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CanadaJohn E Hall, Craig J Webster

and Ronald Kosonic

Rankings and recommended lawyers in 30 jurisdictions

Essential legal questions answered in 22 key jurisdictions

Analysis of critical legal issues

INVESTMENT FUNDS

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PRACTICAL LAWMULTI-JURISDICTIONAL GUIDE 2012

Top 10 global firms identified

© This article was first published in the Investment Funds multi-jurisdictional guide 2012 and is reproduced with the permission of the publisher, Practical Law Company.

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MULTI-JURISDICTIONAL GUIDE 2012

INVESTMENT FUNDS

Canada

John E Hall, Craig J Webster and Ronald Kosonic

Borden Ladner Gervais LLP

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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

The open-ended retail fund or mutual fund market is well estab-lished in Canada, with the majority of Canadian households holding at least some mutual funds. After a period of dramatic net redemptions, mutual funds are experiencing positive inflows again, particularly into the bank-owned complexes and larger independent players. Assets in open-ended funds are currently worth approximately Can$800 billion (as at 1 November 2011, US$1 was about Can$1).

Closed-ended retail funds

The dramatic decline in new product launches in the listed struc-tured product market that began in 2008 (following more than five years of very strong growth) appears to have ended. Some new funds are now being brought to market. However, many exist-ing closed-ended funds are still being:

� Merged to produce entities of a reasonable size.

� Converted into open-ended mutual funds.

It is difficult to predict when this sector of the market will rebound more significantly.

Regulatory framework and bodies

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


Regulatory framework. The key regulations that regulate open-ended retail funds are:

� National Instrument 81-102: the core rules for the organi-sation and conduct of mutual funds.

� National Instrument 81-101: prospectus disclosure rules.

� National Instrument 81-106: continuous disclosure requirements.

� National Instrument 81-105: sales practice rules.

� National Instrument 81-107: fund governance regime.

Regulatory bodies. Open-ended and closed-ended funds are cur-rently regulated by the securities regulators in the ten provincial and three territorial jurisdictions in which they have qualified their securities. There are many rules designed to co-ordinate the efforts of the regulators to avoid duplication of effort or inconsistent regu-lation. The Canadian federal government is seeking to establish a national securities regulator by mid-2012 that would replace most of the current regulators (a few provinces have indicated that they will opt out of any national regulatory body and have challenged the initiative in the courts on constitutional grounds: a decision from Canada’s highest court is expected shortly).


Regulatory framework. The key statutes that regulate closed-ended retail funds are:

� National Instrument 41-101: prospectus disclosure rules.

� National Instrument 81-106: continuous disclosure requirements.

� National Instrument 81-107: fund governance regime.

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

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


A mutual fund’s securities are qualified for sale by a simplified pro-spectus (SP). This requirement applies equally to domestic and for-eign-domiciled funds. However, various securities laws create signif-icant disincentives for foreign funds. These apply to publicly offered funds (and include investment restrictions, custodial requirements and so on) and tax considerations, making it extremely unlikely that they would qualify an SP for sale to the retail public.

A preliminary SP, a short fund facts document (see Question 14) and annual information form and associated documents are filed for review with the applicable securities regulators. Once comments from the regulators are addressed, final prospectus documents are filed. Once a final receipt is issued for the final SP, the securities of the fund can be sold to the public. Typically, an initial seed capi-tal amount (a minimum of Can$150,000) is invested by the fund manager in the fund before the final prospectus filing. Therefore, no closing occurs following the filing of the final prospectus, unlike with closed-ended funds (see below, Closed-ended retail funds). Open-ended mutual funds typically remain in continuous distribution.


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Currently, the fund facts document must be posted on the man-ager’s website, but is only sent to the investor upon request (see Question 14).


The prospectus qualification process for a long-form prospectus of a closed-ended fund is relatively similar to open-ended retail funds (see above, Open-ended retail funds), except that the fund manager or promoter does not invest the initial seed capital. Most closed-ended funds are listed on the Toronto Stock Exchange (Exchange). Securities are conditionally listed by the Exchange before the final prospectus is filed. A closing is then held at which any minimum offering amount must be raised and any other conditions imposed by the underwriters or the Exchange must be met.

Again, it is highly unlikely that foreign open-ended funds would qualify for sale to retail investors by prospectus as they would not comply with various aspects of National Instrument 81-102, including the requirement to have a Canadian custodian. Similarly, while Exchange issuers can typically be inter-listed on certain foreign exchanges, the requirement for a closed-ended fund being sold to retail investors to have a Canadian custodian would prevent this from occurring. At present, it is extremely unlikely that the applicable regulators would give the relief nec-essary to remove these obstacles to foreign funds.

Marketing

4. Who can market retail funds?


The following can market and sell to any investor, including retail investors:

� Investment dealers (members of the Investment Industry Regulatory Organisation of Canada (IIROC), who are licensed to sell any type of security).

� Mutual fund dealers (members of the Mutual Fund Dealers Association of Canada (MFDA)).


Investment dealers can market and sell to any investor.

For both types of funds, an exempt market dealer can market and sell securities to exempt purchasers. In certain jurisdictions, dealer registration is not required to market and sell fund securi-ties to exempt purchasers under specific dealer exemptions. See Questions 18 and 19 for a discussion of when dealer registration is not required or an exempt market dealer licence is sufficient to enable an intermediary to sell securities.

The dealers qualified to sell open-ended and closed-ended funds to retail investors in Canada cannot sell foreign funds to those retail investors unless these funds are qualified for sale to the public by prospectus in Canada (or interlisted, in the case of closed-ended funds), which is highly unlikely to occur (see Question 3, Open-ended funds).

While there has historically been some cross-border activity which effectively ignores the strict letter of the law, securities

regulators have started clamping down on this activity. Dealers can sell foreign funds to investors who are eligible to purchase on a prospectus-exempt basis (see Question 18).

5. To whom can retail funds be marketed?


Open-ended retail funds can be marketed to any investor in a Canadian jurisdiction in which the SP has been qualified.


Closed-ended retail funds can be marketed to any investor in a Canadian jurisdiction in which the prospectus has been qualified.

As foreign funds are not qualified for sale to retail purchasers (see Question 3, Open-ended funds), they cannot be marketed to retail investors. They can only be marketed to investors who are eligible to purchase their securities on a prospectus-exempt basis (see Question 18).

Managers and operators

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

Both open- and closed-ended fund managers must be registered as “investment fund managers” (National Instrument 31-103). This subjects them, among other things, to capital, insurance and proficiency requirements.


In addition, the manager must comply with the requirements set out in:

� National Instrument 81-102 which imposes, among other things:

� restrictions on the permitted investments; and

� obligations on the manager in relation to purchases and redemptions.

� National Instrument 81-107 in relation to fund governance.

� National Instrument 81-106 in relation to continuous disclosure.


The manager is subject to the same requirements as a manager of an open-ended retail fund, with the exception of National Instrument 81-102.

Foreign funds are effectively prohibited from operating in the retail market in Canada (see Questions 5 and 6). A foreign entity can provide all of the portfolio management to a Canadian fund by registering as an adviser in Canada (or under sub-advisory exemptions from adviser registration). It could also be the invest-ment fund manager, provided the fund is domiciled in Canada. The registration requirements to be imposed on foreign entities acting as investment fund managers remain unclear, but it is anticipated that the same requirements will apply to domestic and foreign investment fund managers.

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Assets portfolio

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


The assets must be held by a custodian that is one of the following:

� A bank under the Bank Act (Canada) (C.46, 1991, as amended).

� A registered trust company with shareholders’ equity of at least Can$10 million.

� An affiliate of a bank or trust company meeting the above criteria, provided that:

� the entity has shareholders’ equity of at least Can$10 million; or

� the bank or trust company assumes responsibility for the entity’s obligations.

The custodian can appoint sub-custodians in Canada or outside Canada. The criteria for sub-custodians are similar to the above, except that the minimum shareholder equity requirement increases to the equivalent of Can$100 million. A custodian or sub-custo-dian must carry out its duties concerning the safekeeping of, and deal with, the fund’s assets with (National Instrument 81-102):

� The degree of care, diligence and skill that a reasonably prudent person would exercise in the circumstances.

� The same degree of care it would exercise in relation to its own property of a similar kind if that would be a higher standard.


Essentially the same requirements for a custodian or sub-custo-dian apply as for open-ended funds (see above, Open-ended retail funds) (National Instrument 41-101).

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?


Legal vehicles. Open-ended retail funds are structured as either:

� Trusts. Participant interests in trusts are called units.

� Corporations. Participant interests in corporations are called shares. They are often established with multiple classes and series, with each class constituting a separate fund and each series offering different purchase and pricing options.

Advantages. A trust offers a better tax conduit and is more flex-ible from a governance perspective.

Corporations can be desirable for taxable investors who trade frequently as transfers between classes or funds are not treated as dispositions and therefore do not trigger capital gains at the shareholder level.

Disadvantages. A transfer between trust funds by participants con-stitutes a taxable disposition of property which is not the case with a transfer between classes or series of a corporate fund structure.

By comparison, the corporate structure is less tax efficient (only capital gains and Canadian dividends flow through). Since a cor-poration with multiple classes is still a single legal entity, there is a risk that the liabilities of a class or series could exceed its portion of the corporation’s assets. As a result investors in the other classes or series could be exposed to the remaining liabili-ties. However, this risk is largely theoretical (given the investment restrictions that apply to retail funds, most notably the restric-tions on borrowing and derivative transactions).


Legal vehicles. The same considerations as described for open-ended funds also apply (see above, Open-ended retail funds), although multi-fund corporations are not typically offered as closed-ended funds.

Advantages. Closed-ended corporations (called split corps) have been structured to effectively provide leverage and stream differ-ent types of income to different classes of shares. Trusts cannot generally accomplish income streaming to different types of inves-tors. In addition, structuring as a corporation can be necessary to avoid a tax which applies to specified investment flow-through trusts (SIFTs). Very generally, in relation to certain earnings, a SIFT is taxed similarly to a regular corporation and its unitholders are deemed to have received dividends in relation to distributions.

Disadvantages. See above, Open-ended retail funds.

Investment and borrowing restrictions

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


National Instrument 81-102 contains a large number of restric-tions designed to ensure that mutual funds are liquid and rela-tively stable. Key restrictions include:

� No more than 10% of net assets can be held in a single security.

� No more than 10% of the securities of any class of any issuer can be held by the fund.

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

� temporarily up to 5% of the fund’s asset value to fund redemption requests to permit the fund settle portfolio transactions; or

� where required to effect a specific derivative transaction in accordance with the industry practice.

� Illiquid assets cannot be purchased if that would result in more than 10% of net assets being illiquid assets (funds must take steps to reduce exposure if illiquid assets exceed 15%).

� Conservative rules concerning derivative transactions, securities lending, and repurchase and reverse purchase transactions.



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Discretionary relief from these restrictions can be obtained in certain limited circumstances, to enable, for example:

� Short selling to a limited degree. Proposed amendments to National Instrument 81-102 will, if adopted, allow short selling without requiring discretionary relief subject to the very conservative conditions (for example, 150% cash cover) that are currently imposed in discretionary relief decisions.

� Inclusion of certain amounts as “cash cover” for deriva-tives transactions not otherwise permitted by NI 81-102. Proposed amendments to National Instrument 81-102 will, if adopted, make applying for this relief unnecessary.


The above restrictions do not apply to closed-ended funds, which currently is one of the main reasons for selecting a closed-ended fund. However, the regulators (see Question 1, Open-ended retail funds: Regulatory bodies) have indicated a long-term intention to review whether some of the NI 81-102 restrictions should apply to closed-ended funds.

National Instrument 31-103 and provincial securities legislation impose certain self-dealing restrictions, many of which apply equally to closed-ended and open-ended funds.

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


Restrictions on redemptions are only permitted when more than 50% of a fund’s assets cannot be priced due to suspended trading or with the consent of the regulators. The issue of fund securities must be suspended if redemptions are suspended. A manager is free to suspend the issue of securities at any time; it can reject any purchase order it wishes provided it rejects the order no later than one business day after receipt and all cash is returned (and the SP indicates the manager has this authority).


Closed-ended funds are not typically in continuous distribution so the manager controls when any additional issues of securities are made. Redemptions are regulated by the fund’s governing documents. Certain funds offer no redemptions at net asset value (only at a discount to the market price reinforcing that liquid-ity is expected to be realised through secondary market trading). Others allow redemption at net asset value once annually, and some others allow it more frequently (for example, quarterly).

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


There are typically no formal restrictions (in practice, they occur very infrequently).


There are typically no formal restrictions.

Reporting requirements

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


Investors. The following reporting requirements apply:

� Audited annual financial statements must be made avail-able within 90 days of the year end.

� Unaudited semi-annual statements must be made available within 45 days of the semi-annual period.

� Management Reports of Fund Performance (MRFPs) must be made available semi-annually within the same time period as financials.

� Quarterly portfolio disclosures must be made available on a website (for most funds).

� Proxy voting disclosures must be made available on a web-site annually.

Investors have the right to receive financial statements and MRFPs, but can opt not to receive them.

Regulators. The fund must file the financial statements and MRFPs with the regulators by the same deadlines as they are required to be sent to security holders who have expressed inter-est in receiving them.


Investors. The same financial statement 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). As a closed-ended fund does not have a prospectus it is also required to prepare an annual information form.

Tax treatment

13. What is the tax treatment for retail funds?


Funds. Retail funds typically qualify as mutual fund trusts or mutual fund corporations for tax purposes. Trusts generally do not pay tax as they distribute sufficient income and capital gains to unitholders. Corporations generally do not pay tax on Canadian dividends and capital gains as they flow through to shareholders by way of ordi-nary dividends and capital gains dividends. Other income (including interest, foreign source income and income from certain derivatives), which cannot be offset by expenses, is taxable in the corporation. A capital gains refund mechanism is available to mutual fund trusts and mutual fund corporations, and generally mitigates the double taxation of capital gains triggered by redeeming investors.

Gains from derivative transactions are generally included as ordinary income (rather than capital gains). However, gains on certain derivatives transactions, which are settled in specie (in its actual form) or which are entered into for hedging purposes,


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can constitute capital gains. The tax implications of a multi-fund mutual fund corporation are more complex as tax is levied at the corporate level, rather than at fund level.

Resident investors. Individual trust unitholders who are resi-dent in Canada are taxed on distributions of income and capital gains. Distributions generally retain their character in the hands of unitholders as Canadian dividends, foreign source income, capital gains, interest and other income. Individual corporate shareholders who are resident in Canada are taxed on ordinary dividends and capital gains dividends received from the fund. Ordinary dividends are afforded one of two dividend tax credits, depending on whether the dividend is an eligible dividend or not. Capital gains dividends are taxed as capital gains.

Returns of capital received by unitholders and shareholders are not immediately taxable. However, they reduce the adjusted cost base of the units or shares on which they are paid. If that adjusted cost base is reduced to less than zero, both:

� The unitholder or shareholder is deemed to have a capital gain equal to the negative amount.

� The adjusted cost base is increased to nil.

Dispositions (including redemptions) of units or shares trigger a capital gain or loss. One-half of a capital gain is generally included in calculating income. One-half of a capital loss can be claimed against capital gains.

Units and shares of retail funds generally are qualified invest-ments for Canadian tax-deferred retirement and savings plans.

Non-resident investors. Non-resident unitholders of a mutual fund trust are subject to Canadian withholding tax on distribu-tions of income and certain capital gains that are connected with the disposition of taxable Canadian property by the fund. Other capital gains distributions are not subject to Canadian withhold-ing tax.

Non-resident shareholders of a mutual fund corporation are sub-ject to Canadian withholding tax on ordinary dividends and cer-tain capital gains dividends that are connected with the disposi-tion of taxable Canadian property by the fund. Other capital gains dividends are not subject to Canadian withholding tax. Returns of capital are not subject to Canadian withholding tax. However, they reduce the adjusted cost base of the units or shares on which they are paid.

The rate of withholding tax is 25%, subject to reduction under one of Canada’s tax treaties. Capital gains realised on the disposi-tion of units or shares are usually not subject to Canadian tax as the units or shares are typically not taxable Canadian property.


Funds. Closed-ended retail funds are taxed in the same manner as open-ended retail funds (see above, Open-ended retail funds: Funds). Closed-ended retail funds that are structured as trusts can also be subject to tax as SIFTs (see Question 8, Closed-ended retail funds). Funds would generally be structured to avoid this result.

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

Non-resident investors. Non-resident investors are taxed in the same manner as non-resident investors in open-ended retail funds (see above, Open-ended retail funds: Non-resident inves-tors ). In addition, non-resident investors are subject to a 15% withholding tax on otherwise non-taxable amounts received from a fund if more than 50% of the fair market value of the unit or share is attributable to Canadian real property, resource property or timber resource property.

Reform

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

Currently proposed regulations would:

� Require the short fund facts document (two to four pages) to be delivered at point of sale for open-ended retail mutual funds.

� Only require the more complete prospectus to be provided on request.

If implemented as proposed, these changes will have a significant impact on the sales process for every distribution channel. As an interim step, the regulators are proposing:

� To make the fund facts document the document that must be delivered (rather than the SP) without requiring that this be pre-sale.

� The expansion of the fund facts requirements to other prod-ucts, including closed-ended retail funds.

In addition, regulators are reviewing the Independent Review Committees’ role in regulating conflicts of interest that involve retail fund managers, with a view to decreasing the prescrip-tive nature of the regulation. Proposed amendments to National Instrument 81-102 will liberalise investment restrictions in cer-tain areas. This will:

� Eliminate the need to apply for discretionary relief (see Question 9, Open-ended retail funds).

� Require money market funds to hold even more highly liquid investments than is currently required.

Canada has not seen any widespread class action or enforcement action relating to retail funds in recent years. The last issue of that nature concerned market timing.

HEDGE FUNDS

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

The hedge fund market in Canada dates back to the late 1980s, but it is still perceived to lag more mature markets such as the US and the UK, both in size and diversity of products. Current estimates put the size of the hedge fund market in Canada at over Can$40 billion.

Management fees still predominantly follow the traditional “2+20” model. However, more funds are offering multiple classes



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with lower fees to seed investors, and these are also being offered to investors who agree to longer initial lock-up periods or higher minimum investments or both.

The Canadian market continues to be dominated by long/short equity funds. However, there has been a recent growth of fixed income funds relying on derivative instruments to hedge out or exploit various investment risks. The Canadian market has also seen growth in tax-advantaged structures.

Regulatory framework and bodies

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

Regulatory framework

Provincial securities and commodity futures legislation regu-late hedge funds to some degree when offered as exempt-mar-ket investment vehicles, but typically to a much lesser degree than retail funds. However, fund managers, advisers and dis-tributors are subject to registration requirements under National Instrument 31-103 (Registration Requirements, Exemptions and Ongoing Registrant Obligations (see Questions 18 and 22)). Federal banking legislation regulates hedge fund products that are sold in the form of principal-protected notes (PPN) where returns are linked to the performance of a hedge fund or hedge fund strategy. Federal anti-money laundering and anti-terrorism regulations apply to fund advisers and dealers.

Regulatory bodies

See Question 2, Open-ended retail funds: Regulatory bodies.

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

Risk

Retail products (sold by prospectus) are restricted in terms of:

� Concentration.

� Leverage.

� Exposure to illiquid securities.

These restrictions effectively prevent hedge funds being sold directly to the retail market. Hedge funds sold to exempt purchas-ers (where no prospectus is required) are generally unrestricted. However, conflict of interest rules can apply to restrict self-dealing, and prudent business standards applicable to fund managers and fund advisers require risk management policies and procedures.

Valuation and pricing

These are not regulated for privately offered products. However, reg-istered fund advisers (that is, most hedge fund advisers in Canada) are regulated through the compliance audit process. Their valuation and pricing procedures must conform to prudent business practices.

Systems and controls

These are not regulated for privately offered products. Registered fund managers and fund advisers must have systems and controls that conform to prudent business practices.

Insider dealing and market abuse

Provincial securities laws (and, to some extent, the federal crimi-nal code) prohibit insider dealing and front-running (that is, the illegal practice of fund managers executing orders on a security for their own account while taking advantage of advance knowl-edge of pending orders from the fund they manage). Provincial securities laws prohibit market abuse by industry participants, directly and indirectly.

Transparency

Provincial securities regulation has increasingly required trans-parency for certain hedge funds, their managers and their advis-ers (for example, financial reporting and full disclosure of self-dealing and referral arrangements).

Money laundering

Federal anti-money laundering regulations apply to all registered advisers and dealers, and are enforced both by the federal agency that oversees the regulations and by provincial securities authori-ties through their compliance audit mandate.

Short selling

Short selling is regulated by local stock exchanges and the Investment Industry Regulatory Organization (IIROC), the self-reg-ulatory organisation that regulates Canadian investment dealers.

Marketing

18. Who can market hedge funds?

Firms that market hedge funds directly to Canadian investors can require registration, depending on:

� The nature of the firm’s business.

� Whether the firm is a Canadian firm or a foreign firm.

� Whether the fund is a Canadian fund or a foreign fund.

Registered investment fund managers that market only to regis-tered dealers are not required to register as dealers themselves.

Firms that are registered as exempt market dealers in the appli-cable province or territory of Canada can sell hedge fund prod-ucts where prospectus exemptions are available (for example, to accredited investors or to persons investing at least Can$150,000 in any one hedge fund) without regard to whether the hedge fund is a Canadian fund or a foreign fund.

Exempt market dealers are the least regulated category of dealer. However, among other things, they are still subject to certain requirements concerning:

� Capital.

� Insurance.

� Proficiency.

In certain Western provinces and territories, firms can be exempt from dealer registration provided they both:

� Are not otherwise registered.

� Limit their marketing and sales activities to these jurisdictions.


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Non-Canadian dealers that are not registered in Canada can mar-ket foreign hedge funds in Canada to only certain permitted cli-ents in reliance on a registration exemption if a number of condi-tions are met, including the filing of notices with the applicable securities regulators.

19. To whom can hedge funds be marketed?

Marketing and sale of hedge funds, whether domestic or foreign, are subject to the same rules as retail funds (see Question 5).

There are no restrictions if hedge funds are marketed through a prospectus or sold in the form of a PPN. However, limitations imposed on prospectus-qualified funds generally exclude hedge fund strategies. Also, market participants have been discouraged by the regulators from using PPNs to sell hedge fund products to the retail market.

Otherwise, sales are generally restricted to accredited investors and others who invest at least Can$150,000 in any one hedge fund. In addition, certain local provincial exemptions can apply (for example, sales through an offering memorandum and sales to family and friends).

Investment restrictions

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

Registered plans (for example, registered retirement savings plans and registered retirement income funds) and certain tax-advantaged investors (such as foundations) can be prohibited from investing in a hedge fund. This depends on, among others:

� Their legal structure.

� Their terms of redemption (liquidity).

� Their total number of investors.

� The relative size of the investment.

� The investment strategies employed.

Assets portfolio

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

Assets of funds privately offered are typically held by the prime broker. Canadian prime brokers are members of IIROC and have limited requirements concerning the segregation of client assets. Otherwise, protective terms must be negotiated in the prime bro-ker agreement. For assets not held by the prime broker, custodial arrangements can be, but are not required to be, made with a Canadian financial institution.

Requirements

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

Privately offered hedge funds generally do not require an offering document, but if one is used:

� It must contain certain disclosures concerning statutory rights of action.

� It gives rise to statutory civil liability for the fund in case of misrepresentation, which can include the omission of a material fact.

� It must be filed in certain provinces (but is not reviewed by the securities regulators).

Continuous disclosure rules (regulating the preparation, fil-ing and delivery of financial information to purchasers of retail fund products) partially apply to certain privately offered hedge funds. These may not apply at all to non-redeemable hedge fund products.

Limited disclosure rules exist in relation to PPN products.

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

Fund managers, and others (such as general partners) who direct the business, operations or affairs of an investment fund, that are resident in Canada must be registered as “investment fund man-agers”. The registration subjects them to, among other things, requirements regarding:

� Capital.

� Insurance.

� Proficiency.

Fund managers that are not resident in Canada are not currently required to register, but may be required to register in the future, if their fund is sold to residents of Canada.

Subject to very limited exceptions, all fund portfolio managers that are resident in Canada and all portfolio managers, wherever resident, that advise funds resident in Canada:

� Must be licensed in Canada to provide their portfolio man-agement services.

� Are subject to minimum capital, insurance and proficiency requirements.

All registrants must have policies and procedures in place that conform to applicable law and prudent business practice.



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Legal fund vehicles and structures

24. 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?


Open-ended hedge funds and retail hedge funds are not synony-mous and, for the most part, are mutually exclusive. In fact, it is more likely that a closed-ended fund will become a retail prod-uct by listing its securities on a stock exchange (as the principal means of providing investor liquidity).

Legal vehicles. The most common legal entities used for open-ended hedge funds are:

� Limited partnerships. (Participating interests in limited partnerships are called units.)

� Trusts. (Participating interests in trusts are called units.)

� Corporations (to a lesser extent). (Participating interests in corporations are called shares.)

Hedge fund strategies can also be offered through the use of PPNs.

Advantages. Limited partnerships provide:

� A pure flow-through to investors for tax purposes.

� Statutory limited liability to passive investors.

� The greatest flexibility as regards investment terms and profit-sharing as between investors and management.

Trusts can pass profits through to investors, and are more readily accessible to tax-deferred retirement and savings plans.

Corporations can provide a means of offering multiple investment strategies and investor flexibility in re-allocating their investment among the strategies without triggering income tax gains.

PPNs typically offer principal protection, provided the investment is held for a minimum number of years, and are the most used vehicles for providing exposure to hedge fund strategies to the retail market.

Disadvantages. Limited partnerships are typically not available to tax-deferred plans or foundations and are required to publicly disclose investors in certain jurisdictions.

Trusts cannot flow net losses through to investors (but can carry them forward) and it is uncertain as to whether investors in a commercial trust have limited liability (other than for retail funds where there is some statutory protection). Trusts and corporations have restrictions on flexibility in structuring terms of investment among different investors.

Corporations are taxable entities and cannot flow profit or loss through to investors.

Limited partnerships, trusts and corporations that are directly offered as retail products are restricted as to investment strate-gies, composition and concentration.

PPNs linked to hedge fund strategies have lost popularity as retail products since coming under close regulatory scrutiny, and criti-cism, in recent years.


Legal vehicles. The same vehicles used for open-ended hedge fund products are available for closed-ended hedge funds (see above, Open-ended retail funds: Legal vehicles). However, closed-ended vehicles listed on a stock exchange can be made available to tax-deferred plans, regardless of legal form.

Advantages. These are the same as for open-ended hedge funds (see above, Open-ended retail funds).

Disadvantages. These are the same as for open-ended hedge funds (see above, Open-ended retail funds: Legal vehicles).

25. What are the advantages and disadvantages of using onshore and offshore structures?

Onshore

Advantages. For tax reasons, Canadians may prefer to invest in an onshore product, as offshore investments can be subject to offshore investment fund property rules under which an investor is taxed on a notional accrual of income on the investor’s invest-ment in the offshore investment. Specific adverse Canadian tax consequences can also arise in connection with investments in an offshore trust.

Disadvantages. Non-Canadian investors typically prefer to invest in an offshore vehicle, as a Canadian vehicle can indirectly sub-ject a non-resident investor to certain Canadian taxes. In addi-tion, non-resident investors could “taint” an onshore vehicle (in particular, if it is a limited partnership) for Canadian income tax purposes. Most onshore funds are managed on a parallel basis rather than in a master-feeder structure.

Offshore

Advantages. Offshore structures can provide non-residents with neutral tax treatment (that is, no taxation of the fund by Canadian tax authorities) if both:

� Their “controlling mind and management” is not in Canada.

� They are not carrying on business in Canada.

Disadvantages. Non-resident trust rules and offshore investment fund property rules can result in adverse consequences in con-nection with investments in offshore vehicles by Canadians. If receiving services from Canada, a fund may need to rely on a “safe harbour” rule to not be considered to be carrying on busi-ness (and therefore possibly taxable) in Canada.

Tax treatment

26. What is the tax treatment for hedge funds?

Funds

Hedge funds structured as trusts are generally subject to the same tax treatment as open-ended retail funds (see Question 13, Open-ended retail funds: Funds). However, where the fund does


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not meet certain dispersal requirements (essentially, a minimum of 150 unitholders) it does not qualify as a mutual fund trust for tax purposes, which means its tax treatment is different, and often less favourable.

Hedge funds structured as limited partnerships are not tax-able. All the partnership’s income is allocated to the partners. The partnership is considered a non-resident for Canadian with-holding tax purposes if even one member of the partnership is a non-resident.

Resident investors

Individual trust unitholders who are resident in Canada are gen-erally subject to the same tax treatment as for investments in open-ended retail trust funds (see Question 13, Open-ended retail funds: Resident investors). However, if the fund does not qualify as a mutual fund trust, the tax treatment differs and the units may not be qualified investments for Canadian tax-deferred retirement and savings plans.

Individual limited partners resident in Canada are subject to Canadian tax on their share of the partnership’s income. This income retains its character in the hands of the partners. Dispositions (including redemptions) of the trust or partnership units trigger a capital gain or loss. One-half of a capital gain is included in income and one-half of a capital loss can be claimed against capital gains.

Non-resident investors

Non-resident unitholders of a trust are generally subject to the same tax treatment as for investments in open-ended retail trust funds (see Question 13, Open-ended retail funds: Non-resident investors). However, if the fund does not meet the dispersal requirements, the tax treatment differs.

Distributions of all capital gains to non-residents by a trust that is not a mutual fund trust are subject to Canadian withholding tax. Capital gains realised by a non-resident on the disposition of a unit of a trust that is a mutual fund trust are usually not subject to Canadian tax as the units are typically not taxable Canadian property.

If the trust is not a mutual fund trust and more than 50% of the value of the units is derived directly or indirectly from certain Canadian property, the units are taxable Canadian property and capital gains on the units are subject to Canadian tax (subject to relief under a tax treaty between Canada and the jurisdiction in which the investor is resident. There is an additional requirement for the purchaser (including the fund on a redemption of units) to withhold and, unless the vendor unitholder provides a certificate of compliance from the Canadian tax authority, remit 25% of the purchase (or redemption) price on account of the non-resident.

Non-resident partners are generally subject to Canadian tax on their share of the partnerships’ income earned in Canada. Capital gains realised by a non-resident on the disposition of a unit of a partnership can be taxable in Canada if the unit is taxable Canadian property. In addition, the purchaser will be required to withhold and remit 25% of the purchase (on redemption) price if the unit is taxable Canadian property unless the vendor unitholder provides a certificate of compliance from the Canadian Tax authority.

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

The fund manager determines the redemption rights, which have an impact on how the fund is regulated in Canada. Redeemable products are generally referred to as mutual funds and are more heavily regulated.

Transfer to third parties

The transfer rights are generally regulated only for exchange-listed products. Privately offered funds are subject to resale restrictions under securities laws (which limit their resale to accredited inves-tors and other exempt purchasers). The fund manager can, and typically does, impose its own restrictions on transfer rights.

Reform

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

Rules aimed at increasing transparency and accountability con-tinue to be imposed at both the regulation-making and the com-pliance-audit levels. Financial reporting requirements that com-ply with International Financial Reporting Standards have been imposed on fund managers, but have not yet been imposed on hedge funds. There have been no high profile lawsuits aimed at hedge fund managers in Canada, other than suits arising from fraudulent schemes.



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Qualified. Canada (Ontario), 1983

Areas of practice. Investment funds; asset management.

Recent transactions � National leader of over 50 investment management

lawyers.

� Lead external counsel to numerous bank-owned and independent fund managers and portfolio managers, many of which are non-Canadian or have non-Canadian parent companies.

� Advising manager, portfolio manager and dealer clients on a wide range of registration and compliance issues.

� Assisting various clients with direct and indirect invest-ments in China A shares and other international invest-ment strategies.

� Acting as counsel to, among others, the Independent Review Committee of the TD Mutual Funds (Canadian equivalent of a US fund board).


Areas of practice. Investment funds; asset management.

Recent transactions � Practice is focused on the areas of domestic and off-

shore hedge funds, investment management companies, securities regulation and regulatory compliance.

� Regularly assisting portfolio managers in creating new hedge funds, mutual funds and other pooled fund products.

� Advising Canadian and foreign issuers and investors in relation to the private placement of securities.

� Representing and advising portfolio managers, dealers and investment fund managers on ongoing legal compli-ance matters and regulatory audits.

JOHN E HALLBorden Ladner Gervais LLPT +1 416 367 6643F +1 416 361 7379E [email protected] www.blg.com

RONALD KOSONICBorden Ladner Gervais LLPT +1 416 367 6621F +1 416 361 7325E [email protected] www.blg.com

CONTRIBUTOR DETAILS


Areas of practice. Tax law, with an emphasis on investment funds and structuring investment products.

Recent transactions

Practice focuses primarily on the investment fund industry and related tax issues, including:

� Fund structuring.

� Taxation of innovative investment strategies and derivatives.

� Fund reorganisations.

� Structuring and reorganising management and dealer businesses.

� Sales commission financing.

� International tax planning.

CRAIG J WEBSTER Borden Ladner Gervais LLPT +1 416 367 6149F +1 416 361 7373E [email protected] www.blg.com


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Funds Law categories of The Best Lawyers in Canada ® 2012 and the Investment Funds and Asset Management category

of the 2011 Lexpert ®/American Lawyer Guide to the Leading 500 Lawyers in Canada. The Firm is also ranked in the

Leading category for Investment Funds in Canada by the Practical Law Company.

With over 750 legal professionals spanning six offices in Canada, BLG is ready to help you chart a successful course.

To find out how Canada’s top Investment Management team can assist you, contact John Hall at 416.367.6643 or

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