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.