New draft rules would tax unrealized gains on SPDRs, WEBS and more

One of the most important elements in a self-assessing tax system like ours is that it be widely seen as being basically fair. If the population perceives that it is unjust, people will rapidly lose confidence in the integrity of government and will take steps to protect themselves against what they regard as the unwarranted usurpation of their wealth and property.

One of the basic tenets of fairness is that you pay your appropriate share of tax on the income you receive. Most people do not regard it as fair ball, however, to be taxed on income they do not receive. And that is what lies at the heart of the building storm around new proposals advanced by the federal Finance Department which are supposedly intended to cut off the flow of Canadian money to offshore tax havens.

Ottawa has already gone part way down this slippery slope of taxing money people have never seen. Strip bonds, for example, have been rendered useless in non-registered accounts because of the Finance Department's decision to tax the imputed income on such bonds years before they mature - even though the owner has not received a penny in income at that point.

But the latest proposal casts a much wider net and opens the door to fundamental changes in the tax system that could have far-reaching consequences for us all. Unfortunately, this story has emerged when many people are away on vacation and the government, whether by design or not, has left very little time for reaction - speak by Sept. 1 or forever hold your piece.

Before I get into the details, some background. Ottawa has for some time been concerned about what it sees as a problem with Canadian investment income moving into off-shore tax shelters that are set up in places like Barbados, the Caymans, Bermuda, etc. Such money is often placed in investment trusts, where it is left to compound for years. As long as the money remains offshore and no income is paid out, the investor is not liable for taxes in Canada. (We have to pay tax on world-wide income, but not on unrealized capital gains, which is the key point to bear in mind here.)

The bureaucrats in Finance have become increasingly concerned about this, especially after a couple of high-profile cases and the publication of some well-promoted books on how to take advantage of these havens. Of course, such offshore shelters are pretty much the exclusive preserve of the very rich, which only fusses the public servants and their Liberal overseers even more.

I worked in Ottawa as a parliamentary correspondent years ago, so I know how all this works. The word gets passed down: do something about it. Meetings are held, ideas are exchanged, and the whole project becomes a bureaucratic obsession. These tax avoiders (not evaders because they aren't breaking any laws) must be stopped. At all costs!

And so here we are, with the folks at Finance having tabled their draft legislation. And, as so often happens in this type of situation, they are dragging out the sledgehammer to kill a fly!

Buried in all the convoluted legalese of the proposal is a clause that will have the effect of requiring people who invest in some of the most popular American index participation units (IPUs) to pay tax on money they have not received (and may never receive!) These include Standard & Poor's Depository Receipts (SPDRs), which track the S&P 500 Index; Morgan Stanley's World Equity Benchmark Shares (WEBS), which track various international indexes, and a host of other widely-traded IPUs. The proposed legislation could also catch stocks like Warren Buffett's Berkshire Hathaway, which is essentially a mutual fund, and even, some tax experts says, Microsoft, which holds a lot of investment assets. All U.S.-based mutual funds (Vanguard, Janus, etc.) would also be hit, although they are not as widely held by Canadians as the exchange-traded IPUs.

The proposal is quite simple. Every year, you would have to determine the market value of any securities that fall under this rule and pay tax on your unrealized capital gains, as if they were regular income. Yes, you read that correctly. Currently, you would not be taxed on these securities until they were sold and then you would be liable at the capital gains rate. The new rules would turn that on its head.

The folks at Finance are coming up with all kinds of sophistries to try to justify this. None of them hold water. The U.S. is not the Caymans. Investors in these securities receive annual reporting slips listing all taxable distributions which have to be declared. Canada and the U.S. have a very tight tax treaty and the IRS and CCRA (formerly Revenue Canada) exchange information as a matter of course. To put SPDRs, WEBS and Berkshire Hathaway in the same category as offshore tax havens is so far off the mark that it leaves one wondering which planet the Finance bureaucrats are living on.

Apart from the inherent unfairness of taxing unreceived money, questions of how to deal with losses arise. Suppose the S&P drops in a year and your SPDRs lose ground? It has happened, after all. Since the profit the year before was taxed as income (not capital gain), can this year's loss be deducted from regular income? That's a principle that runs counter to anything the government has allowed before.

And what about the precedent? If the Liberals and bureaucrats succeed in pushing this through, it's only a short step to applying the principle to all non-Canadian securities. After all, it's going to become a nightmare to administer this policy as it stands, so why not just simplify the whole thing? I can hear the nabobs now. And after that, what?

This is bad tax law, plain and simple. If the government wants to go after offshore tax havens, let them do so - with rifle shot legislation, not a shotgun blast like this. The sooner Finance Minister Paul Martin sends his minions back to the drawing board on this one, the better.

If you want to make your opinion known (and remember, there is little time to do so), you can do so in the following ways:

1) Send a letter, fax or e-mail to Paul Martin. Mailing address is The Hon. Paul Martin, Minister of Finance, Department of Finance Canada, 140 O'Connor Street, Ottawa, ON K1A OG5 Fax: (613) 992-4291. His e-mail address is martin.p@parl.gc.ca

2) Send a letter or fax to Len Farber, General Director Legislation, Tax Policy Branch, Department of Finance Canada, 17th Floor, East Tower, 140 O'Connor Street Ottawa, ON K1A 0G5 Fax: (613) 992-4450

3) Contact your MP.

For more information on this subject, visit the Bylo Selhi Web site (www.bylo.org) or the Wealthy Boomer Web site (www.wealthyboomer.com).