How the 2013 Budget Will Affect ETFs

The federal budget on March 21 included a proposal to put an end to investment funds that “seek to reduce tax by converting, through the use of derivative contracts, the returns on an investment that would have the character of ordinary income to capital gains.” (For the complete text visit the Budget 2013 website and scroll down to the heading “Character Conversion Transactions.”)

These proposed changes affect a number of ETFs, as I explain below. I stress that none of what follows should be considered tax advice: it’s still not clear what changes will be made to the Income Tax Act, nor how these changes will be interpreted. If you own any of the affected ETFs, you should consult with a tax specialist before taking any action.

Advantaged ETFs. The iShares Advantaged ETFs (originally launched by Claymore) will all be affected by the proposed changes, as BlackRock Canada confirmed in a press release on March 25. These ETFs use a type of derivative called a forward agreement that re-characterizes bond interest or foreign dividends (both of which are fully taxable) as return of capital and capital gains. I explained this complicated structure back in 2011, and some of these ETFs were included in one of my model portfolios until I removed it in January. Here are the five affected funds:

iShares Advantaged Canadian Bond (CAB)
iShares Advantaged Convertible Bond (CVD)
iShares Advantaged U.S. High Yield Bond (CHB)
iShares Advantaged Short Duration High Income (CSD)
iShares Global Monthly Advantaged Dividend (CYH)

The press release also states the affected funds are no longer allowing the creation of new units, but “they are available and continue to trade normally in the secondary market.”

Commodity ETFs. The second affected category is commodity ETFs that use futures contracts. (I wrote about managed futures last July. Since the budget proposal clearly targets funds that re-characterize income, it would seem the most vulnerable commodity ETFs would be those that pay distributions, such as the Horizons Gold Yield (HGY) and the Horizons Natural Gas Yield (HNY).

It’s less clear what will happen to commodity ETFs that use futures but do not distribute any income. BlackRock’s press release does mention that the iShares Broad Commodity (CBR) and the iShares Managed Futures Index Fund (CMF) will be affected by the changes, even though neither has ever paid a distribution.

The proposed changes will not affect ETFs that hold precious metals directly, such as the iShares Gold Bullion Fund (CGL) or the iShares Silver Bullion Fund (SVR).

Swap-based ETFs. Several readers have asked whether the popular Horizons S&P/TSX 60 (HXT) and Horizons S&P 500 (HXS) will be affected. In a press release issued March 22, Horizons made it clear it believes the answer is no: “HXT uses a type of derivatives contract known as a total return swap, and through this structure there is no re-characterization of income taking place by HXT which will be affected by the Character Conversion Budget Measures.” I confirmed with Horizons that HXS, which uses the same type of structure, is also believed to be unaffected.

The ETF specialists at National Bank Financial agree. A report on the proposed changes states their belief that HXT and HXS “are not impacted by these rules given their structure and lack of distributions.”

Look for the best before date

While no one yet knows what legislative changes will follow, ETF investors don’t need to beat a hasty retreat from these funds. The budget states that “this measure will apply to derivative forward agreements entered into on or after Budget Day,” or those extended after March 21. McMillan LLP, a Toronto law firm, stated in its budget report that “investors in such funds with forward contracts entered into before Budget Day will generally be ‘grandfathered’ from the effect of the new character conversion transaction proposals.”

This means if you held the affected funds during 2012, the tax return you file this month should not be affected. In fact, some of the forward agreements in these ETFs do not expire for several years, so investors might continue receiving tax-advantaged income for some time yet.

First Asset, which has one bond ETF that uses a forward agreement, has already issued an opinion on this matter: “Based on its review to date, First Asset believes that these changes will not affect First Asset Morningstar Emerging Markets Composite Bond Index ETF … or the tax treatment of its distributions, until the expiration of the Fund’s forward agreement in September 2015.”

BlackRock hasn’t yet commented, but you can learn the expiration date of the forward agreements in the affected iShares ETFs from the 2012 financial statements: look in the footnotes at the end of each individual fund’s statements. For example, for CAB the note on page 121 says, “The equity forward agreement, with an expiration date of November 19, 2014, is entered into with TD Global Finance having a Standard & Poor’s credit rating of AA-.” Some of the forward agreements don’t expire until 2016 or 2017.

If you have questions about individual funds in your portfolio, don’t hesitate to email a customer service rep at iShares, Horizons, or other ETF provider.

22 Responses to How the 2013 Budget Will Affect ETFs

  1. Maurcar Hoche April 2, 2013 at 1:57 pm #

    Unlike First Asset, BlackRock iShares have hedged its bets and did not indicate grand-fathering of the distribution tax treatment until the expiration of the forward agreement. It simply states “Depending upon the application of a proposed measure in the 2013 Federal Budget relating to any extension or replacement of the Forward Agreement following the Budget date, such distributions may be treated as ordinary income.”

    BTW, the expiration date of January 9, 2015 is for CHB, not CAB (Nov 19, 2014).
    Also, CYH’s forward agreement expired Jan 15, 2013. Can one assume the forward agreement was extended such that it expires Jan 15, 2018 (assumption is a 5 year renewal)?

  2. Canadian Couch Potato April 2, 2013 at 2:07 pm #

    @Maurcar: The consensus view seems to be that existing agreements will be grandfathered. You’re correct that iShares has not issued a clear opinion, but it’s important to remember that it is not up to the ETF provider. The final decision rests with CRA.

    Thanks for pointing out the error regarding CAB/CHB, which is now fixed. Regarding CYH, I would not assume anything regarding the renewal of the forward agreement: that is definitely a question only iShares can answer reliably.

  3. Melvin April 2, 2013 at 2:27 pm #

    So does that mean individuals holding these ETFs in a registered account are unaffected by this change in legislation?

  4. sleepydoc April 2, 2013 at 6:52 pm #

    Thanks for reading my mind – this topic is exactly what I have been thinking about since budget day! While I guess one doesn’t have to “beat a hasty retreat” from these funds just yet – when does that retreat start? As the forward agreement renewal date draws near, wouldn’t the value of my CAB holdings steadily drop – who would want to buy my shares knowing that the tax-advantage is lost? What are the options of these funds at the renewal date – taking CAB for example, I suppose it could just become an interest bearing bond fund, but I would imagine that would not be unlike XBB. Can they just close the fund and give your money back as cash with a capital gain/loss? Do they just split the NAV by the number of shares – in which case would it be better to hold on to shares until the bitter end?

  5. Melvin April 2, 2013 at 9:39 pm #

    @sleepydoc “As the forward agreement renewal date draws near, wouldn’t the value of my CAB holdings steadily drop”

    I don’t believe the price of CAB will go down since it “aims to provide a return based on the price and performance of the DLUX Capped Bond Index”. Therefore the price of the ETF should follow it’s index.

  6. Andrew F April 3, 2013 at 10:21 am #

    I wonder if this will be like a game of whack-a-mole. If total return swaps are exempted, as with HXT and HXS, then there will be a market for a total return swap high yield bond fund, at the least.

    I’m sure those investors who are fixated on cash distributions will be dismayed, but those who realize that total return is total return ought to be comfortable with a total return fund that does not pay distributions.

  7. Canadian Couch Potato April 3, 2013 at 10:22 am #

    @Melvin: In theory, investors who hold any of these funds in registered accounts should not be concerned about how the distributions are characterized. However, investors should never hold the Advantaged ETFs in a registered account: by doing so, they are paying at least 50 basis points for a structure that gives them absolutely no benefit. There are always better alternatives for registered accounts.

    The other important concern is that once the tax advantage of these funds is eliminated by legislation, they may be terminated. It is way too early for any of the ETF providers start talking about liquidating these ETFs, but the fact that iShares is no longer creating new units would seem to be a red flag.

    @sleepydoc: Remember that an ETF’s net asset value is determined by its underlying holdings, not the desirability of its structure. If a fund like CAB holds a portfolio of bonds (even if it does so indirectly via a forward agreement) its net asset value will be equivalent to the value of those bonds. You’re correct that the demand for the ETF will fall dramatically, but that should not affect the fund’s net asset value.

    It’s possible that the ETF providers will convert these funds rather than liquidating them. For example, when the new income trust rules came into force, iShares did not terminate its income trust ETF: it simply changed the strategy to continue focusing on income, but with dividend stocks, REITs and bonds instead.

    If an ETF provider does decide to liquidate a fund, you typically get a couple of months’ notice, during which time you can decide to sell the ETF if you desire. If you hold on until the fund is liquidated, you will receive a cash payment equal to the net asset value of your holdings. If there is any capital gain or loss, you would need to report that.

    @Andrew F: Your logic is right on, but if we know anything, we know that most investors are not interested in total return, they’re interest in income. How else to explain the popularity of income-oriented ETFs that use covered calls or pay out return of capital?

  8. sleepydoc April 3, 2013 at 2:27 pm #

    Thanks. I guess the term value was ambiguous in my earlier post. I realize that the NAV is determined by the underlying holdings, but what I was referring to was the market value or price/share. If I sell all my shares, the cash I would receive would depend on the market price at the time. I thought that the market price is essentially determined by the demand, not the NAV (although I realize it should be close). I would have thought that if a product like CAB no longer has benefit, the demand would go do, as would the market price, regardless of the NAV.

  9. Canadian Couch Potato April 3, 2013 at 2:44 pm #

    @sleepydoc: That was the case with income trusts, but individual securities and ETFs are very different in this respect. Regardless of the demand for the ETF, its market price should not diverge significantly from its NAV—at least not for any sustained period of time. Not sure if you saw these posts from a couple of weeks ago:

    http://canadiancouchpotato.com/2013/03/13/two-ways-to-measure-an-etfs-performance/
    http://canadiancouchpotato.com/2013/03/18/the-etfs-price-is-right-except-when-its-not/

  10. Canadian Couch Potato April 3, 2013 at 4:32 pm #

    @Jas: There should be no impact on corporate class funds, since these are not designed to re-characterize distributions. The idea behind corporate class funds is they allow you to rebalance a portfolio by selling equities and buying bonds (or vice versa) without realizing capital gains. The do not use forward agreements to do this.

  11. sleepydoc April 3, 2013 at 11:29 pm #

    Your posts in March about ETF pricing were exactly what made me worry. The take home point for me from those articles were that 1) you don’t generally have to worry “especially if you’re a long-term investor who holds your ETFs for many years” and 2) that “large discrepancies occasionally indicate a genuine problem with the way the ETF is managed”, generally relating to low trading volume or illiquid underlying securities. I had figured that if these funds are forced to liquidate, you 1) can’t be a long term holder in and 2) trading volume would drop off and the ETF can’t be managed according to its original intention. This is why I had thought that the market price and NAV for these products would diverge significantly.

    I’m a bottom line kind of guy, and I take it that in the case of the Ishares advantaged products, one would still benefit from and could continue to buy shares until shortly before the renewal date of the forward agreement. Could you explain what “no longer allowing the creation of new units” means?

  12. Canadian Couch Potato April 4, 2013 at 8:59 am #

    @sleepydoc: Regarding the creation of new units, ETFs are “open-end funds,” which means that when new money flows in the fund can simply but more assets and issue new shares. Mutual funds work the same way, but this is different from a closed-end fund or an individual stock, both of which have a finite number of units. If you want to invest in a closed-end fund or a stock, you need to buy existing shares from another investor. Here’s a complete explanation:
    http://canadiancouchpotato.com/2011/12/28/an-etf-creation-story/

    If an ETF provider no longer allows the creation of new units, it means that any new purchases will have to come from existing inventory. This will never be a problem for retail investors, but if an institution wanted to buy a few million dollars worth of shares it might not be able to do so.

  13. Brian April 4, 2013 at 10:01 am #

    I just read an article on the Toronto Star, the 2013 budget contained what it called bail-in rules that it could impose should one of the country’s big banks face collapse (a worst case scenario). Basically the author stated that deposits over 100k and mutual funds would be at risk if the Canadian Government wanted to take that money to prop up a faltering bank. Because the article explicitly mentioned mutual funds and not ETFs, I wonder if this is another benefit of ETFs or if the article is just not well written and ETFs would be at risk as well? Any thoughts?

  14. Andrew F April 4, 2013 at 11:34 am #

    I don’t think MFs would be at risk as they are structured as separate corporate entities–they are not generally liabilities of the manager. I would even be surprised if uninsured deposits were affected by a bank failure unless it was a very severe one.

    And mechanically speaking, a bank failure that affects depositors should affect all depositors equally (ie, a 10% loss), only the deposit insurer would face a claim for 10% of insured deposits. It’s not that the full brunt of the bank restructuring would fall on deposits over the insurance limit, as in Cyprus. That means CDIC would still be on the hook for losses.

    Unless of course the government changes the rules…

  15. Canadian Couch Potato April 4, 2013 at 11:57 am #

    @Brian: I agree with Andrew—I can’t imagine the government going after investment funds. If they did, however, I can’t see why ETFs would be treated differently from mutual funds. I have to say the whole idea seems pretty alarmist.

  16. Brian April 5, 2013 at 10:18 am #

    “Unless of course the government changes the rules…”

    That was exactly my point, in the 2013 budget it appears that the government IS changing the rules . I agree the article was alarmist, and I think that CDN banks are in better shape than the banks in Cyprus so the situation may never arise – but it seems they are putting rules in place to do exactly what was done in Cyprus if ever the need arises. Using uninsured funds (ie over $100k CDIC limit) and non-guaranteed investments (mutual funds were mentioned in the article, and I agree with CCP that ETFs probably as well) to prop up a bank about to collapse. I could not believe what I was reading so that is why I asked the original question.

  17. Park April 8, 2013 at 9:12 am #

    Advantaged ETFs were costing the government revenue, and so they will no longer be permitted. A precedent has been set. Swap-based ETFs are also costing the government revenue. Will one day they no longer be allowed? I think of income trusts.

  18. Al September 10, 2013 at 2:15 pm #

    What is the latest on the claymore advantaged etfs. are they still trading? any role for them?if not are they going to be rolled over into another entity?

  19. Canadian Couch Potato September 10, 2013 at 2:31 pm #

    @Al: They are still trading, but I believe most are no longer accepting new subscriptions. They may enjoy their advantaged tax treatment for a while longer, as the rules are being grandfathered for existing contracts. But I don’t know what iShares plans to do with these funds in the future. Once the tax advantage disappears, there is no reason for them to continue with their current mandate.

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