If you’re investing outside of tax-sheltered accounts like RRSPs and TFSAs, you need to choose your investments carefully—otherwise you risk giving a big slice of your returns to the good people at the Canada Revenue Agency. Today we’ll look at ways to create a tax-efficient index portfolio using some innovative ETFs.
Swapping dividends for capital gains
In Monday’s post, I explained that Canadian dividends are not always as tax-advantaged as people believe. Capital gains are not only taxed at a lower rate in the highest tax brackets, but investors can also control when to take them—dividends, on the other hand, are taxable in the year they’re paid, even if you reinvest them.
Horizons’ swap-based ETFs—which I wrote about here—were designed to address this issue. They use a type of derivative that allows investors to earn the same return as the index, without collecting any distributions. Dividends paid by the companies in the index are reflected in the fund’s return, but all of the growth is characterized as capital gains and deferred until the fund is sold. There are currently just two funds in the family: the Horizons S&P/TSX 60 (HXT) for Canadian large-cap stocks, and the Horizons S&P 500 (HXS) for US large-caps.
The tax advantage is especially large for HXS, because dividends from US companies are fully taxable, while capital gains are taxed at half that rate. Consider this: if you held the iShares S&P 500 Index Fund (XSP) in 2011, you received $0.24 per share in cash dividends, a yield of about 1.6%. At the highest tax bracket, you would have lost almost half of that to taxes, reducing your return by about 80 basis points. If you held HXS instead, you would have received a similar 1.6% price appreciation instead, and you would have paid no tax. If you eventually sell the fund at a profit, you’ll pay tax on only half the gain.
Forward thinking
Claymore’s Advantaged ETFs—read a detailed description here—use forward contracts that “recharacterize” bond interest or foreign dividends as capital gains or return of capital (ROC). Unlike swap-based ETFs, which pay no distributions, the Advantaged ETFs are designed for investors who want current income.
Return of capital is the most tax-efficient of all distributions, though it’s not a free lunch. ROC is not taxed in the year it’s received: instead, it lowers your adjusted cost base, and if you sell your shares at a profit in the future, you’ll incur a capital gain. So you’re not getting truly tax-free income—you’re really just getting your own money back—but you are generating tax-deferred cash flow. This document from Claymore explains the idea.
You can see why ROC is preferable to bond interest, which is fully taxable. In 2011, the Claymore Advantaged Canadian Bond (CAB) returned 6.8%. Roughly half of that came from price appreciation, while the other half came from distributions. However, unlike every other bond ETF, those distributions were return of capital, not interest. So you would have collected that entire 6.8% return without a tax bill.
Before you get too excited, there are downsides. All of the 2011 distributions from Claymore’s Advantaged ETFs were return of capital, but that won’t always be the case. In 2010, for example, CAB’s distributions were all capital gains. These would have been taxable—albeit at only half the rate of bond interest.
More important, the Advantaged ETFs have considerably higher costs than plain-vanilla index funds, which will lower their pre-tax returns. Those added costs offset some of the tax savings, and may even wipe out the advantage altogether. For example, both the iShares DEX Universe Bond (XBB) and BMO Aggregate Bond (ZAG) returned well over 9% last year—dramatically outperforming CAB. Even if you lost half your interest income to taxes, you might still have been better off with XBB or ZAG.
If you’re out of RRSP and TFSA room, you could use these ETFs to build a reasonably well diversified and tax-efficient portfolio of Canadian stocks (HXT), US stocks (HXS) and bonds (CAB). In some years—including 2011—you’ll have no tax payable at all. Just spend some time researching these complex products first, and don’t invest in anything you don’t understand simply because you think you’ll save some tax.
H&R Block software giveaway
Speaking of tax, the folks at H&R Block have offered to give away copies of their DIY tax software to five lucky Canadian Couch Potato readers. To enter the draw, leave a comment below or tweet this post to your followers before midnight EST on Sunday, January 29. I’ll announce the winner next Monday.
So much to think about. Thanks for the articles.
Good article, once again, Dan. Please enter my name for this draw!
I would appreciate H&R tax software!
Thank you for even more great information!
Good article.
Any chance this ETFs can be used to write off interest expense on money borrowed to fund a leverage investment portfolio? I understand there have to be an expectation of making an income.
Thanks!
Count me in for the draw.
I wish there were more ETFs of this type (ie, capital-gains only).
Is H&R Block’s software available for sale ( in case I don’t win ) and how does it compare to Turbo Tax?
Thanks,
Rick
Assuming our tax law doesn’t have any gaping holes in it, shouldn’t all the ETFs that track a given index give the same returns after tax? If we as investors aren’t paying as much tax (because a bond fund is providing RoC instead of interest, for example), doesn’t that just mean more tax is being payed by other parties?
I suspect that the fund provider is just paying more tax and using a higher MER to pay the tax or maybe a 3rd party in a swap who is holding actual bonds is paying more tax and charges a higher fee as a result.
Am I wrong or does it all come out in the wash?
Great Article. Please enter my name for the H&R tax software.
I would love to win some tax software!
Thanks for the info. Put me down for the tax software.
good read, enter me for the software please
Are there any US listed ETF’s that would help get around the dividend problem? I already have funds in USD and wondering if I need to exchange some of it back to Canadian to gain the benefits.
Draw please! :)
Great Article. Please call me when I win the H&R tax software.
@Canadian Couch Potato: That sounds good. I guess there aren’t enough tax efficient ETFs to put together a Tax Efficient Couch Potato Portfolio. Right?
If one holds US and international index funds (Eg. TD e-series) in the non-registered account, are the distributions taxed as interest income? (Because they are considered foreign dividends).
Hence, is it better to hold these in registered account, and hold Canadian index fund
TDB900 in non-registered?
Thanks as always Dan! And I would love a copy of the tax software.
Always learning…Thanks!
@Leverage: HXT, HXS and CAB are not a bad start for a small portfolio. If you have a large portfolio and want to branch into other asset classes, then there will be some tax implications, but you’d still be doing very well.
@Peter: Yes, you’re correct: the distributions from US and international index funds are fully taxed as income, so if possible, it’s best to keep these in a registered account. If you need to keep some money in non-registered accounts, then Canadian equities are usually the best choice.
Draw, padner!
CAB needs a bit more history, but the level of underperformance relative to XBB makes it a tough sell. I noticed that CAB has slightly better credit quality, slightly lower duration, and slightly lower YTM. These factors might have contributed to the underperformance. I suspect it is the higher MER and the forward contract fees that ate most of it.
I think a more interesting comparison is with high yield bonds, given that the interest income they generate is substantially higher. Claymore’s high yield fund is too new to make a meaningful comparison of relative performance, I think.
Hi Dan, great article!
I guess that if you hold a Canadian equity ETF (like XIC), the ETF distributions attributable to dividends (rather than turnover) would be eligible for the preferred dividend rate, but I’m not 100% sure.
I’d like to get in the draw too, thanks!
Always interested in a freebie.
Thanks, please enter me in the draw.
Please include me on the draw!
Dan: Continuing the discussion raised by @leverage’s question, how would you craft a globally diversified tax efficient portfolio? Would this type of portfolio (for a non-sheltered account) be a candidate for your “model portfolio” page? I appreciate that everyone’s tax situation is different. To account for this, perhaps you could make some simplifying assumptions. For example, you might have one “model portfolio” for someone in the highest tax bracket versus other “model portfolios” for those in lower tax brackets. Just food for thought.
Once again, you written another excellent article. Thanks.
Come on big money free tax software!
I am just starting out in the personal finance world and am newly acquainted with the Couch Potato strategy – great stuff! Please count me in for the H&R block draw.
thank you! we have been seeking tax efficient etfs for the taxable accounts as we have maxed out all our contributions for 2012! this is perfect, thank you.
btw, i have also been wondering the same as BNW above.
Informed by the article, also the linked readings are helpful. Thanks.
Nice article! The problem that remains is how not to lose the avoided taxes to higher fees.
To @Leverage & Couch Potato – here a link at CRA regarding deducting borrowing costs on investments. I am not a tax professional so I normally pay attention to the CRA guidelines – they are quite specific about only being able to deduct borrowings costs from income. So you’d need to be receiving dividends rather than capital gains.
http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns206-236/221/menu-eng.html. Cheers.
@Clint: Many thanks for the excellent link. As you say, the CRA is pretty explicit: “If the only earnings your investment can produce are capital gains, you cannot claim the interest you paid.”
Another reminder to get tax advice from accountants and other specialists. :)
@Clint: Thanks for pointing us to the CRA link. Yes, they have it very clear in there!
@Couch Potato: Thanks to you as well for making this clarification possible.
HXS sounds too good to be true. No US withholding tax! Dividends taxed like capital gains!
What is the catch?
Please include me in the draw.
Good article. Thanks.
Very interesting article. Thanks for the chance to win this :-)
Thank you for the great info. I would appreciate H&R tax software!
Please include me in the draw. Thanks.
Yes Dan, please include me in the draw for the H&R Tax software. I have been using U File, but would welcome an opportunity to try out this one since it’s free!
Good article.
Thanks, great article. Does exist any other free ETF trader , like Scotia iTrade?
First time visit to this site. Great articles. Read quiet a few of them from archieve as well… thanks for all the learning.
Am a newbie in Canada. Just have some breathing space now for investing. Hope to have landed at the right place to do my reserach before start investing in DIY mode.
And yes please add me to the free tax software lottery pool.
Thanks for another very insightful article. Please enter me in the drawing.
@Rakesh: Welcome to the site, and to Canada. Great to have you here. Don’t hesitate to post a comment or drop me a line if you have any questions about DIY investing.
@aziz: Counterparty risk, currency hedging, .3% swap fee and very low volume.
Great article. Please enter me for the draw. JD.
Thanks for the great info. Please enter me in the draw.