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.