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The Foreign Property Rule

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The Foreign Property Rule (FPR) limits the amount that an individual can hold as foreign assets in an RRSP or RPP account. Prior to 1990, the FPR limited foreign assets to 10 percent of the book value of a portfolio. Beginning in 1991, the limit was increased gradually, 2 percent per year over 5 years, to 20 percent. Since 1994, Canada has had a 20 percent foreign-property restriction, which limits the amount of foreign investments that may be held in tax-deductible pension and retirement savings plans to 20 percent of the portfolio's book value.

Foreign property defined

Subsection 206(1) of the Income Tax Act, coupled with Section 5000 of the Income Tax Regulations define foreign property as follows.

a share of a corporation other than a Canadian corporation (as defined in subsection 89(1)), notwithstanding that the share may be listed on a prescribed stock exchange in Canada (see 3(d) and (e) below);

a mortgage on property situated in Canada or elsewhere where the mortgagor is not a resident of Canada;

deposits in a bank or similar institution outside Canada whether or not they are payable in Canadian currency;

a right or warrant to acquire a share which would, if it were acquired, be foreign property;

a share of or debt obligation issued by a Canadian corporation if the corporation's shares may reasonably be considered to derive their value, directly or indirectly, primarily from foreign property which the corporation holds as portfolio investments;

for months after 1991, indebtedness of a non-resident person, other than indebtedness issued or guaranteed by:

the International Bank for Reconstruction and Development;
the International Finance Corporation;
the Inter-American Development Bank;
the Asian Development Bank;
the Caribbean Development Bank; or
prescribed persons

a share of the capital stock of an investment corporation other than a registered investment or one prescribed by section 5000 of the Regulations (Revenue Canada, 1995).

Section (4), of the same section of the Income Tax Act explains what is not considered foreign property:

a bond, debenture or other debt obligation issued by a resident of Canada and expressed in a foreign currency, provided the issuer remains a resident of Canada;

Government of Canada treasury bills whether or not they are expressed in a currency other than Canadian;

commodity futures traded on a foreign exchange for a commodity which is situated in Canada;

other than a share described in 3(e) above, a share of a Canadian corporation listed on a prescribed stock exchange in Canada, notwithstanding that the share may be exchanged for a share that is foreign property;

foreign currency situated in Canada; and

a mortgage or other debt obligation issued by a resident of Canada and secured by real property situated outside Canada, provided the indebtedness does not provide the holder with an interest in, or right to acquire, a foreign property and is not convertible into or exchangeable for a foreign property (Revenue Canada 1995).

Maintenance of the 20 percent limit on foreign property is enforced by a penalty tax assessed on a portfolio's foreign content beyond the 20 percent limit. Specifically, the Act places a tax of 1 percent per month on any foreign assets in a Canadian pension fund or RRSP in excess of 20 percent of the book value of the fund.

A stipulation of the Income Tax Act regarding RRSPs that is not often recognized is that previously defined Canadian property can be re-classified as foreign property. Section 206(7) states that:

Property may become foreign property after it is acquired. For example, if a Canadian corporation has a portfolio of investments in Canada and abroad and some or all of the Canadian investments are realized and the proceeds disbursed, then the shares of the Canadian corporation become foreign property since they will derive their value primarily from foreign property as described in 3(e) above (Revenue Canada 1995).

Thus, even investments that were once deemed to be Canadian content can be re-classified as foreign property.

Ambiguous definitions of "Canadian" and "foreign"

It is difficult to define effectively and fairly what constitutes "Canadian" or "foreign" property. Many flourishing Canadian firms have a global market presence. They market their goods and services and issue their stocks and bonds globally. The securities they issue are traded as part of an integrated global financial market. In other words, these securities are traded concurrently on both domestic and foreign markets.

Seagram Company, Thompson Corporation, the Potash Corporation of Saskatchewan and Northern Telecom are illustrative of this trend. It is certainly true that they all started as Canadian companies. They have grown into large global firms with dispersed manufacturing, distribution, and sales facilities around the world (Ambachtsheer 1995).

Seagram Company, for example, is the fourth largest firm in Canada in terms of assets. Ninety-seven percent of its sales, however, originate outside of Canada. Ninety-five percent of the sales of Thompson Corporation, the eighth largest firm in Canada in terms of assets, come from its foreign operations. While Seagram Company and Thompson Corporation both qualify as "Canadian" content under the Act, a bulk of their sales come from abroad.¹¹

Another interesting case that has received a great deal of media attention in the last few years, is Sherritt International Corporation, which exemplifies the ambiguity present in the definition of 'foreign' and 'Canadian' content. Sherritt's assets are located in Canada (49 percent), the Bahamas (17 percent), Cuba (29 percent), and Europe (5 percent). Sherritt's revenues are similarly distributed: Canada (28 percent), the Bahamas (37 percent), Cuba (31 percent), and Europe (4 percent). Sherritt International is however, deemed to be Canadian content even though a "majority," (i.e., more than 50 percent) of its assets (or property) as well as a majority of its sales are located outside Canada.¹²

According to the Act, a company is deemed foreign content if a "majority" of the firm's "value is derived from foreign property" (Revenue Canada 1995). The term "majority," however, is not specifically defined in the Act and thus lends itself to flexible interpretation and ambiguity. The concern is not that Canadian companies are being defined as Canadian content even though they have substantial assets or sales in foreign countries. On the contrary, this type of indirect foreign exposure increases the level of diversification in an investor's portfolio.

There is, however, concern that many companies that have a presence in Canada are not considered Canadian content and thus individuals are prohibited from investing in those companies due to the FPR restrictions. For instance, IBM, the seventeenth largest company in terms of income in Canada, with 15,383 employees, is considered foreign content. Ford Motor Company, the third largest in terms of revenue, with 24,402 employees in Canada, is also considered foreign content.¹³ A similar situation exists for such other prominent companies as Intel, Home Depot, Office Depot, Honda, and American Telephone and Telegraph (AT&T), among others.

Methods of increasing foreign exposure beyond the limits imposed by the Foreign Property Rule

The impetus to manoeuvre around the FPR is enormous. As discussed in the section on portfolio management and diversification, increasing the foreign content of an investor's portfolio generally leads to reduced risk and greater long-term rates of return. As Garth Turner noted in a recent article, individuals who invested solely in the Canadian market over the last decade earned a cumulative rate of return of approximately 75 percent. Those who invested in global funds during the same period earned a rate of return of 500 percent or more (Turner 1999).

Further evidence of the adverse effects of the FPR is noted in a study commissioned from Ernst & Young Consultants by the Investment Funds Institute of Canada. It concluded that restricted Canadian portfolios were out-performed by globally diversified portfolios over the last 20 years by between 76 and 110 basis points per year (Ernst & Young 1997).

Another recent study, by the Bank of Nova Scotia, found that Canadian market returns were substantially out-performed by foreign markets. Between 1970 and 1998, the American, Japanese, French, German, British, and Hong Kong markets out-performed the Canadian market by 225.7 percent, 226.3 percent, 247.6 percent, 249.5 percent, 294.2 percent, and 715.0 percent, respectively (Corcoran 1999).

The innovative and entrepreneurial spirit that characterizes the financial markets has developed two methods for increasing foreign exposure: portfolio content and derivatives. Although both methods allow individuals to increase the amount of foreign exposure in their portfolio, and thus enable investors to increase the level of diversification, they should not be viewed as substitutes for the elimination of the FPR. Each of the methods, while furthering the foreign exposure of investors has limitations that would not exist outside the confines of the FPR. Thus, while the methods are beneficial given the presence of the FPR, they are not substitutes for its elimination.

Portfolio content (double-dipping)

The Act clearly stipulates that an individual's foreign assets in an RRP or RRSP account must be equal to or less than 20 percent of the book value of the total portfolio. The first method available to increase an investor's foreign exposure deals with the purchase of multiple portfolios.

Individuals are free to purchase investments that include mutual funds as well as to allocate their savings, or a portion thereof, to professional pension managers, as is the case with almost all employer-sponsored pensions. Each particular portfolio is limited to 20 percent foreign content. However, by purchasing a mix of portfolios, an individual investor can actually achieve 36 percent foreign content.

Suppose an individual has $1,000 to invest in an RRSP. Under the reading of the FPR, the individual would be limited to $200 in foreign assets. However, consider the scenario if the individual purchases $200 (20 percent of portfolio) worth of foreign assets through a mutual fund, invests $400 in a Canadian equity fund and the remaining $400 in Canadian bond fund. At first glance, one would conclude that the individual maintains 20 percent foreign content.

The increase in foreign content is achieved by the fact that both of the "Canadian" funds can also hold up to 20 percent of their book value in foreign assets. The Canadian bond fund could have up to 20 percent of its holdings in foreign bonds. Similarly, the Canadian equity fund could have up to 20 percent of its holdings in foreign equities. Thus, the investor achieves 36 percent foreign content by purchasing multiple portfolios, e.g. mutual funds.

Derivatives

The other method available for increasing an investor's foreign exposure without exceeding the 20 percent foreign content limit is through the use of derivatives.¹⁴ A derivative is a financial instrument that derives its value, wholly or in part, from some underlying asset. It is essentially a contract whose returns are linked to the price--or, more precisely, the price movements--of an underlying asset, such as a commodity, a share in a traded company, or a currency. (For a more thorough discussion of derivatives, their use, risk profiles, and examples, please see Appendix C.)

The critical distinction between derivatives on, say, securities and the securities themselves is that stocks are assets, "physical pieces" of a company, while derivatives are contracts based on the securities. Derivatives enable investors to control foreign assets without actually owning the asset. A derivative strategy can therefore allow investors to mirror the performance of an underlying asset.¹⁵ For example, an investor purchasing certain types of derivatives in order to mirror the Standard & Poor 500 Index can effectively match the return performance of the underlying asset without actually owning the asset.

It is important to note that the use of derivatives is extremely complex and based on a host of sophisticated mathematical formulations (see Appendix C). The main point of derivatives is that their value is derived from another asset, specifically the contracted ability to sell or buy a particular asset at a predetermined price. That is, a derivative gains all of its value from the value of the underlying asset.

The losses associated with not being able to diversify one's portfolio beyond the 20 percent limit (or, effectively, 36 percent) have led to an interesting development in the Canadian mutual-fund market.¹⁶ A recent phenomenon, based on the use of derivatives and their eligibility for RRSP and pension inclusion, is the rise of parallel foreign products offered by financial and non-financial institutions. One of the two parallel funds is 100 percent RRSP-eligible while the other is restricted by the FPR (20 percent) even though both products effectively invest in the same underlying assets. The difference is that the restricted product actually invests in the foreign assets while the unrestricted product utilizes derivatives to mirror the performance of the underlying assets.

The following section provides three brief examples of the development of parallel foreign products. Note that the funds are not restricted to any particular institution or category of assets. Each example illustrates a situation wherein a particular financial institution offers two products that are essentially the same, but where one is 100 percent RRSP-eligible and the other is restricted by the FPR to 20 percent of the portfolio value.

TD US Index Fund and US RSP Index Fund

The Toronto-Dominion Bank offers two American equity funds that track the Standard & Poor 500 (S&P 500), a broad market index.¹⁷ The fund replicates the S&P 500 by purchasing shares in the American companies in the weights used by the S&P 500. That is, the fund mirrors the index by purchasing the same stocks in the same ratios. The US Index Fund is restricted to 20 percent of an individual's portfolio because the fund actually purchases American assets. The Toronto-Dominion Bank also offers the TD US RSP Index Fund. This fund, rather than purchasing the specific equities that make up the S&P 500 Index, uses derivatives in such a way as to mirror the performance of the S&P 500. This particular fund, unlike the TD US Index Fund, is 100 percent RRSP-eligible becau se it does not actually purchase any foreign assets and provides, therefore, a means for investors to diversify their portfolio internationally beyond the limit imposed by the FPR.

There is also a material difference between the Management Expense Ratios (MER) assessed on each fund. The MER is the fee charged on funds by the providers to cover the costs associated with operating the fund and provide a reasonable return. The MER for TD US Index Fund (restricted RRSP-eligibility) is 0.66 percent of the fund's asset value while the MER charged on the derivative-based US RRSP Index Fund (full RRSP-eligibility) is 0.80. So, although the presence of the derivatives-based fund allows for greater international exposure outside of the FPR, it does so at a cost, namely a higher MER.

CIBC International Index Fund and
CIBC International Index RRSP Fund

Two similar parallel international equity funds are offered by the Canadian Imperial Bank of Commerce (CIBC).¹⁸ Although both funds invest in the same assets, one is RRSP-eligible while the other is restricted. CIBC offers the International Index Fund that invests primarily in securities in Europe, Australia, and the Far East from the Morgan Stanley Capital International Index. The fund invests in broad indices in these regions either by purchasing the respective shares in the specified ratios or by simply purchasing specific index products. The fund is deemed to be foreign content since it actually purchases foreign assets. It is, therefore, restricted to 20 percent of an individual's total portfolio. The CIBC International Index RSP Fund is offered as a fully RRSP-eligible product. The description of the fund indicates that it approximates the performance of the indices of the countries included in the Morgan Stanley Capital International Index. This fund, however, is 100 percent RRSP-eligible because it uses derivatives to mirror the performance of the various indices.

CIBC US Equity Index Fund and
CIBC US Index RRSP Fund

Another example of parallel foreign products offered by CIBC is its US Equity Funds. Again, one product actually purchases American stocks listed in the S&P 500 Index. The fund is considered foreign content because it actually purchases and holds the U.S. equities included in the S&P 500. CIBC also offers the US Index RRSP Fund, which approximates the performance of the Standard and Poor's 500 Index through the use of derivatives. The fund is 100 percent RRSP eligible because it technically does not hold any foreign assets.

The ability to increase the foreign content of an investor's portfolio has clear advantages in terms of diversification. Neither the purchasing of portfolios or the use of derivatives should be seen as an alternative to the elimination of the FPR. Rather, they are investment vehicles created within the context of the FPR to increase foreign exposure. There are costs associated with both methods, which would not otherwise be incurred if individuals were permitted to diversify their portfolios according to their investment preferences and individual risk tolerance.