Foreign Affairs

An old friend, Daniel Rose, was waiting for me when I arrived at my office the other day. “I want to discuss an investment proposition my broker has made,” said Danny. “I don’t have the entire offering memorandum. It hasn’t been finalized yet. But I do have a written summary of what the investment participation would look like.”

I read the proposal twice to make sure I understood it and then I put it down and grinned at Danny.

“What so funny?” he said.

“This just seems totally unlike you. A year ago, you told me half of your portfolio was in GIC’s and the other half was in Canadian banks. Now you’re looking at what seems to be some kind of hedge fund — and a foreign one at that.”

“I thought you might be dubious,” Danny said. “But as I understand it, there is no risk to the deal. I invest $10,000 with the Cayman Island subsidiary of a major French bank. Of that, 60% goes into a fund that guarantees my original investment. The remaining 40% is invested in European stock markets by a respected hedge fund operator. At the end of 10 years, I’m guaranteed a complete refund of my money. But I’m also guaranteed any gains earned by the hedge fund. Everything is taxed as a capital gain.”

“That sounds fine, assuming the plan works,” I said. “I have some worries based on how the deal will be taxed — and that’s ignoring the issue of whether or not the investment makes sense with your retirement looming shortly.”

“I thought it would be taxed like any mutual fund investment.”

“It won’t be,” I said. “In this proposal, you’re buying a participation in a foreign investment entity or FIE. There’s draft legislation before Parliament now that would have a strong impact on investments of this sort.”

“What’s an FIE?” Danny asked.

“Basically it’s a foreign entity designed to earn investment income outside Canada. The goal of the FIE legislation is to discourage Canadians from trying to defer or avoid taxes by investing offshore. The new tax provisions will achieve the government’s objective by levying punitive taxes on many types of foreign investments. Personally buying American or Euro stocks is all right. There’s a key exemption in the proposal covering investments in equities that are widely traded on the public exchanges of their countries of origin. So investing in Microsoft stock in the U.S. or Nestle shares in Switzerland is permitted. Those investments are treated like any other share purchase. The other major exclusion is for participation in foreign entities engaged primarily in active business. But when you invest in a foreign entity designed to earn investment income, you become exposed to a tax mechanism designed to accelerate Canadian taxes.”

“What do you mean accelerate Canadian taxes?” Danny asked.

“That’s best explained by thinking about the behaviour that the Finance Department is attacking. Here’s the problem from the government’s point of view. Say you invest $10,000 in an investment scheme with ABC Limited located in a tax haven like Bermuda. You invest your $10,000 and ABC earns 8%. In that case, you’d expect to pay tax when ABC remits the money to you. But assume it didn’t. Instead it accumulates 10 years of income, that is $8,000. At the end of 10 years, it provides you with a purchaser that buys your investment for $18,000. That would mean you’d pay capital gains tax on your earnings after a 10 year tax deferral.

“The FIE legislation doesn’t allow you to achieve a tax deferral by shipping your funds offshore,” I continued, “and it doesn’t permit you to obtain capital gains treatment (allowing 50% to go tax-free) unless you’re absolutely entitled to it. Instead, the draft legislation taxes you on a prescribed baseline rate of return, or on the increased market value of your investment if that’s determinable, or on the actual income of the investment if you invest in a controlled foreign affiliate.”

“I end up paying tax even if I haven’t received the money?”

“Yes. And that’s why I call the provisions punitive.”

“And this investment summary doesn’t mention that?”

“The final offering memorandum probably will. These provisions aren’t law yet, but some version of them will be. The draft legislation represents a major initiative of the Finance Department aimed at stopping the tax leakage on investment funds. This is an important issue for the government and some form of the legislation will definitely be passed.”