2000 Ruling 2000-0005263 - Derivatives - 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. What is the cost amount of the forward contract ?

2. Is Forward Contract A a foreign property ?

3. Does the use of derivatives by one mutual fund trust to mimic the return of another mutual fund trust that holds foreign property be subject to GAAR ?

Position:

1. For the purposes of subsection 248(1) of the Act and section 5000 of the Regulations, the cost amount to a Fund of its investments in Forward Contracts which are substantially the same as the draft contract submitted will be equal to the brokerage fees, legal fees and other costs incurred by the Fund and incidental to entering into or acquiring the investment and will not include an amount in respect of the Forward Price or Final Price or the amount of any initial or variation margin deposit in respect of the Forward Contract.

2. A Forward Contract A described in paragraph 8 above entered into between the Fund and Counterparty A, and which is substantially similar to the draft Forward Contract A submitted will not be considered to be foreign property as defined in subsection 206(1) of the Act
3. GAAR is not applicable.

Reasons:

2. The definition of foreign property in subsection 206(1) of the Act includes property which is exchangeable for, convertible to or confers a right to acquire foreign property. Since the Forward Contract A describes in the ruling is settled in Canadian dollars and does not entitle the Fund to units of the Underlying Fund, and the Contract would not otherwise be considered foreign property based on the situs of the contract and does not involve the indebtedness of a non-resident person, we can reasonably conclude that the Forward Contract A is not foreign property.

3. The effect of the transaction does not increase the amount of foreign property held by the trust.

XXXXXXXXXX
XXXXXXXXXX 2000-000526
XXXXXXXXXX

Attention: XXXXXXXXXX

XXXXXXXXXX, 2000

Dear Sir/Madame:

Re: Advance Income Tax Ruling Request:

XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

This is in reply to your letter of XXXXXXXXXX in which you requested an advance income tax ruling on behalf of the above-noted taxpayers in respect of the income tax consequences arising out of the proposed transactions described below. We also acknowledge your correspondence of XXXXXXXXXX.

We understand that, to the best of your knowledge and XXXXXXXXXX, none of the issues involved in this ruling request is:

(a) in an earlier return of XXXXXXXXXX or a person related thereto;

(b) being considered by a tax services office or taxation centre in connection with a previously filed tax return of XXXXXXXXXX or a person related thereto;

(c) under objection by XXXXXXXXXX or a person related thereto;

(d) before the courts and no judgement has been issued which may be under appeal; and

(e) the subject of a ruling previously issued by the Directorate to XXXXXXXXXX or a person related thereto, other than advance ruling 991774 dated XXXXXXXXXX, 1999 and advance ruling 992304 dated XXXXXXXXXX, 1999.

In this letter, unless otherwise indicated, all statute references are to the Canadian Income Tax Act and Regulations (R.S.C. 185, 5th Supplement, c.1, as amended) (the "Act"), and the following terms have the meanings specified:

"Basket of Shares" with respect to a Forward Contract B means securities of corporations listed in the Forward Contract B; such Basket of Shares will consist of the number and kind of shares specified in the appendix to the contract and will generally match the securities held by the Underlying Fund at the time and may include common shares, preferred shares and warrants to acquire such shares;

"Cost amount" means the cost amount of property as defined in subsection 248(1);

"Counterparty A" means XXXXXXXXXX, a resident of Canada and a party that is related to the Manager, or some other corporation that is resident in Canada and that is related to XXXXXXXXXX;

"Counterparty B" means XXXXXXXXXX, a non-resident of Canada and a party that is not related to the Manager within the meaning of subsection 251(2);

"Counterparty" means Counterparty A, Counterparty B or any other party with which a Fund enters into a Forward Contract; such other party may or may not be resident of Canada and may or may not be related to the Manager;

"Dividend Amount" in respect of a Forward Contract B means the total of all cash dividends payable in respect of the relevant number of shares contained in the Basket of Shares where the ex-dividend date for such dividends occurs after the date the Forward Contract B is entered into and on or before the date the contract matures for a particular Forward Contract B;

"Final Price" with respect to a Forward Contract B means the market value of the Basket of Shares on the maturity of Forward Contract B;

"Forward Contract" means Forward Contract A or Forward Contract B;

"Forward Contract A" has the meaning set out in paragraph 8 of this letter;

"Forward Contract B" has the meaning set out in paragraph 9 of this letter;

"Forward Price" with respect to a Forward Contract B means an amount determined by formula and is based on the market value of the Basket of Shares on the date the Forward Contract B is entered into, adjusted to reflect an interest component and sales commission component;

"Forward Settlement Date" with respect to a Forward Contract A means the date as of which either the Fund or the Counterparty pays the Settlement Amount to the other in respect of a Forward Contract A;

"Forward Start Date" with respect to a Forward Contract A means the date on which the Forward Contract A commences;

"Fund" means XXXXXXXXXX;

"Manager" means XXXXXXXXXX, the manager and trustee of the Fund and Underlying Fund; its business number is XXXXXXXXXX and its Tax Services Office is XXXXXXXXXX;

"Money Market Securities" means securities offered in the Canadian money market such as treasury bills of the Government of Canada, bankers' acceptances of chartered Canadian banks and short-term debt obligations of Canadian corporations, the Government of Canada, a province or a municipality;

"Payment Date" with respect to a Forward Contract B means the date on which the Forward Contract B is settled and will normally occur on the third business day following the maturity of the particular Forward Contract B;

"Settlement Amount" in respect of a Forward Contract A has the meaning set out in paragraph 8 of this letter; and

"Underlying Fund" means the XXXXXXXXXX.

FACTS AND PROPOSED TRANSACTIONS

1. The Manager is a taxable Canadian corporation within the meaning of the Act.

2. The Manager will establish the Underlying Fund as an inter vivos trust pursuant to a declaration of trust. The Underlying Fund will be, at all relevant times, a mutual fund trust as defined in section 132. The Manager will be the manager and the trustee of the Underlying Fund. The Underlying Fund will not be a registered investment under the Act and units of the Underlying Fund will be "foreign property" as defined in subsection 206(1).

3. The Manager will establish the Fund as an inter vivos trust pursuant to a separate declaration of trust. The only activity of the Fund, as described further below, will be the investing of its funds in property (other than real property or an interest in real property). The interest of each beneficiary under the Fund (a "Unitholder") will be described by reference to units ("Units") of that Fund. There will be a single class of Units of the Fund and the conditions attached thereto will require the Fund to accept, at the demand of the Unitholder, the surrender of the Units of the Fund on any business day at a price determined in accordance with those conditions to be the net asset value per Unit on that day.

4. The Fund will apply to become a "registered investment" under subsection 204.4(2) forthwith after it is established with effect from the date that it is established.

5. Units will be offered to the public by the Fund pursuant to the terms of a prospectus to be filed by the Fund with the securities regulatory authorities of each province of Canada (the "Offering"). The Units will be sold to residents of Canada and it will not be reasonably considered that the Fund will be established or maintained primarily for the benefit of persons who are not residents of Canada. As a result of the Offering, the Fund will comply with the conditions prescribed in section 4801 of the Income Tax Regulations (the "Regulations") for the purposes of paragraph 132(6)(c) so as to qualify as a mutual fund trust under the Act. The Fund will comply with such conditions before XXXXXXXXXX (or XXXXXXXXXX, if the Fund elects to have a XXXXXXXXXX taxation year end) and, pursuant to subsection 132(6.1), will elect in its return of income under Part I of the Act for 2000 to be deemed to have been a mutual fund trust from the time of its establishment.

6. From time to time, the Fund will invest its funds, including the proceeds of the Offering, any amounts received under a Forward Contract and income earned on its investments, net of the expenses incurred by the Fund, primarily in Money Market Securities. From time to time the Fund may also invest in its fund temporarily in short term Deposits ("Cash Deposits") with Canadian financial institutions pending the investment of such funds in Money Market Securities. The Money Market Securities and Cash Deposits will not be foreign property as defined in the Act. The Fund may also invest in units of the Underlying Fund provided that the cost amount of such investment and any other foreign property held by the Fund does not exceed 20% of the cost amount of all the property of the Fund at the end of any month.

7. The Fund will enter into one or more separate forward contracts (a "Forward Contract") with either Counterparty A or Counterparty B. In either case, a Forward Contract will require the deposit of a portion of the Fund's assets in deposits with the Counterparty ("margin deposits") which will consist of Money Market Securities or Cash Deposits and which will be held by the Counterparty in Canada.

8. The Forward Contracts between the Fund and Counterparty A (each a "Forward Contract A") will relate to units of the Underlying Fund. A draft Forward Contract A was included with your submission. A Forward Contract A will be adjusted each day if necessary to reflect the net cash received by the Fund from subscriptions and cash paid in respect of redemptions of units of the Fund. Payments will be made under each Forward Contract A as of the Forward Settlement Date, and early settlements will be made when the market value of the Forward Contract A exceeds 10% of the net assets of the Fund for a specified period of time, as required under applicable Canadian securities laws. The Forward Contracts A will also be appropriately adjusted for any distributions made by the Underlying Fund to its unitholders.

A Forward Contract A entered into by a Fund will commence on a Forward Start Date and will terminate on a Forward Settlement Date. On the Forward Settlement Date, the Settlement Amount will be paid by either the Fund to Counterparty A, or by Counterparty A to the Fund, as is applicable. The Settlement Amount under a Forward Contract A will generally be determined as:

(a) the sum of:

• the net asset value per unit of the Underlying Fund on the Forward Settlement Date, and
• the distributions per unit made by the Underlying Fund from the Forward Start Date to but excluding the Forward Settlement Date;

minus

(b) the sum of

• the net asset value per unit of the Underlying Fund on the Forward Start Date, and
• an amount in respect of Counterparty A's notional funding costs plus an interest component to compensate Counterparty A for entering into the Forward Contract A in respect of the period from the Forward Start Date to the Forward Settlement Date

multiplied by the number of units of the Underlying Fund that are the subject of the Forward Contract A.

If the Settlement Amount as determined above is a positive amount, it will be payable by Counterparty A to the Fund and if it is a negative amount, it will be payable by the Fund to Counterparty A.

9. The Forward Contracts between Counterparty B and the Fund (each a "Forward Contract B") will relate to a Basket of Shares. A sample of a Forward Contract B was included in your submission. The sample Forward Contract B which was submitted for our review will be settled by means of a cash payment in U.S. dollars. This Forward Contract B will be foreign property for the purposes of the Act. Each Forward Contract B will provide for a payment of an amount either by the Fund to Counterparty B, or by Counterparty B to the Fund, which payment will be determined by reference to the increase or decrease in the Final Price from the Forward Price. In particular, on each Payment Date, the Fund will be obligated to pay to Counterparty B the amount by which (a) exceeds (b), or Counterparty B will be obligated to pay to the Fund the amount by which (b) exceeds (a) where

(a) is the amount, if any, by which the Final Price is less than the Forward price, and

(b) is the sum of any Dividend Amount and the amount, if any, by which the Final Price is greater than the Forward Price.

Each Forward Contract B will be for a term of 30 days and will be subject to renewal at the option of the parties. A Forward Contract B may be terminated before its maturity in certain circumstances set out in the Forward Contract B, including a decision by the Fund to alter the composition of the Basket of Shares in the event that the Underlying Fund makes changes in its holdings.

10. Each Forward Contract will be executed in Canada and will be governed by the laws of Canada. No Forward Contract will be listed on any stock exchange or traded over-the-counter. None of the Forward Contracts will be convertible into, exchangeable for, or provide the Fund with any right to acquire property that is foreign property. Each Forward Contract will be settled by means of a cash payment and will be subject to any risk of default by the Counterparty.

11. When it is considered appropriate, the obligations of the Counterparty under the Forward Contract will be guaranteed by another person who may or may not be resident in Canada. The Fund will not incur any costs in connection with such a guarantee and thus, the cost amount to the Fund of the guarantee will be nil.

12. The Fund will earn interest on its Cash Deposits and Money Market Securities and will pay or receive an amount on each Forward Settlement Date under a Forward Contract A and on each Payment Date under a Forward Contract B.

13. As a result of a fund entering into the Forward Contracts, the return on the investment in units of the Fund will approximate the investment return on units in the Underlying Fund plus the income derived from the Fund's Cash Deposits and Money market Securities less any amount required to be paid to the Counterparty under the Forward Contract and any expenses of the Fund. As it is expected that the income derived from the Fund's Cash Deposits and Money Market Securities will be less than the amount required to be paid to the Counterparty under the Forward Contract, the public documents relating to the Offering will state that the rate of return on units of the Fund is expected to be less than the rate of return on units of the Underlying Fund. The public documents relating to the Offering will state that the units of the Funds are suitable for investment by investors that are subject to the foreign property limits under Part XI of the Act.

14. At the end of any month, the aggregate cost amount for purposes of the Act of the Cash Deposits and Money Market Securities and any other assets held by the Fund that are not foreign property will equal or exceed 80% of the cost amount of all the property of the Fund.

PURPOSE OF PROPOSED TRANSACTIONS

15. The purpose of the proposed transactions is to provide investors that are subject to foreign property limits under Part XI of the Act an opportunity to realize investment returns that are linked to the returns realized on units of the Underlying Fund without increasing the amount of foreign property held by the investors.

RULINGS GIVEN

Provided that the preceding statements are accurate and constitute complete disclosure of all relevant facts, proposed transactions and purpose thereof and the proposed transactions are carried out as herein described, our advance income tax rulings are as follows:

A. Provided that the Fund is accepted by the Minister as registered investment as set out in subsection 204.4(2) and has not been notified of a revocation of such status under subsection 204.4(3), the units of the Fund will not be foreign property as defined in subsection 206(1).

B. Provided that the cost amount at the end of a particular month of the Fund's Money Market Securities, Cash Deposits and any other property of the Fund that is not foreign property is not less than 80% of the cost amount of all property of the Fund, the Fund will not be liable for tax under subsection 206(2) for that month.

C. For the purposes of subsection 248(1) and section 5000 of the Regulations, the cost amount to a Fund of its investments in Forward Contracts which are substantially the same as the draft contract submitted will be equal to the brokerage fees, legal fees and other costs incurred by the Fund and incidental to entering into or acquiring the investment and will not include an amount in respect of the Forward Price, the Final Price, the Settlement Amount or the amount of any margin deposit in respect of the Forward Contract.

D. A Forward Contract A described in paragraph 8 above entered into between the Fund and Counterparty A, and which is substantially similar to the draft Forward Contract A submitted will not be considered to be foreign property as defined in subsection 206(1).

E. Subsection 245(2) of the Act will not apply to redetermine the tax consequences arising from the above rulings.

The above rulings are given subject to the general limitations and qualifications set out in Information Circular 70-6R3, Advance Income Tax Rulings, and are binding on the Canada Customs and Revenue Agency (the CCRA) with respect to Forward Contracts as described in paragraphs 8 and 9 above which are entered into or acquired by the Fund within six months of the date of this letter.

The above rulings should not be construed as providing the CCRA's views on whether the Fund will qualify as unit trust, mutual fund trust or registered investment for purposes of the Act.

Yours truly,

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