Feds want investment dealers to pay income on exposure

A proposal to change tax laws that govern “marked to market” reporting released by the federal government could have a big impact on the way Canada’s large investment dealers do business, according to tax experts.

Unlike retail investors, who don’t have to account for capital gains or losses until they’ve actually sold a security, financial institutions must pay accrued tax on the market value of many holdings, as required by a tax law introduced in 1994. To make matters worse, gains and losses from movement on mark-to-market property are taxed as income rather than as capital gains or losses.

The proposal, which was announced in November by federal Finance Minister Jim Flaherty, would require financial institutions to start recording and paying tax on the market value of “tracking properties” — holdings in which the institution has exposure to a security but does not actually hold the security.

The definition of “tracking property” is vague. In the draft legislation, the government says a tracking property is “defined to mean property of the taxpayer the fair market value of which is determined primarily by reference to one or more criteria in respect of property if owned by the taxpayer would be mark-to-market property of the taxpayer.”

Accounting firm KPMG says tracking property would likely include units of certain trusts and partnerships, broker warrants and certain derivatives. However, because the definition still applies only to “property,” the mark-to-market rules do not appear to apply to an investment dealer’s obligations or liabilities.

“If you have a financial institution investing in a trust, and that trust is invested in shares, all of a sudden that trust can become mark-to-market property,” says tax specialist Carmela Pallotto, a partner with KPMG’s financial institutions group.

Pallotto says some financial institutions have been voluntarily reporting these types of securities, but it’s never been mandated by law. Under the proposed changes, it would be required, forcing financial institutions to determine if complex financial instruments with exposure to underlying securities would be considered tracking properties.

Properties like derivatives and broker warrants can have a high degree of volatility, so companies will have to overhaul their accounting to take this into account. In some ways, the process would seem unfair because institutions are going to have to pay tax on securities they don’t actually hold. On the flip side, it will give a clear picture of their specific market exposure on their balance sheet.

Pallotto says the new rules would apply only to companies defined as financial institutions, so many fund companies and smaller brokerages will likely not have to change their reporting methods. Large security brokerages and bank dealers would.

These firms would be hit particularly hard in securities underwriting.

“This is a big issue on the broker warrant side. A lot of times, investment dealers dealing with an up-and-coming company will give the broker warrants to buy the company at a set price. The brokers will be forced to include these on their financial statements,” Pallotto says. “Broker warrants are not widely traded or held, so you often get valuations that are not necessarily reflective [of the security’s true value].”

KPMG believes that with the proposed changes, particularly in broker warrants, investment dealers may increasingly raise more capital to fund their tax liabilities.

KPMG notes that there will be no transitional relief for institutions while they change their reporting methods. In 1994, the government allowed investment dealers to amortize the initial gain arising from the introduction of the mark-to-market requirement over five years.

In a release sent out, KMPG wrote, “This lack of transitional relief may lead to a harsh result. In many instances, broker warrants are recorded in the financial statements, before they can be traded, at a significant value that may not ultimately be realized. Investment dealers may be forced to raise additional capital or dispose of other securities to finance the resultant tax liabilities.”

If the proposals become law, institutions will be required to start accounting for tracking properties for taxation years on or after November 7, 2007.

Filed by Mark Noble, Advisor.ca, Mark.Noble@advisor.rogers.com

(02/14/08)

Mark Noble