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.
Principal Issues: Is the total or partial redemption of the "seeding capital" of a mutual fund unit on account of income?
Position: YES
Reasons: Not invested in the general way like an investor - made for the purpose of creating a fund that will generate management income
June 18, 2004
TORONTO CENTRE TSO HEADQUARTERS
C. Tremblay, CMA
Attention: Dominic Tiu (613) 957-2139
Large File Case Manager2004-006514
Seeding Capital for Canadian Public Mutual Funds
This is in reply to your memorandum of February 18, 2004 with regard to seeding capital connected to your audit of XXXXXXXXXX ("A Co") and the reference in paragraph 15 of IT-479R, which states as follows:
"...All gains and losses of a taxpayer that relate to a participation in the promotion or underwriting of a particular issue of a security are on income account..."
The facts as we understand them:
1. The regulatory regime in Ontario requires that each new mutual fund trust or corporation start with a minimum investment of $150,000. The funds cannot be withdrawn until at least $500,000 in investments is received from unrelated parties to the Fund Management Entity.
2. The business of A Co is to earn management fees from the development, distribution and ultimate management of various Funds. The management fee A Co can generate from a fund depends on both the net incremental number of fund units outstanding (new sales less redemptions and, the net asset value of the investment portfolio held by the fund from period to period).
3. New mutual funds, in the form of a trust or corporation are created when it is determined that there is a market for a certain type of fund. A Co conducts investment and market research, and incurs professional and regulatory costs to organize a new fund and bring it to market. As a general rule, most mutual funds are broadly held by a large number of investors.
4. To attract the broad base ownership necessary to sustain an efficient and profitable mutual fund, A Co would have to show the prospective buyer how the Fund might perform. Business experience would dictate to A Co the minimum size a particular fund needed to start with in order to showcase what it would do for the investor. This start up investment, which far exceeds the minimum regulatory requirement, represents the seeding capital amount under review. Seeding capital can range from about $XXXXXXXXXX for equity funds down to about $XXXXXXXXXX for income and registered funds.
5. Business experience and working capital requirements would dictate to A Co, as to how soon any given seeding capital amount, in part or in whole, might be withdrawn from a new performing fund.
TSO's VIEW:
The gains and losses of Fund Management Entities like A Co that relate to a participation in the promotion and distribution of each Fund should be reported on income account. This is consistent with CRA's view as noted in paragraph 15 of IT Bulletin 479R dated February 29th, 1984. Accordingly, gains and losses of A Co on seeding capital invested from the start up of a fund to the earliest nominal withdrawal date should be on income account as they relate to the promotion and distribution of the Fund.
CONCEPT OF INVENTORY
We suggest that you not argue the concept of inventory. A Co has not viewed the units as inventory. The units were booked at cost. However, if the concept of inventory is argued, we do not feel there is a change in use, as the seed money is not invested in the ordinary way. Its purpose as you suggest is to demonstrate how a particular fund can perform so it can attract investors and eventually allow A Co to earn management fees and have the "seed capital" returned to them.
TAXPAYER'S VIEW
In A Co's submission, they highlight factors found in paragraph 11 of IT-479R that would indicate that the transactions are on account of capital as well as their policy dealing with Seeding Strategy.
A Co states that there is no official policy on providing seed capital for new funds. Historically, A Co would invest $XXXXXXXXXX per fund. However, in the past few years A Co has launched a number of specialty funds and multi-manager funds with the seed capital ranging from $XXXXXXXXXX to $XXXXXXXXXX. Further, there is no official A Co policy dealing with the redemption of seed capital (i.e. there is no pre-determined threshold that must be reached prior to the partial or full redemption of seed capital and there is no pre-determined period of time that the seed capital will remain invested). Historically, seed capital has remained invested in the funds on a long-term basis with the goal of capital appreciation for equity funds and obtaining long term yields on fixed income funds.
Redemptions of seed capital occur, on an infrequent basis, based on corporate objectives and have occurred for the purpose of raising cash required to meet these corporate objectives. When redemption of seed capital occurs, A Co treats this transaction as a capital transaction consistent with A Co's policy of investing in the Fund on a long-term basis.
As you know, arriving at the characterization of an amount (whether a receipt or a payment) as being on capital or income account in any particular fact situation usually involves a difficult balancing act. A number of tests/factors found in IT-479R are used to determine whether or not the gains and losses are on account of income or capital. However, we agree with you that the tests found in IT-479R are applied only when it is unclear if such transactions are to be on account of income or capital: in our view, the redemptions of seeding capital whether in whole or in part are on account of income.
A Co is in the principal business of developing, marketing and managing public mutual funds in Canada. One of the principal components in the development, marketing and management services is the provision and promotion of the Funds developed by A Co to the public.
We consulted XXXXXXXXXX who had already looked at this issue and was kind enough to send us a discussion paper he had prepared on the subject. In his paper, he noted that there are two types of income from the seed capital for the fund manager.
(i) One is related to income distributed by the fund to unitholders.
(ii) The other is the gain or loss due on the redemption of the unit itself.
He concluded that both should be on account of income, since the purpose of this investment is to receive management fees from the mutual fund and to recuperate the amount invested, as soon as possible. However, due to subsections 104(13), (19) and (21) of the Act, it may be impossible to recharacterize the income of a mutual fund trust attributed from the fund. Further section 131 of the Act contemplates capital gains treatment with respect to the disposition of mutual fund corporation investments.
In his opinion, when managers of mutual funds are audited, CRA should consider adding gains and losses due to the redemption of units, which are seed capital, as business income of the manager. He further states that seed capital are outlays engaged by the fund manager in doing business. The starting portfolio of the funds to attract public investors is important. The manager wants to ensure a good performance by the fund (to keep investors) and recuperate as soon as possible its own investments. The fund manager never has the intention to invest in the ordinary way. To be on capital account, the investor has the intention to earn a return on the capital (interest, dividends or appraisal). Generally, the intention of the fund manager is to generate management fees income paid by the mutual fund and to recuperate as soon as possible the amount invested.
There appears to be no uniformity by the industry in this area. Dispositions of units are taxed as capital property, inventory property or mark-to-market property.
In your memorandum, you ask about the history and technical notes behind the paragraph 15 in IT-479R. Paragraph 5 of that same IT uses the term "trader or dealer in securities" to mean a taxpayer who participates in the promotion or underwriting of a particular issue of shares, bonds or other securities or a taxpayer who holds himself out to the public as a dealer in shares, bonds or other securities. Towards the middle of paragraph 15 in IT-479R, it is stated "Further, the gains and losses made by a corporation whose prime activity is trading in securities will be considered to be on income account, notwithstanding that the corporation does not hold itself out to the public as a trader or dealer in securities." Paragraph 15 of the Bulletin refers to the same idea discussed in paragraph 5. Our research indicates that there is no difference between the expression "prime business activity" employed in paragraph 5 and "prime activity" employed in paragraph 15. The presumption is that taxpayers in the securities business are to report on income account. Since A Co is a registered licensed security dealer with the Ontario Securities Commission and a manager of a mutual fund, the position described in these paragraphs should apply. It is recognized that paragraph 39(5)(a) of the Act was at least intended to prevent persons who are registered or licensed traders or dealers in securities from converting their income arising from that trade into capital gains. When licensed dealers trade on their own account, it seems clear that the legislator did not intend the dealers or traders who, by their trade, have professional knowledge of the market in which they deal to benefit from the election.
We also note that the Assessing Guide on page 4-152 has a long established policy (since at least 1953) to consider gains on security transactions as income gains where the gains are derived from participation in the underwriting or promotion of a particular issue.
The Federal Court of Appeal stated in Vancouver Art Metal Works Limited (1993 DTC 5116) that the expression "trader or dealer in securities" refers to anyone who carries on a business of trading or dealing in securities, not only to brokers or professionals registered or licensed. This expression refers to anyone who is professionally engaged in the business of dealing in securities or when his dealings amount to carrying on a business and can no longer be characterized as investor's transactions or mere adventures or concerns in the nature of trade.
We looked at the issue of "seed capital" for mutual funds in file 1999-000451 and were advised that many fund managers are treating the gain from the redemption of the seed capital unit in a new mutual fund on account of capital. We did not recommend a reassessment at the time but rather a consultation with XXXXXXXXXX. To date, as far as we know, no mutual fund manager has ever been challenged on the issue. It is our opinion that XXXXXXXXXX's recommendation that the redemption of the unit or units, in whole or in part, representing "seed capital" be considered to be on account of income has merit and should be pursued.
In our view, we cannot override the application of subsection 104(21) of the Act to other gains from disposals within the investment portfolio of a mutual fund trust and which are distributed to the unitholders. To do so would require an amendment from the Department of Finance. Thus the portion of the capital gain of the trust designated by the trust in respect of a beneficiary under the trust is deemed to be a taxable capital gain for the year of the particular beneficiary.
If it is a mutual fund corporation, and it elects under subsection 131(1) in respect of a dividend paid, the dividend will be deemed to a capital gains dividend, to the extent of the corporation's capital gains dividend account, and the corporation will be entitled to a capital gains refund approximating the corporate tax paid on its capital gains. A mutual fund corporation has been excluded from the definition of "financial institution" in subsection 142.2(1) of the Act. Given the potential scope of the term " trader or dealer in securities" as interpreted by the Federal Court of Appeal in Vancouver Art Metals Works, the appropriate exclusion was made to subsection 39(5) of the Act to clarify the situation for the CRA and for mutual fund corporations or mutual fund trusts so they can elect to treat each gain or loss arising on a disposition of a Canadian security as a capital gain or a capital loss. That however, in our view, does not extend to the full or partial "seed capital" redemption of the mutual fund unit itself.
We hope our comments will be of assistance to you.
Steve Tevlin
For Director
Financial Industries Division
Income tax Rulings Directorate
Policy and Planning Branch
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