Note and Trust Swap Payments. In order to retract Units, a Unitholder must deliver a retraction notice to a participant in CDS requesting the retraction of Units. Retraction notices received by CDS will be forwarded to the Trustee. Units surrendered for retraction in respect of which the Trustee receives a retraction notice on or before noon (XXXXXXXXXX time) on the XXXXXXXXXXth day of March, June, September or December will be retracted on the Retraction Date in that month, and payment of the retraction price will be made three business days thereafter. Where a Unitholder's Units are retracted in March, June or September, the Unitholder will receive payment of the retraction price in cash in an amount per Unit equal to XXXXXXXXXX% of the Net Asset Value per Unit on the Retraction Date, less any expenses associated with the retraction, and less a redemption fee payable to XXXXXXXXXX (refer to paragraph 21 below). In the case of Units surrendered for retraction in December, the Unitholder Will receive payment of the retraction price in cash in an amount per Unit equal to XXXXXXXXXX% of the Net Asset Value per Unit on the Retraction Date, less any expenses associated with the retraction and less the applicable redemption fee (refer to paragraph 21 below). It is anticipated that the expenses associated with any retraction (e.g., transfer agents' fees) will not be material in amount. The retraction price will be comprised of any net income payable to the retracting Unitholder described in paragraph 24 below and the balance will consist of proceeds of disposition for the Units. In order to fund retractions of Units on a Retraction Date, the Trust will determine the applicable Early Termination Reduction which will be equal to $XXXXXXXXXX multiplied by the number of Units to be retracted on the Retraction Date. The Trust will demand repayment of the same amount of the outstanding principal of the Note. Retractions implemented, other than in December, will result in the Trust having assets other than the Swap and the Note. Such assets will be invested in interest-bearing deposits or short-term debt securities issued by the government of Canada or a province.

11. "Net Asset Value" per Unit will generally be equal to (i) the value of the Note and the Swap plus (minus) any other assets (liabilities) of the Trust, divided by (ii) the number of Units outstanding on the relevant date.

12. It is anticipated that the redemption fee referred to above in paragraph 19 will be determined in accordance with the following schedule:

	If Units retracted		Percentage of
	during the following	assets of the Trust
	period after Closing	per Unit retracted

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	xxxxxxxxxx	xxxxxxxxxx
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13. As the Units will be listed on the XXXXXXXXXX Stock Exchange, it is not anticipated that the retraction feature will be the primary method of affording Unitholders liquidity. A Unitholder may opt to retract Units where the proceeds received on a cash retraction would be greater than those achieved through a sale of Units on the XXXXXXXXXX Stock Exchange. This could occur in situations involving minimum sales commissions on the stock exchange, or in the case where a large number of Units are being disposed of which, if sold on the stock exchange, would likely result in a steep discount.

14. XXXXXXXXXX is not aware of any arrangement or intention to enter into an arrangement under which a Unitholder will be able to dispose of Units, other than through retractions

(as described above in paragraph 19), or through the facilities of the XXXXXXXXXX Stock Exchange in the normal course (i.e., the normal course does not include any takeover bid).

15. The Declaration of Trust will provide that XXXXXXXXXX% of any income realized by the Trust in order to fund a retraction of Units (XXXXXXXXXX% in the case where the Retraction Date is in December) will be made payable to the Unitholder who retracts such Units. However, if the Trust has non-capital losses (as defined in paragraph 111(1)(a) of the Act) from prior taxation years that can be deducted in computing taxable income for the taxation year, the total amount of income otherwise payable to Unitholders who retract Units in the taxation year will be reduced by the amount of such losses that can be so deducted.

16. The Declaration of Trust will provide that the Trust will make payable to its Unitholders on the last business day of each taxation year (determined before giving effect to retractions implemented on such date) such amount as would, but for subsection 104(6) of the Act, be its income for the year (as defined in section 3 of the Act) except to the extent that such income has been made payable to Unitholders who retract Units in the year or the Trust has non-capital losses from prior taxation years that can be deducted in computing taxable income for the current taxation year, or the Trustee exercises its discretion, before the end of the taxation year, to retain an additional amount in the Trust. It is anticipated that the Trustee would exercise its discretion to retain an additional amount where retractions have taken place, other than on the December Retraction Date, resulting in the Trust receiving XXXXXXXXXX% of the income relating from the relevant Early Termination of the Swap, but paying only XXXXXXXXXX% of that amount to Unitholders retracting Units (see paragraph 19, above). All amounts payable to Unitholders (other than amounts payable for retractions) on the last business day of a taxation year will be automatically reinvested in additional Units and the outstanding Units will immediately thereafter be consolidated in order to restore the Net Asset Value per Unit to the amount prevailing but for the distribution. If the Act is amended as proposed by draft legislation released on December 23, 1998, which would add subsection 107(2.11), the Trust may simply capitalize the amounts payable without the issuance of additional Units.

17. Until an amount is received or becomes receivable by the Trust from the Bank (i.e., including Early Termination Payments on an Early Termination or the Swap Termination Payment on the Swap Termination Date), no amount in respect of the value of the Swap will be included by the Trust in computing its income (as defined in section 3 of the Act) for any taxation year (i.e. the Trust will report its income for income tax purposes using the “realization principle"). Therefore, in determining the amount that would, but for subsection 104(6) of the Act, be its income for a taxation year (as defined in section 3 of the Act), the Trust will, pursuant to the realization principle, compute such income (1) by including all interest on the Note and on any deposits or debt securities (referred to above in the last sentence of paragraph 19) that accrues to it to the end of such year, or becomes receivable or is received by it before the end of the year, to the extent that the interest was not included in computing its income for a preceding taxation year, and (2) by including all amounts that are received or are receivable by the Trust from the Bank in such year under the Swap (i.e., including any Early Termination Payments on an Early Termination in the year, or the Swap Termination Payment if the year includes the Swap Termination Date). The Trust will deduct in computing such income, the Trust's Swap Payments made by it in the taxation year to the Bank, any Trust Unwind Payments made to the Bank in the year, and the administration fees paid or payable to XXXXXXXXXX in the taxation year (referred to above in paragraph 12(a)).

18. In preparing its financial statements in accordance with generally accepted accounting principles, the Trust will include in computing its income for a year the interest on the Note that accrues to it to the end of the year or that is receivable or is received by it before the end of the year, to the extent that it was not included in computing income for a preceding year, and the Trust will deduct the Trust's Swap Payments incurred in the year. The net amount will be included in the Trust's income statement as interest income of the Trust for the year. The Trust will also mark the Swap to market at the end of each year and any change in value will be reflected as a component of the equity of the Trust (i.e., unrealized gain/loss of Swap) with a corresponding adjustment to the value of the underlying assets of the Trust (also presented at market value). Further, the Trust's equity will be affected by Trust Unwind Payments or Early Termination Payments through a reclassification of unrealized gain/loss on the Swap to realized gain/loss on the partial unwind of the Swap. This accounting presentation is in accordance with accounting principles generally accepted in Canada for the preparation of mutual fund financial statements.

19. The Declaration of Trust will provide that, unless the Unitholders elect to extend the Trust, the Trust will terminate on or about XXXXXXXXXX (the "Trust Termination Date"). On the Swap Termination Date, the Trust will receive from the Bank the amount, if any, due under the Swap. The Trust will make payable to Unitholders on the last business day of the taxation year that includes the Swap Termination Date (determined without regard to retractions of Units implemented on such day) such part of its income for the taxation year, determined without regard to subsection 104(6) of the Act, that has not been made payable to Unitholders who have retracted Units in the year less any undeducted non-capital losses of prior taxation years. Such amount will be paid in cash to Unitholders on the last business day of the taxation year.

20. Prior to the Trust Termination Date, the Trustee will liquidate the remaining assets of the Trust (the Note) and satisfy, or make provision for, any liabilities of the Trust. On the Trust Termination Date, the Trustee will distribute to Unitholders an amount equal to their pro rata portion of the remaining net assets of the Trust.

PURPOSE OF THE PROPOSED TRANSACTIONS

The purpose of the proposed transactions is to afford Unitholders the opportunity to achieve a rate of return that closely tracks the Index. As the Index tracks over XXXXXXXXXX bonds, it is impractical to assemble a portfolio comprised of the underlying bonds. In addition, retractions of Units could not be appropriately funded as it would be impractical to sell an appropriate portion of each of the XXXXXXXXXX bonds in the portfolio. The Swap provides the Trust and investors with a return that closely tracks the Index without the need to invest in the underlying bonds.

RULINGS

Provided that the statement of facts, the proposed transactions and the purposes thereof, all as described herein, are accurate and constitute complete disclosure of all of the representations, relevant facts, proposed transactions and the purposes thereof, and all of the proposed transactions are carried out as described above, we confirm the following:

A. Having chosen to report its income for all taxation years using the realization principle, the Trust will, in addition to its annual reporting of interest income in respect of the Note and the deposits and debt securities, as described above in paragraph 26, be required to include amounts that are received or receivable by the Trust from the Bank in the taxation year under the Swap, including Early Termination Payments and the Swap Termination Payment received or receivable as a result of an Early Termination or the Swap Termination Date occurring in the taxation year. For greater certainty, other than the foregoing, no amount will be required to be included in computing the income of the Trust for a taxation year in respect of the value of the Swap (i.e., the mark-to-market method will not be applicable).

B. Provided that the Trust continues to own the Note (other than the portion repaid in order to pay extraordinary expenses of the Trust, or to fund retractions of Units, as described above in paragraphs 12(b) and 19, respectively), the Trust's Swap Payments paid or payable in a taxation year will be deductible in such taxation year in computing the Trust's income, pursuant to subsection 9(1) of the Act.

C. Provided that the Trust continues to own the Note (other than the portion repaid in order to pay extraordinary expenses of the Trust, or to fund retractions of Units, as described above in paragraphs 12(b) and 19, respectively), the Trust Unwind Payments (referred to above in paragraph 18) paid or payable in a taxation year will be deductible in such taxation year in computing the Trust's income, pursuant to subsection 9(1) of the Act.

D. Section 18.1 of the Act will not apply to restrict the deduction of the Trust's Swap Payments or the Trust's Unwind Payments paid or payable in a taxation year, by virtue of the application of paragraph 18.1(15)(a) of the Act. This ruling is given provided

(i) the Trust continues to own the Note (other than the portion repaid in order to pay extraordinary expenses of the Trust, or to fund retractions of Units, as described above in paragraphs 12(b) and 19, respectively),

(ii) the wording in the final Prospectus, as it relates to the income tax consequences of the proposed transactions, is substantially the same as was in the preliminary prospectus provided to us with your letter dated XXXXXXXXXX, and as represented above in paragraph 14, and

(iii)no other statements or representations will have been made or proposed to be made that would cause the Trust's interest in the Swap to be a tax shelter, as defined in subsection 18.1(1) of the Act.

E. Provided that the fee payable to XXXXXXXXXX as administrator, referred to above in paragraph 12(a), is reasonable having regard to the services provided by XXXXXXXXXX and management fees charged by managers of comparable mutual funds, such fee paid or payable by the Trust in a taxation year will be deductible in computing the income of the Trust in such taxation year, pursuant to subsection 9(1) of the Act.

F. The Units will have conditions attached thereto that are described in subparagraph 108(2)(a)(i) of the Act.

These rulings are given subject to the general limitations and qualifications set forth in Information Circular 70-6R3 issued by Revenue Canada December 30, 1996, and are binding provided the Units are issued and the Note and the Swap are entered into on or before XXXXXXXXXX. This ruling is based on the Act in its present form and does not take into account the effect of any proposed amendments. Except as expressly stated, our rulings do not imply acceptance, approval or confirmation of any income tax implications of the facts or proposed transactions. In particular, we are not commenting on

a) whether Unitholders will hold their Units on capital account or not,

b) the reasonableness or fair market value of any expenditures referred to in this letter, or

c) the proper generally accepted accounting principle applicable in the determination of the Trust's income, as referred to above in paragraph 27.

As stated in paragraph 7 of Information Circular 70-6R3, rulings are not provided for transactions that are not seriously contemplated and are hypothetical in nature.

Therefore, notwithstanding that Unitholders may elect to extend the Trust past the Trust Termination Date (refer to paragraph 28, above), our rulings are only in respect of the transactions described herein, where the Trust Termination Date is on or about XXXXXXXXXX.

Yours truly,

for Director
Resources, Partnerships and Trusts Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch