It’s been a stressful few months for investors using the popular swap-based ETFs from Horizons. These funds have been available since 2011 and have attracted some $5.3 billion in assets because of their innovative, tax-efficient structure. But when the federal government released its budget in March 2019, it looked like the days of swap-based ETFs might be numbered.
The day after the budget, Horizons issued a press release saying the company was “actively pursuing alternatives to mitigate any potential future tax impact on the ETFs or their unitholders.”
Following the release of draft legislation in July, Horizons has developed new a plan for keeping its swap-based ETFs alive. The funds will be restructured, but when the dust settles, the company expects the ETFs to continue operating “in a manner that provides unitholders with all of the same benefits that they have enjoyed for the past ten-plus years, including minimal tracking error, tax efficiency and competitive fees.”
Let’s take a detailed look at the expected changes to these ETFs, and what they’ll mean for unitholders.
A tax-efficient structure
First, some background on the structure of these ETFs, which are unique in Canada. Rather than directly holding the individual stocks and bonds in their benchmark indexes, Horizons’ family of 44 ETFs use an instrument called a total return swap. If the stocks in the index experience, say, a 5% increase in price and pay a 2% dividend, the swap would gain 7% and investors in the ETF would receive that return minus fees.
Most of the swap-based ETFs in Horizons’ lineup are inappropriate for Couch Potato investors, but many buy-and-hold indexers use the Horizons S&P/TSX 60 Index ETF (HXT) and Horizons S&P 500 Index ETF (HXS) for the Canadian and US equity markets, respectively, and the Horizons Canadian Select Universe Bond ETF (HBB) has also been popular with investors looking for tax-efficient exposure to bonds.
Swap-based ETFs have a number of advantages. The first is they’re virtually guaranteed to deliver the same return as the underlying index, minus only a fee that is known in advance. Traditional index funds sometimes lag their benchmarks by larger amounts, which is known as tracking error.
But their biggest advantage is tax efficiency: rather than paying dividends or interest in cash, swap-based ETFs are designed to pay no distributions at all, which means unitholders receive no taxable income. All of the gains are deferred indefinitely, and they’re only taxable when you sell your units, at which point they’re taxed as capital gains. That means the swap structure can result not only in tax deferral, but also a significant tax reduction.
The problem is that any strategy for reducing taxes eventually faces the scrutiny of the Canada Revenue Agency. The CRA has put the kibosh on a number of tax-advantaged investments over the years, including income trusts and forward agreements, and it recently squashed one of the advantages of corporate class mutual funds (much more about these later).
The 2019 budget seemed to make swap-based ETFs the next target. On page 371, the government proposes to introduce new legislation aimed at funds that “convert the returns on an investment that would have the character of ordinary income to capital gains,” which of course is what swaps are designed to do.
But it’s important to clear up this misunderstanding: the government has never specifically targeted total-return swaps. That’s a key point, because even after the Horizons ETFs are restructured, they will continue to use swaps to deliver returns to their investors.
It’s not about the swap
So if the government has no issue with swaps, then what’s the problem here?
It has to do with an accounting technique called the “allocation to redeemers methodology.” This gets complicated, but the important idea is that it was originally designed to prevent situations where there would be double taxation when a mutual fund investor sells some of her units, and the fund in turn sells some securities to free up cash to pay that investor.
The allocation to redeemers methodology is intended to prevent this double taxation by allowing the mutual funds to claim a deduction that offsets the capital gain claimed by the party making the redemption. This is not a tax loophole: the CRA has issued several rulings approving of the practice for some 20 years. However, the government believes some mutual funds and ETFs have been misusing the methodology.
Swap-based ETFs have been using the methodology to allocate income (as opposed to capital gains) to their market makers, the financial institutions that ensure there is always an inventory of ETF units to buy and sell on the exchange. As a result, the government believes what was supposed to be a tax-neutral transaction has turned out to be a form of tax avoidance.
The bottom line is that the new legislation would prevent swap-based ETFs from using the allocation to redeemers methodology. As a result, the ETFs would no longer be able to offer their unitholders the same tax benefits they enjoy now.
A touch of corporate class
All right, let’s move on to the plan Horizons has drawn up to address this problem.
Later this year, the company will merge all 44 of its swap-based ETFs into a single mutual fund corporation, with each ETF being issued as a different share class. “The corporate class structure is expected to preserve all of the benefits offered by these ETFs under their synthetic investment strategies,” says the Horizons press release.
This is going to need some unpacking as well, so here goes. The vast majority of mutual funds (and remember, ETFs are simply a type of mutual fund) are organized as trusts. Trusts don’t pay any tax as long as they pass along all of their dividends, interest and capital gains to their unitholders. You may have noticed that when you receive a T3 slip from your ETFs or mutual funds at tax time it’s described as a “Statement of Trust Income Allocations and Designations,” and there are different boxes for eligible dividends, capital gains, other income, and so on. Now you know why.
But not all mutual funds or ETFs are set up as trusts. Instead, some are structured as corporations. A mutual fund corporation typically owns several portfolios of stocks and bonds with different investment objectives, and each is assigned a different share class. For example, it might issue a share classes for bonds, another for Canadian stocks, and a third for foreign stocks. These share classes are referred to as “corporate class funds,” and each can be purchased separately.
Unlike a trust, a mutual fund corporation must pay taxes on its net income, and it can only distribute lightly taxed eligible Canadian dividends and capital gains to its shareholders. A corporation can also aggregate all of its income and expenses, even across the various share classes, giving it some control over how much it distributes to each one. For these reasons, corporate class funds are offered as tax-efficient options by most large mutual fund companies, as well as by two Canadian ETF providers (Purpose ETFs and CI First Asset).
By setting up a mutual fund corporation that covers all of its swap-based ETFs, Horizons should be able to comply with the new legislation proposed in the 2019 budget. The allocation to redeemers methodology is only relevant for mutual fund trusts, not corporations, so the new structure would sidestep this issue and stay out of the crosshairs of the Canada Revenue Agency.
What does this mean for unitholders?
Following the conversion, the day-to-day experience for investors in the Horizons funds should not change. They’ll continue to trade on the TSX with the same tickers, although Horizons says their names may change slightly to reflect the new corporate class structure.
Inside the new corporation, the investment strategy will also remain largely unchanged. Each individual share class will continue to be tied to a total return swap, just as it is now. Horizons has also said the management fees and swap fees will stay the same.
That said, if you’re a unitholder of any of the affect ETFs, you’ll need to take some action in the coming weeks.
First, you will be asked to vote in favour or against the proposed changes. If you hold one of the affected ETFs in a self-directed account, your brokerage is responsible for sending you the relevant materials. If you hold the ETFs in a managed account, speak to your advisor.
In practice, many individual unitholders will not bother to vote, and proposed changes like these virtually always get passed anyway. So if you choose not to exercise your vote, it’s not likely to make a difference.
Much more important is that each unitholder will have to make a joint election under Section 85 of the Income tax Act. This is a part of the tax code that allows an individual to transfer (or “roll over”) property to a corporation without an immediate tax consequences. Horizons has created a web page about this process (updated November 20, 2019).
If you fail to make this election and continue to hold on to your ETF units, you could potentially face significant tax consequences. Your old units may be subject to a deemed disposition, which means the CRA would consider them to be sold at market value, and any accumulated capital gains would be taxable in the current year.
What are the risks?
Should investors be concerned about additional risks in the new corporate class structure? And what is the likelihood that the new ETFs will continue to deliver the returns of their underlying indexes with no taxable distributions?
Impossible to know, of course, but it’s possible the mutual fund corporation will earn income that cannot be fully offset by expenses, which would require it to pay income taxes, something mutual fund trusts normally don’t do. If that’s the case, holders of the corporate class ETFs might see higher tracking error.
If the new corporate class ETFs are forced to pay distributions in the future, the good news is they would be in the form of tax-efficient eligible Canadian dividends or capital gains, even if the share class is tied to an index tracking foreign equities or bonds, since corporations can’t distribute other types of income. (At tax season, you would get a T5 slip rather than a T3.)
Horizons says they don’t expect tracking error or taxable distributions to be a problem, as they believe there will be enough losses and expenses to offset any income received within the corporation.
Perhaps the most obvious question is whether these changes are simply kicking the can down the road. The government has consistently shown its willingness to shut down tax-reducing investment fund structures. So what’s to stop them from targeting total return swaps directly, or simply disallowing the corporate structure for mutual funds?
Horizons readily admits that the federal government ultimately can do whatever it wants. For its part, the company argues that there are approximately $157 billion of assets in corporate class mutual funds in Canada, so a decision to shut them down would have a huge impact on investors. That’s true, but in 2016 the government did take away one of the biggest benefits of corporate class mutual funds: the ability for investors to switch from one share class to another without realizing capital gains. It’s not a stretch to imagine they could take further steps if they believe corporate class funds are costing them significant tax revenue.
That said, if you’re a unitholder in these ETFs, it would appear you have nothing to lose from voting in favour of this new structure and continuing to hold on to your investment. If, ultimately, the funds are forced to distribute taxable income, or even if they’re closed altogether and you’re forced to liquidate your holding, it’s still in your best interest to make the Section 85 election now and defer the gains as long as you can.
Horizons has created a useful FAQ with more information.
Hi, I just found out that I have to complete the T2057 form. Can anybody provide an example of how to fill it out please? The information at Horizon web site is not clear to me. Thank you very much in advance!
Can someone share the non-sensitive portion of 2057 (ie pg 2 and pg 3)? The info should be the same for everyone with the exception of # of shares, ACB and Questions 5, 6, 8?
You do not have to fill out a joint election form if you have a loss at the time of the reorg., but can you claim a loss for 2019 taxes
For those who filed their tax returns by overriding box 21 on their T5008 (after opting to do a Section 85.1 rollover), have you received a Notice of Assessment already? I got contradictory responses from two tax accountants and so still bit unclear on how to proceed. Please write back with your experience!
ok, its now the end of May 2020 , a bit late on this topic, and/but for various reason I am finally getting into our 2019 income tax filing: Recently, doing my taxes, found/reviewed the T5008 info from CRA info download into turbo tax, and noticed the surprise tax impacts of what horizon did -unbeknownst to me – in December 2019 ; the machinations and associated tax implications of that move 6 months ago now require dealing with. Found the abovethread, indeed illuminatory ;
I do thank the original post (Dan B) and all the above commentators for their insights.
I have the cra T2057 form printed, working on attempting to complete, and/but it seems to me on the balance, the downside of all the overhead and risk of ‘follow up tax issues’ are not worth the small savings on my income tax bill. Compounding this I might be late on some unknown and unspecified reporting/filing deadlines and will face some unspecified fines and fees. Thinking I will just pay the tax on the capital gains in 2019 – then I will sell – get out of all horizon funds. good riddance. Life is too short to get sucked into this ‘too good to be true’ investment and be faced with the headache of dealing with it that is way bigger than any tax saving. Just too complicated. the very antithesis of Couch potato. Regretting my association with Horizon.
Cameron in Kanata: I don’t know anything, but here is some information that may be helpful for anyone who did not proceed in a timely manner with the requests Horizons sent out last year to unitholders. (There was a website dedicated to this process, but it is now closed).
After you followed the process, Horizons was sending out completed copies of the T2057 complete with signature and all you had to do was sign and mail them.
If you never went through that process and your T5008 amounts are substantial, you can still take action. Subject to the fact that I am not an accountant and anything I write cannot be taken as advice, and you are 100% responsible for your own taxes, it is my understanding is that you can still proceed and should not pay any tax, although if you miss the June 1 tax filing deadline for sending in the T2057 you might face interest or penalties.
Filing the T2057 means you should be able to overlook the T5008, provided you file the co-signed T2057 form and send it CRA.
This Horizons site explains the process.
Once you fill out the T2057, you send it to Horizons for their signature: :
Attn: Chief Compliance Officer
55 University Avenue, Suite 800
Then Horizons sends you back the signed T2057 so you can submit it to CRA.
I hope that helps you or anyone who is trying to do this last-minute. Again, I am a total idiot so please check everything out yourself.
……….review Horizons’ website information, contact Horizons for clarification,and speak with an accountant.
Still have some time to get the forms filled and submit your taxes without penalties…at the latest Sep 1, 2020
So, can anyone tell me if the tax advantages of HXT over VCN are now obsolete?
Just to clarify that if you held one of the Horizon funds in an RRSP then you do not need to fill out any of these forms?
@Scott: That’s correct.
It’s been 10 months or so since the conversion. Would you have any opinion or knowledge or guess as to whether the new structure is likely to withstand CRA scrutiny? I currently have shares of HXT and HXS in a non-registered account (and I went thru the T2057 song-and-dance) and am wondering if to double down, so to speak, or to look at something like XEQT instead.
Anything you can say on the matter appreciated.
@Jim R: I’m afraid I have no inside information here. The government has shown a pattern of shutting down tax-advantaged structures, but it’s impossible to predict whether this one will persist.
Hi Dan, I notice HXT and HXS are displaying counterparty exposure between 30 and 40% on the Horizons website. Wasn’t this exposure supposed to be limited to 10%? I found an Advisor’s Edge article that you participated in(but did not write) which included the following:
“ETFs are governed by NI 81-104, which permits 10% maximum counterparty exposure within a fund.” https://www.advisor.ca/news/etfs/whats-a-total-return-swap/
Did the reorganization somehow change this or do you know why counterparty risks are being allowed to significantly exceed 10%?
Hmmm, I also just realized that counterparty exposure had significantly increased, and was about to ask some of the same questions as gsp (who beat me to it).
So at the risk of repeating what’s already been asked:
1) Any idea why counterparty exposure has increased so significantly?
2) Should a unit holder be concerned about this increase? 30% to 40% seems like a scary amount of exposure compared to 10%.
3) Why is counterparty exposure now allowed to exceed 10%? I’ll make a WAG that corporate class ETFs are not subject to the 10% ceiling restriction, unlike trust ETFs.
As a unit holder of HXS and HXT, any answers on this appreciated.
@gsp and Jim R: I reached out to Mark Noble at Horizons ETF, who provided a thorough response to your questions. The executive summary: the 10% maximum counterparty exposure is no longer a requirement as of January 2019. And the reason the current counterparty exposure is so high is that the funds did some tax-loss selling of the swaps during the downturn in March and the subsequent recovery increased the banks’ obligations. Full response below.
Truly appreciated blog post! Thanks =)
Just wanted to share a special niche I think these total return ETF have for me.
I have a very smallish LRSP because of my former job. Because the amount in this account is so small, I would not be able to reinvest the dividends without loosing all gains due to transaction costs. There is no use to get a 50$ dividend if you have to pay 10$ to reinvest it.
Is my reasoning good or would you rather ask your brokerage to create a DRIP on this LRSP?
@Thiéry: If the distributions are enough to buy at least one share, then I would likely just use a traditional ETF with a DRIP.
Hello everyone. Sorry this may be a bit of a dead thread. I have held some HXTs since 2018, but I somehow missed all of this until just now when I discovered the unexpected T5008 from the 2019 tax year in my Questrade account when preparing for 2020. I’ve followed the process all online, and I went through the process to send T2057 to Horizons, which they turned around to me via email in just a few days.
My question is regarding the penalty I will need to pay for filing this election late. In the penalty section of T2057, the formula takes into account the number of months since the filing deadline. Am I correct in understanding that the filing deadline would have been September 30, 2020, so I will need to count all months starting with October 2020? I tried Googling this specific question but I couldn’t find anything. Makes me think I’m the only one who completely missed these necessary steps this late.
Thanks for any advice.
Hi Wesley, You are not the only one who missed this – I also made the same mistake and I am just starting the process of trying to figure it out. Can you tell me if you managed to get an answer to your question?
I bought some HGRO last year after the changes to the ETFs. It is a Horizon Total Return ETF that holds other swap based ETFs by Horizon for exposure to different indexes. I was surprised to receive a T3 this year for capital gains and dividend income as it is supposed to be a tax efficient ETF where you pay the tax on sale. I sent an email to Horizon yesterday and will see if they respond but figured I would ask here in case Dan or anyone else knows why this T3 was issued (even in this article Dan says if income were to be paid out it would be a T5)
@Jerry: See the section titled “Your year-end surprise” in this blog:
Thanks for the response! I just got an e-mail from Horizon in response to my inquiry that was basically the same answer/explanation so I was coming back to add a comment for others but I still that you already responded very quickly after my initial post. I do love you site and recommend it to anyone that asks me “how do I get involved in investing”. Such a great resource plus more advanced topics for others that want to know more too!
@Jerry: Many thanks for the kind words, and glad you found the answers you needed!
Is there a Horizons equivalent for VCE.TO? I am getting killed with the withholding tax being a non-resident canadian (25%). Thanks
@Mark: HXT tracks a similar index.