Investment funds in Canada: regulatory overview

A Q&A guide to investment funds law in Canada.

This Q&A is part of the global guide to investment funds. It provides a high level overview of investment funds in Canada, looking at both retail funds and hedge funds. Areas covered include a market overview, legislation and regulation, marketing, managers and operators, restrictions and requirements, tax and upcoming reform.

To compare answers across multiple jurisdictions, visit the Investment Funds Country Q&A tool. For a full list of jurisdictional Q&As visit www.practicallaw.com/investmentfunds-mjg.

Contents

Retail funds

1. What is the structure of the retail funds market? What have been the main trends over the last year?

Open-ended retail funds

Open-ended funds are referred to in Canada as mutual funds. Mutual funds are pooled funds that generally issue shares/units continuously. The redemption price of a mutual fund security must:

  • Be the net asset value (NAV) of the security.

  • Be paid within three business days of the NAV calculation.

Securities of exchange-traded mutual funds (ETFs) are listed on a stock exchange and, if continuously offered, are redeemed based on their trading price.

The mutual fund market is well developed and active:

  • Total mutual fund assets under management (AUM) for October 2014 were Can$1.123 trillion, an increase of 15.6% from October 2013. Of this amount, Can$562.5 billion was invested in balanced funds (source: The Investment Funds Institute of Canada).

  • Canadian-listed ETF assets reached Can$73.1 billion in October 2014 (source: The Canadian ETF Association).

Closed-ended retail funds

Closed-ended funds are also referred to as non-redeemable investment funds. They typically raise a fixed amount of capital through an initial public offering (IPO). Most closed-ended funds are listed on the Toronto Stock Exchange (TSX).

The closed-ended fund market is also well developed and active, but it is facing challenges including increasing regulation and competition from ETFs and issuers of principal protected notes (PPNs) and principal at risk notes (PARs). Although the closed-ended fund market has maintained an aggregate market capitalisation of approximately Can$30 billion in recent years, new issuance activity in 2014 has nearly fallen to 2008 levels.

The regulation of closed-ended funds recently underwent extensive reform through the Modernisation of Investment Fund Product Regulation (Phase 2) (the Modernisation Project) that extends certain provisions of National Instrument 81-102 (NI 81-102) to closed-ended funds, including fundamental investment restrictions and operating requirements. Previously named Mutual Funds, NI 81-102 was renamed Investment Funds under amendments that came into force on 22 September 2014.

 

Regulatory framework and bodies

2. What are the key statutes, regulations and rules that govern retail funds? Which regulatory bodies regulate retail funds?

Open-ended retail funds

Regulatory framework. The key regulatory instruments that apply to open-ended funds are:

  • National Instrument 81-102 (Investment Funds) (NI 81-102) that sets out core investment restrictions and fundamental operational requirements.

  • NI 31-103 (Registration Requirements, Exemptions and Ongoing Registrant Obligations) (NI 31-103) that regulates registration requirements and the activities of registrants.

NIs are securities rules that are effective nationally as they were adopted by the 13 provincial regulators (see below).

Mutual funds are also subject to the following NIs:

  • NI 81-101 (Mutual Funds Prospectus Disclosure).

  • NI 81-104 (Commodity Pools).

  • NI 81-105 (Mutual Fund Sales Practices).

  • NI 81-106 (Investment Fund Continuous Disclosure).

  • NI 81-107 (Independent Review Committee for Investment Funds).

Portfolio managers that advise mutual funds investing in commodity futures contracts or options may need to register as advisers under applicable commodity futures legislation unless their activity can be characterised as incidental.

Regulatory bodies. Each of Canada's ten provinces and three territories has its own securities laws, administered by a local securities regulatory authority. However, in a growing number of areas, including investment fund regulation, the rules have been largely harmonised across the 13 jurisdictions. These rules are generally known as NIs (see above).

The Canadian Securities Administrators (CSA) is the umbrella group that co-ordinates securities regulation among the 13 provincial and territorial regulators.

Dialogue continues about overcoming the constitutional obstacles and regional concerns that have stood in the way of the longstanding goal of a single national securities regulator. Following the most recent federal government initiative, five provinces (British Columbia, New Brunswick, Ontario, Prince Edward Island and Saskatchewan) have indicated their willingness to join a voluntary multi-jurisdictional securities regulator, the Cooperative Capital Markets Regulatory System (CCMR), that is expected to begin operations in Autumn 2015. The objective is that the CCMR becomes a national regulator if and when the remaining provinces and territories decide to join.

Closed-ended retail funds

Regulatory framework. Closed-ended funds are subject to many of the same regulations as mutual funds, including NI 81-102, NI 81-106 and NI 81-107. The prospectus rules for closed-ended funds are contained in NI 41-101 (General Prospectus Requirements). Most closed-ended funds are listed on the Toronto Stock Exchange (TSX) and must therefore comply with the TSX rules.

Regulatory bodies. See above, Open-ended retail funds: Regulatory bodies.

 
3. Do retail funds themselves have to be authorised or licensed?

Open-ended retail funds

Local retail funds. In order to sell securities to the public, National Instrument 81-101 (NI 81-101) requires a mutual fund to prepare and file:

  • A simplified prospectus (SP).

  • An annual information form (AIF).

  • A fund facts document for every class or series of the fund.

Preliminary versions of these documents and other prescribed documents are filed for review with the applicable securities regulators. The length of the review, which is led by the principal regulator, is generally ten working days. Once comments are addressed and preliminary documents amended to the satisfaction of the regulator (if required), final prospectus documents are filed. A fund may sell securities once a receipt has been issued for a final prospectus.

In addition, the investment fund becomes a reporting issuer in the applicable jurisdictions and is subject to certain ongoing filing and disclosure requirements.

Mutual fund managers must bear the organisation costs of new funds under NI 81-102. The sponsor (or certain related parties) must invest at least Can$150,000 in the fund's securities before launching a new mutual fund or the prospectus must provide that the fund will not issue securities until subscriptions for at least Can$500,000 have been received from other investors. Seed capital cannot be redeemed until at least Can$500,000 has been received from other investors.

The fund facts documents must be posted on the manager's website. Dealers must deliver the fund facts to an investor within two days of the investor's purchase of units or shares of a mutual fund. The prospectus is available to investors on request.

A mutual fund SP must be periodically updated to reflect material changes and must be renewed annually by filing a pro forma SP. A mutual fund SP lapses after 12 months.

Mutual funds pay fees for filing a preliminary or pro forma SP and AIF. Fund managers are also subject to annual participation fees in Ontario based on their specified Ontario revenues for the reference fiscal year.

Foreign retail funds. Foreign funds are effectively precluded from filing an SP and offering shares to the public because of the following substantial barriers:

  • Tax treatment of non-resident funds.

  • Investment fund manager (IFM) registration requirements (see Question 6, Open-ended retail funds).

  • Requirements under NI 81-102, including the fundamental investment restrictions and operating requirements.

Non-resident retail funds may be offered as a private placement in Canada, but this is unusual.

Closed-ended retail funds

Local retail funds. Closed-ended funds must prepare a long form prospectus under NI 41-101. The prospectus clearance process is substantially the same as for a mutual fund (see above, Open-ended retail funds). Closed-ended funds that meet certain eligibility requirements, including the requirement to file audited financial statements (other than an opening balance sheet) can file a short form prospectus for a subsequent offering. This streamlined filing is subject to a review period of three working days.

Most closed-ended funds seek to provide secondary market liquidity by listing on the Toronto Stock Exchange (TSX). While a redemption right based only on the net asset value (NAV) may cause a fund to be a mutual fund under securities laws, redemption rights based on market value do not.

Unlike mutual funds that are in continuous distribution, most closed-ended funds have a single initial public offering (IPO), which closes after the specified minimum proceeds have been raised and when TSX requirements and any conditions imposed by the dealers have been satisfied.

Managers of closed-ended funds are not required to bear the organisation costs of new funds under NI 81-102, although such a requirement was proposed in phase 2 of the Modernisation Project (see Question 1, Closed-ended retail funds). In any event, managers are beginning to take measures to address these expenses such as assuming issue costs and imposing redemption charges.

Closed-ended funds pay fees for filing a preliminary prospectus that, in some jurisdictions, is based on the size of the distribution or the value of gross proceeds realised in the local jurisdiction. Fund managers are also subject to annual participation fees in Ontario based on their specified Ontario revenues for the fiscal year. Proposed amendments to Ontario Securities Commission (OSC) Rule 13-502 (Fees), published for comment on 18 September 2014, will remove the reference to "reference fiscal year". Participants will be required to calculate their participation fees based on the most recent information for the financial year.

Foreign retail funds. As is the case for open-ended funds (see above, Open-ended retail funds), foreign funds are limited to being offered as a private placement.

 

Marketing

4. Who can market retail funds?

Open-ended retail funds

Retail funds can be marketed by registered dealers. Mutual funds are typically distributed to retail investors by either:

  • Investment dealers.

  • Mutual fund dealers.

Exempt market dealers (EMDs) can also market prospectus qualified, open-ended funds to eligible investors under a prospectus exemption. The most common prospectus exemptions are:

  • The accredited investor exemption. Under this prospectus exemption, securities can be distributed to a purchaser that qualifies as an accredited investor, including:

    • an individual who alone or with a spouse has either Can$1 million in financial assets or Can$5million in net assets;

    • an individual who had net income before taxes exceeding Can$200,000 in each of the two most recent calendar years (or Can$300,000 when combined with income of a spouse);

    • a Canadian financial institution or Schedule III bank;

    • an adviser or dealer;

    • the Government of Canada or a jurisdiction of Canada (including crown corporations and agencies);

    • a municipality, public board or commission in Canada;

    • certain pension funds; and

    • certain investment funds.

Institutional investors that are "permitted clients" may be less relevant for retail funds, but are the focus of hedge and non-resident funds (see Questions 19 and 20).

  • The minimum purchase amount exemption. This applies where the purchaser purchases as principal for a minimum investment of Can$150,000.

A firm registered as an investment dealer or mutual fund dealer must generally be a member of a self-regulatory organisation. Investment dealers must generally become members of the Investment Industry Regulatory Organisation of Canada (IIROC). Mutual fund dealers must generally become members of the Mutual Fund Dealers Association of Canada (MFDA).

Foreign retail funds are unlikely to be distributed in Canada except on a private placement basis (see Question 3). Foreign funds' securities can be distributed on a private placement basis by investment dealers, EMDs and, to permitted clients, by foreign dealers pursuant to the international dealer exemption (IDE) (provided all requirements are met). The IDE is not available unless a person or company:

  • Has a head office or principal place of business in a foreign jurisdiction (home jurisdiction).

  • Is registered as a dealer or to act in similar capacity under the securities legislation of its home jurisdiction.

  • Engages in the business of a dealer in its home jurisdiction.

  • Is acting as principal or as agent for:

    • the issuer of the securities;

    • a permitted client; or

    • a person or company that is not a resident of Canada.

  • Submitted to the securities regulatory authority a "Submission to Jurisdiction and Appointment of Agent for Service" (Form 31-103F2).

Closed-ended retail funds

The following dealers can market prospectus qualified, closed-ended funds to retail investors:

  • Investment dealers.

  • Restricted dealers (if permitted under the terms of their registration).

EMDs can also market prospectus qualified, closed-ended funds to eligible investors under a prospectus exemption (see above, Open-ended retail funds).

As is the case for open-ended funds, foreign funds are unlikely to be distributed in Canada except on a private placement basis (see above, Open-ended retail funds).

 
5. To whom can retail funds be marketed?

Open-ended retail funds

A mutual fund can be marketed to any investor in a Canadian jurisdiction in which it has obtained a receipt for a prospectus. Mutual funds may impose restrictions on certain investors (such as non-residents and financial institutions) to maintain their status under Canada's Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (Tax Act) or to comply with anti-money laundering requirements.

Registered dealers, including mutual fund dealers, are subject to "know your client" (KYC), "know your product" (KYP) and suitability requirements that are collectively intended to ensure that purchases of securities are not incompatible with the client's circumstances, risk tolerance and investment goals.

Under KYC requirements, dealers must take reasonable steps to establish the identity of a client and to ensure that they have sufficient information to meet their suitability obligation. Under suitability requirements, a dealer must obtain, understand and is expected to explain how a proposed investment is suitable for the client in light of the client's investment needs and objectives, including the client's:

  • Time horizon for its investments.

  • Financial circumstances (including net worth, income, current investment holdings and employment status).

  • Risk tolerance for various types of securities and investment portfolios, taking into account the client's investment knowledge.

Registrants must conduct their own product due diligence and be able to explain to clients the security's:

  • Risks.

  • Key features.

  • Initial and ongoing costs and fees.

In assessing products sold under a prospectus exemption, the Canadian Securities Administrators (CSA) advise that registrants should also consider risks related to:

  • Liquidity. These result from resale restrictions or indefinite hold periods, and the fact that there will generally be no market for such resale.

  • Valuation. These result from the lack of prospectus and continuous disclosure about the issuer.

  • Conflict of interest, if securities are issued by a related party.

A mutual fund can only qualify as a retail mutual fund by filing a simplified prospectus (SP). Funds that issue redeemable securities, including foreign funds, but that do not file an SP, can offer their securities in Canada on a private placement basis (see Question 3).

Closed-ended retail funds

The same rules apply as for open-ended retail funds (see above, Open-ended retail funds).

 

Managers and operators

6. What are the key requirements that apply to managers or operators of retail funds?

Open-ended retail funds

Local managers. The key requirement is registration as an investment fund manager (IFM), which is defined as a person or company that directs the business, operations or affairs of an investment fund. IFMs are subject to a statutory duty to act in the best interests of an investment fund. The regulators are considering extending this duty of care to other categories of registrants.

An IFM that acts as a portfolio adviser or that distributes securities of its own funds must also register as a portfolio manager (PM) or as an exempt market dealer (EMD), respectively. All registrants, including EMDs, must:

  • Meet minimum capital and insurance requirements.

  • Adopt written compliance policies and procedures.

  • File periodic reports with the principal securities regulator and maintain certain records.

  • Identify, disclose and manage conflicts of interests.

Fund managers must disclose, on a quarterly basis, net asset value (NAV) adjustments. In addition, all registrants must file audited financial statements with the regulators. IFMs of funds that are reporting issuers must comply with the requirements of National Instrument 81-102 (NI 81-102), NI 81-106 and NI 81-107.

Dealers and advisers are subject to best execution requirements under NI 23-101 (Trading Rules) and rules regarding soft dollar arrangements under NI 23-102 (Use of Client Brokerage Commissions).

Foreign managers. A foreign manager of a Canadian resident fund must register as an IFM in the jurisdiction where the fund is resident. The distribution of foreign retail fund securities in Canada may also require IFM registration (see Question 24). A foreign manager can act as PM for a Canadian retail fund by either:

  • Registering as a PM.

  • Acting as a sub-adviser to a Canadian registered PM or IFM.

  • Relying on an exemption such as the international adviser exemption (IAE) to advise permitted clients (other than registered dealers or advisers), provided advising on securities of Canadian issuers is incidental to its advice on a foreign security. The IAE is not available unless all of the following applies:

    • the adviser’s head office or principal place of business is in a foreign jurisdiction (home jurisdiction);

    • the adviser is registered as an adviser or operates under an exemption from registration under the securities legislation of its home jurisdiction;

    • the adviser engages in the business of an adviser in its home jurisdiction;

    • at the end of its most recently completed financial year, not more than 10% of the aggregate consolidated gross revenue of the adviser, its affiliates and its affiliated partnerships was derived from portfolio management activities in Canada;

    • before advising a client, the adviser notifies the client of the prescribed information, including that there may be difficulty enforcing legal rights against the adviser because of its unregistered and non-resident status; and

    • the adviser submitted to the securities regulatory authority a "Submission to Jurisdiction and Appointment of Agent for Service" (Form 31-103F2).

Closed-ended retail funds

The same rules apply as for open-ended retail funds (see above, Open-ended retail funds).

 

Assets portfolio

7. Who holds the portfolio of assets? What regulations are in place for its protection?

Open-ended retail funds

All portfolio assets of an open-ended fund must be held by one custodian in Canada that satisfies the requirements of section 6.2 of National Instrument 81-102 (NI 81-102). Qualified custodians are:

  • Canadian banks.

  • Trust companies incorporated or licensed in Canada with shareholders' equity of not less than Can$10 million.

  • Affiliates of a bank or trust company with shareholders' equity of at least Can$10 million if the bank or trust company has assumed responsibility for the custodial obligations.

Assets may also be held in Canada and outside Canada by eligible sub-custodians. The manager of an investment fund cannot act as custodian or sub-custodian of an investment fund.

Closed-ended retail funds

The same rules apply as for open-ended retail funds (see above, Open-ended retail funds).

 

Legal fund vehicles

8. What are the main legal vehicles used to set up a retail fund and what are the key advantages and disadvantages of using these structures?

Open-ended retail funds

Legal vehicles. Mutual funds are typically formed as a mutual fund trust or a mutual fund corporation for purposes of the Tax Act. Exchange-traded mutual funds (ETFs) are typically mutual fund trusts under the Tax Act. This is to ensure efficient tax treatment and eligibility for deferred accounts, such as registered retirement savings plans (RRSPs). Trust securities are referred to as units whereas corporations issue shares, typically non-voting, participating mutual fund shares.

Advantages. Mutual fund trusts and corporations (for purposes of the Tax Act) generally provide efficient flow through treatment. Mutual fund corporations may use a multiple class structure, with each class of shares tracking a different portfolio of assets. Switches between classes are tax-deferred.

Disadvantages. Mutual fund trusts cannot allocate losses to unitholders. In a mutual fund corporation, interest income is subject to double taxation and liabilities allocable to a particular class may be borne by other classes.

Closed-ended retail funds

Legal vehicles. Closed-ended funds may be structured as mutual fund trusts, mutual fund corporations (see above, Open-ended retail funds) and limited partnerships. Partnership interests are referred to as units.

Although exchange-listed, closed-ended mutual fund trusts and corporations may be mutual funds under the Tax Act, this may not be the case under securities laws if they are not redeemable at a price based on the net asset value (NAV) more than once annually. Redemptions based on the market or trading price do not trigger treatment as a mutual fund under securities laws.

Advantages. For trusts and corporations, see above, Open-ended retail funds. A limited partnership provides complete pass-through tax treatment. A limited partnership (other than a specified investment flow-through (SIFT) partnership (see below, Disadvantages)) is not liable for income tax and is not required to file income tax returns except for an annual information form (AIF).

Disadvantages. For trusts and corporations, see above, Open-ended retail funds. Due to concerns about the ability to comply with statutory requirements to maintain limited liability for limited partners, it is not advisable to list limited partnership units. The Tax Act treats non-portfolio income of a SIFT partnership (which includes a listed limited partnership) in the same way as income earned by a taxable Canadian corporation. Tax is imposed at the partnership level at the corporate tax rates and investors are deemed to have received dividends from taxable corporations.

 

Investment and borrowing restrictions

9. What are the investment and borrowing restrictions on retail funds?

Open-ended retail funds

Mutual funds are subject to the standard investment restrictions under National Instrument 81-102 (NI 81-102). These restrictions are designed to ensure that mutual fund investments are diversified and relatively liquid and to ensure the proper administration of the funds. Principal restrictions include:

  • Concentration restriction. No more than 10% of the net asset value (NAV) can be held in the securities of one issuer.

  • Control restriction. No more than 10% of the securities of any single class of an issuer can be held.

  • Restrictions on illiquid assets. Illiquid assets cannot be purchased if this causes illiquid assets to exceed 10% of NAV.

  • Restrictions on fund of funds investments.

  • Restrictions on borrowing cash.

  • Restrictions on purchasing securities on margin, selling securities short and transactions in specified derivatives, unless these strategies are permitted by sections 2.7 or 2.8 of NI 81-102.

Mutual funds cannot borrow or provide a security interest, except:

  • As a temporary measure to fund redemptions or settle portfolio transactions up to a maximum of 5% of NAV.

  • Where required to effect transactions in specified derivatives other than:

    • a conventional convertible security;

    • a specified asset-backed security;

    • an index participation unit;

    • a government or corporate strip bond;

    • a capital, equity dividend or income share of a subdivided equity or fixed income;

    • a conventional warrant or right; or

    • a special warrant.

Exchange-traded funds (ETFs) are permitted to finance pre-initial public offering (IPO) portfolio acquisitions provided that all amounts are repaid on the IPO closing.

Closed-ended retail funds

The final amendments under phase 2 of the Modernisation Project (see Question 1) extend certain of the standard investment restrictions and practices under NI 81-102 to closed-ended funds, including restrictions on:

  • Control.

  • Investments in real property.

  • Loan syndications and mortgages.

  • The use of fund of funds structures.

  • Securities lending.

  • Repurchase and reverse repurchase transactions.

Additional investment restrictions have been deferred for consideration in conjunction with a more comprehensive alternative funds framework to be effected through amendments to NI 81-104 (Commodity Pools). These include a concentration restriction, restrictions concerning illiquid assets, investments in physical commodities, short selling, the use of derivatives and borrowing cash. Initial proposals for an alternative funds framework are expected to be published for comment in the first quarter of 2015.

Prohibitions on self-dealing in securities legislation and restrictions on certain managed account transactions under NI 31-103 apply to both open-ended and closed-ended funds.

 
10. Can the manager or operator place any restrictions on the issue and redemption of interests in retail funds?

Open-ended retail funds

A mutual fund can reserve the right to reject a purchase order in its prospectus and may establish reasonable requirements applicable to redemptions of securities that are not contrary to National Instrument 81-102 (NI 81-102). Exchange-traded fund (ETF) investors may be offered a right to redeem securities for cash based on a discount to the trading price of the securities on the Toronto Stock Exchange (TSX), whereas the net asset value (NAV) redemptions are available only to dealers that can redeem the prescribed number of units.

A mutual fund may suspend redemptions either:

  • If trading has been suspended on stock exchanges, options exchanges or futures exchanges on which more than 50% by value of the fund's assets are listed and the fund's portfolio securities cannot be traded on any other exchange that represents a reasonably practical alternative.

  • With the consent of Canadian securities regulatory authorities.

Closed-ended retail funds

The final amendments under phase 2 of the Modernisation Project (see Question 1):

  • Extend many of the redemption rules under NI 81-102 to closed-ended funds, including permitting suspensions of redemptions only if the requirements set out above are met (see above, Open-ended retail funds).

  • Require issuances of securities of closed-ended funds not to cause dilution of existing security holders.

Redemption privileges of closed-ended funds vary. Some funds are non-redeemable, while exchange listed, closed-ended fund securities are typically redeemable monthly at a discount to the market price and once annually at NAV.

Open-ended and closed-ended funds may restrict ownership by non-residents and others (in the case of flow through funds) to preserve their tax status. This may require some investors to redeem their securities when their status changes.

 
11. Are there any restrictions on the rights of participants in retail funds to transfer or assign their interests to third parties?

Open-ended retail funds

There are no statutory restrictions on rights to transfer or assign securities to third parties. Most investors will redeem their securities rather than transferring them (other than exchange-traded fund (ETF) securities). Ownership restrictions may be imposed on non-residents to avoid negative legal, regulatory or tax implications.

Closed-ended retail funds

The same rules apply as for open-ended retail funds (see above, Open-ended retail funds).

 

Reporting requirements

12. What are the general periodic reporting requirements for retail funds?

Open-ended retail funds

Investors. Under National Instrument 81-106 (NI 81-106), each of the following documents must be posted within the filing deadlines indicated below on the website of an investment fund that is a reporting issuer:

  • Audited annual financial statements within 90 days of year end.

  • Interim financial statements (semi-annual) within 60 days of the end of the interim period.

  • Annual and interim management reports of financial performance (MRFPs) within the same periods as financial statements (see above).

  • Quarterly portfolio disclosure within 60 days of the end of the quarter.

  • Proxy voting disclosure no later than 31 August each year.

  • Net asset value (NAV) weekly (if the fund does not use specified derivatives or make short sales), otherwise daily.

An open-ended fund must deliver annual and interim financial statements and MRFPs to investors by the filing deadlines, unless they elect not to receive these disclosure documents under applicable securities laws.

Regulators. A mutual fund must file with the securities regulators annual and interim financial statements and MRFPs, material change reports, material contracts, proxy solicitation materials and custodian compliance reports. Mutual funds and their managers are subject to early warning and insider trading reporting requirements.

Closed-ended retail funds

Investors. The same requirements apply as for open-ended retail funds (see above, Open-ended retail funds: Investors).

Regulators. The same requirements apply as for open-ended retail funds (see above, Open-ended retail funds: Regulators). In addition, closed-ended funds must file an annual information form (AIF) under NI 81-106 within 90 days of year end.

 

Tax treatment

13. What is the tax treatment for retail funds?

Open-ended retail funds

Funds. A mutual fund trust is subject to tax on its net income, including net taxable capital gains, not paid or payable to its investors at the end of each calendar year, after taking into consideration any loss carried forward and any capital gains refund. A mutual fund trust will seek to distribute enough of its income and capital gains to investors each year to avoid income tax under Part I of the Tax Act.

A mutual fund corporation does generally not pay tax on taxable dividends received from taxable Canadian corporations or on its net capital gains, provided that it declares and pays sufficient ordinary taxable dividends or capital gains dividends to its shareholders. It may also offset its net capital gains with capital gains refunds or capital loss carry-forwards. A mutual fund corporation is liable for tax on its net income from other sources at full corporate rates, without reduction.

Resident investors. Individual investors who hold securities outside of a registered plan must include in their income for a taxation year the taxable portion of all distributions paid or payable to them from a fund during the year.

Distributions paid by a trust may consist of capital gains, ordinary taxable dividends, foreign source income, other income and returns of capital. Distributions paid by a corporation may consist of ordinary taxable dividends, capital gains dividends and returns of capital. Ordinary dividends may be eligible for the enhanced gross-up and dividend tax credit. Capital gains dividends and capital gains distributions are treated as capital gains.

Return of capital distributions are not taxable, but reduce the adjusted cost base (ACB) of the investor's securities. If the ACB is reduced to less than zero, both:

  • The ACB of such securities is deemed to be increased to zero.

  • The investor is deemed to realise a capital gain equal to the amount of this increase.

A disposal of a unit or a share (including a redemption) may result in a capital gain or a capital loss.

Units and shares of mutual fund trusts and corporations are generally qualified investments for trusts governed by registered retirement savings plans, registered retirement income funds, deferred profit sharing plans, registered education savings plans, registered disability savings plans and tax-free savings accounts.

Non-resident investors. Non-resident investors are subject to Canadian withholding tax on:

  • Distributions of income by mutual fund trusts.

  • Ordinary dividends paid by mutual fund corporations.

  • Certain capital gains distributions or dividends connected to a disposition of taxable Canadian property (TCP).

The Canadian withholding tax rate is 25%, subject to reduction under the applicable income tax treaty or convention.

A disposal of an investment in a Canadian limited partnership, a mutual fund trust or a share of a mutual fund corporation by a non-resident for purposes of the Tax Act is generally not subject to Canadian tax unless the investment is TCP for purposes of the Tax Act, and the gain is not exempt from tax under an applicable income tax treaty or convention. Generally, units of mutual fund trusts or shares of mutual fund corporations do not fall within the definition of TCP.

Generally, returns of capital distributions are not taxable, but they reduce the ACB of the investor's securities.

The Foreign Account Tax Compliance Act (FATCA) was enacted in the US in March 2010. In February 2014, Canada and the US signed an Intergovernmental Agreement (IGA). The IGA is a framework for co-operation and information sharing that may provide relief from FATCA. US persons holding non-registered investment accounts must be reported by an investment fund manager (IFM) to a dealer or the Canada Revenue Agency (CRA), as applicable. Under the IGA, clients who do not provide the FATCA self-certification information must be reported to the CRA, even if the client is not a US person.

Closed-ended retail funds

Funds. Closed-ended funds structured as mutual fund trusts and mutual fund corporations are taxed in the same way as open-ended funds (see above, Open-ended retail funds: Funds).

A limited partnership other than a specified investment flow-through (SIFT) partnership (see Question 8, Closed-ended retail funds) is generally not liable for income tax and is not required to file income tax returns, except for an annual information form. Under the Tax Act, a limited partnership must compute its income (or loss) for each of its fiscal periods as if it were a person resident in Canada. All income, capital gains, losses and capital losses of the partnership fund flow through to its investors, subject to certain exceptions.

Resident investors. Resident investors are taxed in the same way as for open-ended funds (see above, Open-ended retail funds: Resident investors).

In calculating income or loss for a tax year, an investor in a limited partnership generally includes its pro rata share of the fund's annual taxable income or loss, whether or not distributions have been or will be received. Those income or losses generally retain their character in the hands of investors. A disposition of limited partnership interests by an investor holding that interest as capital property will generally result in a capital gain (or loss) to the investor.

Non-resident investors. See above, Open-ended retail funds: Non-resident investors.

 

Quasi-retail funds

14. Is there a market for quasi-retail funds in your jurisdiction?

Specialised Canadian funds include:

  • Flow-through funds structured as limited partnerships that offer Canadian investors tax-assisted investments in flow-through shares issued by resource companies.

  • Labour-sponsored investment funds (LSIFs), which are corporations sponsored by labour organisations designed to invest in small and mid-size Canadian businesses. Federal and provincial governments offer tax credits to Canadians investing in LSIFs.

  • Scholarship plans designed to facilitate savings for future education.

Reform

 
15. What proposals (if any) are there for the reform of retail fund regulation?

Significant regulatory initiatives during the past year include:

  • Stage two of the Point of Sale project (POS project).

  • Phase 2 of the Client Relationship Model project (CRM2).

  • Phase 2 of the Modernisation Project (see Question 1). This proposed reform will affect various National Instruments (NIs) including NI 81-102 and NI 81-104 (see Question 2).

The Canadian Securities Administrators (CSA) (see Question 2) are also considering introducing a statutory fiduciary or best interest standard for dealers and advisers.

Under the POS project, a mutual fund must deliver a fund facts document (see Question 3) instead of a prospectus. Stage three of the POS project will:

  • Require pre-sale delivery of the fund facts document.

  • Introduce a mutual fund risk classification methodology.

  • Introduce a summary disclosure document for exchange-traded funds (ETFs) similar to the fund facts.

CRM2 introduces new requirements for reporting to clients about the costs and performance of their investments and the content of their accounts. The amendments are phased over three years commencing in July 2014. They apply to dealers and advisers in all categories of registration, and partly to investment fund managers (IFMs) (see Questions 4 and 6).

Investment funds will be affected by proposed amendments to the private placement rules including a proposal for enhanced post-trade reporting (post-trade report amendments) in certain provinces, including in relation to:

  • Legal structure and type of fund.

  • Net asset value (NAV) of the fund at the date of the report.

  • Full details of the IFM, including business e-mail address of the IFM's CEO.

  • Name, title and jurisdiction of residence of all directors and executive officers of the fund and its IFM.

  • Fund's trustee, portfolio manager, sub-portfolio managers, custodian, registrar or transfer agent and auditor.

  • Total dollar value of redemptions since the last report filed, or if this is the first report, all redemptions since the fund was created

As noted in Question 1, extensive amendments to NI 81-102 under phase 2 of the Modernisation Project came into force on 22 September 2014.

 

Hedge funds

16. What is the structure of the hedge funds market? What have been the main trends over the last year?

The Canadian hedge fund market is estimated to manage approximately Can$35 billion and is well diversified (source: AIMA Canada Handbook). While it is well developed, the market remains relatively small due to lack of scale, difficulty in reaching large investors and costs of regulatory compliance.

After a poor year in 2013, Canadian hedge funds performed better in 2014. The Scotiabank Canadian Hedge Fund Index, a broad-based index of both open and closed funds managed by Canadian-domiciled hedge fund managers, reports that the industry experienced an asset-weighted return of 1.40% in 2013 compared to a year-to-date non annualised return of 4.14% as at 31 December 2014.

 

Regulatory framework and bodies

17. What are the key statutes and regulations that govern hedge funds in your jurisdiction? Which regulatory bodies regulate hedge funds?

Regulatory framework

Unless they file a prospectus, hedge funds are only indirectly regulated through registrant regulation. Most hedge funds do not file prospectuses, but are sold by way of private placement.

Hedge fund managers, dealers and advisers are subject to National Instrument 31-103 (NI 31-103) (see Question 6, Open-ended retail funds).

Principal protected notes (PPNs) issued by financial institutions may compete with hedge funds as a means of selling alternative investment products to retail investors. Most PPNs are issued by federally regulated banks. Federal PPN regulations specify requirements for the content, manner and timing of disclosure. PPNs distributed through registered dealers are subject to the usual "know your client" (KYC), "know your product" (KYP) and suitability obligations under securities laws (see Question 5, Open-ended retail funds).

Regulatory bodies

The regulatory bodies are the same as for open-ended retail funds (see Question 2, Open-ended retail funds: Regulatory bodies).

 
18. How are hedge funds regulated (if at all) to ensure compliance with general international standards of good practice?

Risk

Hedge funds generally distribute their securities pursuant to private placement exemptions under National Instrument 45-106 (Prospectus and Registration Exemptions) (NI 45-106). While the standard investment restrictions under NI 81-102 may preclude a retail offering of hedge funds, there are no statutory investment restrictions for privately placed funds.

Valuation and pricing

Canadian hedge funds generally value securities in accordance with the International Financial Reporting Standards (IFRS). Valuation and pricing policies are generally disclosed to investors and must conform to prudent business practices.

Systems and controls

All registrants, including investment fund managers (IFMs), must establish, maintain and apply policies and procedures that establish a system of controls and supervision sufficient to both:

  • Provide reasonable assurance that the firm and each individual acting on its behalf complies with securities legislation.

  • Manage the risks associated with its business in accordance with prudent business practices.

Insider dealing and market abuse

Canadian securities law contains prohibitions against insider trading and self-dealing and there are restrictions on certain managed account transactions under NI 31-103.

Transparency

Hedge funds that issue redeemable securities must prepare and deliver semi-annual financial statements under NI 81-106 in all jurisdictions other than British Columbia, Alberta, Manitoba and Newfoundland and Labrador. IFMs and dealers that sell hedge fund securities must report to investors and regulators under NI 31-103. Hedge funds and their managers are subject to early warning and insider reporting requirements.

Money laundering

Dealers and advisers (including international dealers and advisers relying on registration exemptions), are subject to federal anti-money laundering (AML) legislation applicable in all Canadian jurisdictions. They must also comply with guidelines of the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC), the federal agency responsible for ensuring AML compliance in Canada.

Short selling

Short sales are regulated by the Investment Industry Regulatory Organization of Canada (IIROC) under the Universal Market Integrity Rules (UMIR).

 

Marketing

19. Who can market hedge funds?

Any person who distributes hedge funds must be registered as a dealer. However, an investment fund manager (IFM) that promotes a hedge fund solely to registered dealers is not required to register as a dealer. It is recognised that actions that are undertaken by an IFM at the request of, or in response to, an existing or prospective investor who initiates contact with the IFM does not constitute active solicitation (that is, reverse enquiry).

In the exempt market, local and foreign hedge funds can be marketed by investment dealers, exempt market dealers (EMDs) (see Question 4) and restricted dealers (if permitted by the terms of their registration). Canadian Securities Administrators (CSA) Staff Notice 31-325 (Marketing Practices of Portfolio Managers) and Ontario Securities Commission (OSC) Staff Notice: 33-729 (Marketing Practices of Investment Counsel/Portfolio Managers) set out best practice guidelines for marketing hedge funds.

Non-resident dealers can market foreign hedge funds to certain Canadian permitted clients on the basis of the international dealer exemption, but subject to the IFM registration requirement in certain provinces (see Question 20).

Provinces and territories of the Northwest Region exempt certain persons from dealer registration provided they are not otherwise registered, confine their operations to the Northwest Region and comply with the blanket orders.

Investment fund marketing may be subject to detailed regulation in the areas of privacy, underwriting conflicts, anti-spam and unsolicited telecommunication rules.

 
20. To whom can hedge funds be marketed?

Publicly offered hedge funds can be marketed on the same basis as retail funds that file a prospectus (see Question 5).

In the exempt market, Canadian hedge funds are typically marketed to accredited investors (persons who satisfy certain net income or financial asset tests or who fall within a specified investor class, such as a Canadian pension fund) or under the Can$150,000 minimum purchase amount exemption. Other exemptions may be available, such as the "additional investment in investment funds" exemption.

Foreign hedge funds can be marketed under the same private placement exemptions, but their marketing is often restricted to permitted clients so that either:

  • Non-resident dealers qualify for the international dealer exemption.

  • Non-resident investment fund managers (IFMs) can rely on the permitted client exemption from IFM registration requirement in the three provinces of Ontario, Québec, and Newfoundland and Labrador.

 

Investment restrictions

21. Are there any restrictions on local investors investing in a hedge fund?

There are no such restrictions, but most hedge funds are distributed in the exempt market. This means they are not available to retail investors. Local and foreign hedge funds may not be eligible investments for tax-deferred plans.

 

Assets portfolio

22. Who holds the portfolio of assets? What regulations are in place for its protection?

There is no statutory custodian requirement for a privately placed hedge fund. Assets of Canadian hedge funds are typically held by one or more prime brokers. Regulators may impose the requirement for an 81-102 compliant custodian as a condition precedent to granting exemptive relief (such as fund on fund relief).

 

Requirements

23. What are the key disclosure or filing requirements (if any) that must be completed by the hedge fund?

Hedge funds that file a prospectus become reporting issuers and are subject to the same prospectus and continuous disclosure requirements as closed-ended funds (see Questions 3, Closed-ended retail funds and 12, Closed-ended retail funds: Investors).

If an offering memorandum (OM) is delivered to investors, it must contain prescribed disclosures on:

  • Statutory rights of action for misrepresentations.

  • Relationships that could give rise to potential conflicts of interest between the dealers and the fund. This information must appear on the cover page.

An OM must be filed with the securities regulators in certain jurisdictions within ten days of a distribution or the initial closing of an ongoing offering. OMs are not reviewed. It is not mandatory to file marketing materials and side letters but these may be reviewed during compliance reviews by securities regulators.

Post-trade reports and filing fees must be filed within ten days of certain exempt distributions including the accredited investor and minimum amount investment exemptions under National Instrument 45-106 (NI 45-106). An investment fund can elect to file once annually. In certain jurisdictions, the filing fee is based on the size of the distribution.

Post-trade reports must disclose the details of the distribution including dealer compensation and are publicly available. Investor personal information is kept confidential.

Currently, the required post-trade report is the same in all jurisdictions. The proposed post-trade report amendments would introduce a lengthy post-trade report in four provinces and allow for quarterly, rather than an annual filing (see Question 15).

Federal principal protected note (PPN) regulations specify requirements for the content, manner and timing of disclosure for PPNs.

 
24. What are the key requirements that apply to managers or operators of hedge funds?

The key requirements are the same as for retail funds (see Question 6).

A foreign manager cannot manage a Canadian hedge fund without registering as an investment fund manager (IFM) (see Question 6, Open-ended retail funds). The distribution of foreign hedge fund securities in Canada can also require IFM registration. Each of the three provinces of Ontario, Québec, and Newfoundland and Labrador require a non-resident IFM of an investment fund that has distributed securities in that province to register as an IFM, except where either:

  • None of the investment funds the IFM manages has security holders resident in that province.

  • The IFM and those investment funds have not actively solicited residents in the local jurisdiction to purchase securities of the fund at any time after 27 September 2012.

 

Legal fund vehicles and structures

25. What are the main legal vehicles used to set up a hedge fund and what are the key advantages and disadvantages of using these structures?

Canadian hedge funds are typically structured as limited partnerships or mutual fund trusts. The same considerations apply as for retail funds (see Question 8).

It is increasingly common for Canadian hedge funds formed as limited partnerships to layer on a top trust that invests in the limited partnership. Master-feeder structures are uncommon in Canada. Some funds are structured with a Canadian feeder fund that feeds into an offshore (for example, Cayman) master fund.

 

Tax treatment

26. What is the tax treatment for hedge funds?

Funds

Mutual fund trusts and corporations. Hedge funds are taxed on the same basis as open-ended funds (see Question 13, Open-ended retail funds: Funds).

Unit trusts. A hedge fund that qualifies as a unit trust under the Tax Act (for example because it has less than 150 holders) is not eligible for the capital gains refund and could be subject to alternative minimum tax and other taxes under the Tax Act.

Limited partnerships. Hedge funds are taxed on the same basis as closed-ended funds (see Question 13, Closed-ended retail funds: Funds).

Resident investors

Mutual fund trusts and corporations. Resident investors are taxed on the same basis as resident investors in open-ended funds (see Question 13, Open-ended retail funds: Resident investors).

Limited partnerships. Resident investors are taxed on the same basis as resident investors in open-ended funds (see Question 13, Open-ended retail funds: Resident investors).

Non-resident investors

Non-resident investors are taxed on the same basis as non-resident investors in open-ended funds (see Question 13, Open-ended retail funds: Non-resident investors).

 

Restrictions

27. Can participants redeem their interest? Are there any restrictions on the right of participants to transfer their interests to third parties?

Redemption of interest

Canadian hedge funds can typically be redeemed at net asset value (NAV), subject to early redemption fees, investor and fund-level gates, side-pockets, suspensions and reservations. Hedge funds that offer NAV redemptions more than once annually are regulated as mutual funds under applicable securities laws.

Transfer to third parties

Transfers of hedge fund securities are usually restricted and must be approved by the investment fund manager (IFM) or general partner. Transfers are also subject to resale restrictions under securities laws. Investors typically redeem hedge fund securities.

 

Reform

28. What (if any) proposals are there for the reform of hedge fund regulation?

Hedge fund dealers and advisers will be affected by phase 2 of the Client Relationship Model project (CRM2) and the proposed post-trade report amendments (see Question 15).

The Canadian Securities Administrators (CSA) have not outlined the scope of the proposed alternative funds framework (see Question 9, Closed-ended retail funds). It is therefore uncertain whether hedge funds will be affected by those proposals.

 

Online resources

Canadian Securities Administrators (CSA)

W www.securities-administrators.ca

Description. Official website of the Canadian Securities Administrators (CSA), providing access to CSA members' websites, a national registration database and other investor tools.

Cooperative Capital Markets Regulatory System (CCMR)

W www.ccmr-ocrmc.ca

Description. Official website of the Cooperative Capital Markets Regulatory System (CCMR), detailing the development of the new multi-jurisdictional securities regulator scheduled to begin operations in late 2015.

Ontario Securities Commission (OSC)

W www.osc.gov.on.ca

Description. Official website of the Ontario Securities Commission (OSC).

Alberta Securities Commission (ASC)

W www.albertasecurities.com

Official website of the Alberta Securities Commission. It is a good source of unofficial consolidated legislation (the OSC tends to publish amendments only, not restated consolidations).

Investment Industry Regulatory Organisation of Canada (IIROC)

W http://iiroc.ca ( www.practicallaw.com/9-590-6210)

Description. Official website of the Investment Industry Regulatory Organisation of Canada.

Mutual Fund Dealers Association of Canada

W http://mfda.ca ( www.practicallaw.com/5-590-6212)

Description. Official website of the Mutual Fund Dealers Association of Canada.

Toronto Stock Exchange (TSX)

W http://tmx.com ( www.practicallaw.com/9-522-0865)

Description. Official website of the Toronto Stock Exchange.



Contributor profiles

Darin R Renton, Partner

Stikeman Elliott LLP

T +1 416 869 5635
F +1 416 947 0866
E drenton@stikeman.com
W www.stikeman.com

Professional qualifications. Toronto, Ontario, Canada, Solicitor; Bar Admission in Ontario, 1995

Areas of practice. Corporate finance; mergers and acquisitions; investment funds.

Katy M Pitch, Associate

Stikeman Elliott LLP

T +1 416 869 5535
F +1 416 947 0866
E kpitch@stikeman.com
W www.stikeman.com

Professional qualifications. Toronto, Ontario, Canada, Solicitor; Bar Admission in Ontario, 2006

Areas of practice. Domestic and cross-border corporate income tax law.


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