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.
Thank you Dan for this helpful synopsis.
It seems that, whether it be now or a few years down the road, the writing is on the wall for swaps as a tax minimizing strategy.
Is there some other option for those who wish to hold bonds but don’t want the dividends? For example some type of stock that is generally low volatility and low return, that doesn’t necessarily correlate with the rest of the stock market?
Thanks for the great explanation. When the budget was announced I stopped buying HBB in my corporate account and switched to ZDB. Not sure if this news will make me buy more HBB now or just hold what I’ve got.
Dan: I was trying to read between the lines here — I think I understand that the 2019 legislation was intended to be aimed not at the fundamental idea of the Swap mechanism transforming the otherwise taxable benefit into a deferred capital gain for the investor, but more directed at the misuse by a small minority of investors of the accounting provision to avoid double taxation. So the complicated restructuring is only in response to the tightening of regulations in response to this misuse by that minority, not as a preamble to more sweeping prohibitions of the TRS type funds.
The reason that I understand that theTotal Return Swap fund structure is not likely to be a target for Revenue Canada’s prohibition is that while we retail shareholders out there may not be paying taxes currently on the ongoing profits earned by the underlying shares, the tax is still being paid to Revenue Canada in real time, actually by the counter-party financial institutions who are the other participants in the swap, who find it still to their financial advantage to pay the tax and to provide the financing to issue us retail shareholders swap shares with an increase in capital value equal to the declared dividend amount (on which they have paid the tax). Therefore Revenue Canada, not losing out currently in tax revenue from the profits made by the underlying shares, has no particular incentive to go after us retail shareholders by prohibiting the structure and operation of the Total Return Swap type funds. Does my reasoning above bear any resemblance to reality?
Thanks, Dan
Clearest explanation and detail I have seen on this. It removes most of my concerns.
Thanks for the great article. Wondering if you could please address this:
https://finance-yahoo-com.cdn.ampproject.org/c/s/finance.yahoo.com/amphtml/news/big-short-michael-burry-explains-104146627.html
The argument makes sense to me, but I’m curious to hear your take. Also, would you propose gradual diversification into actively managed funds or individual stocks as a solution?
Hi Dan,
Are you aware of how a US resident can make a joint election? I am a US resident and hold HXT in my taxable account. The FAQ says the following:
Will this be a taxable event for unitholders who are non-residents of Canada?
This will vary from jurisdiction to jurisdiction, however, generally, the exchange of the existing ETF units for the series of shares of the
ETF corporation will be deemed as a disposition for tax purposes.
Many jurisdictions, like Canada, have elections tax payers can make in order to defer the taxable event until they dispose of the series
of shares of the new ETF corporation. Investors should consult the local tax advisor for guidance.
We are aware of such a deferral being available to U.S. residents who are unitholders of the ETFs.
Thanks!
Matt
Can you please further explain why the old swap based etfs have virtually no tracking error compared to a plain index fund?
Great explanation, Dan, thank you so much!
@Mark H: A swap is a contract whereby the counterparty has an obligation to deliver the returns of the underlying index. So if the index returns, say 8%, then the counterparty must pay the ETF 8% to fulfill that obligation. If there is a fee deducted, that is known in advance, so there are never any surprises. If an ETF instead holds stocks or bonds directly, its portfolio may not match the underlying index precisely, so it might deliver a return a few basis points below or above the benchmark (i.e. tracking error).
@Matt: I’m afraid I can’t help with tax advice for US residents. I’d suggest contacting Horizons directly or consulting a tax advisor.
@RD: This article certainly scared a lot of investors. Ben Carlson did a great job of debunking it:
https://awealthofcommonsense.com/2019/09/debunking-the-silly-passive-is-a-bubble-myth/
@Su-Chong Lim: That has certainly been the party line from Horizons, i.e. that the counterparty is paying the taxes, so there is no actual tax avoidance going on with a swap. But the truth is none of us really has any idea what the financial institutions are actually doing behind the scenes. What we can say is that neither this budget nor any previous one has raised concerns specifically about swaps, which have been used for a long time by institutional investors.
@Mike: No, unfortunately there are no investments that provide bond-like exposure without also paying bond-like interest (other than HBB). Low volatility stocks, preferred shares, REITs, etc. all have very different risk profiles and are not substitutes.
Hi. This is a bit off topic. Can you address the concerns of an ETF bubble. With the Michael Burry statement I seem to see it everywhere. Thanks!
@Anne: Ben Carlson did a great job of debunking this:
https://awealthofcommonsense.com/2019/09/debunking-the-silly-passive-is-a-bubble-myth/
Hi Dan,
Thanks for highlighting this issue for your readers. I very grateful for all that you do.
I try to follow your advice not to read financial news (with your blog being one of the exceptions, of course).
Hi Dan,
I know you’ve recommended ZAG for bond allocation. What about XLB? It has better performance.
Will your recommendations change for 2019 in terms of the bond portion of the couch potato portfolio?
Thanks,
AJ
@AJ: Long-term bonds (XLB) are much more volatile than funds like ZAG, though they will outperform over any period when long-term rates fall more than short-term rates, which is what has happened recently. Over the very long term I don’t think the risk/reward trade-off favours long bonds.
Thank you for answering my question Dan – much appreciated!
@Erik: I read your comment and realized suddenly that for the last few years I have not read the financial news of the weekend Globe and Mail at all (ok, maybe I sometimes read the financial makeover advice for featured individuals/couples, but even then it’s largely fluff.) Compared to my prior diligence to read all financial information as essential “must-read” updating of current financial literacy, it’s such a relief to be able finally to categorize all that print as totally fabricated bullshit that I never fully understood, anyway (now I know why), and to be able to proceed directly without guilt to the Crossword.
In all seriousness, to the previously acknowledged benefit of absorbing Couch Potato Wisdom (sleeping well at night because I finally understand what is happening in the financial world — a random chaos whose unknown outcome I have adapted to with a well diversified passive indexed portfolio that I know no-one, especially all those self appointed experts, can reliably improve upon), I can now add TIME, that is, the freeing up of all those wasted hours of reading the financial news and trying to analyze what I’ve read and turn it into actionable intelligence. Thank you Canadian Couch Potato for all those free hours of leisure in addition to years of stress free life!
HI Dan,
First, I appreciate you sharing your time, hard work and knowledge with us!
I’m a latecomer AND a newcomer to index investing, however, a couple of years ago, I did build a standard CCP newbie portfolio, using the TD E-series, which was set up as a DRIP. I now would like to restructure the portfolio using dividend ETF’s (not DRIP) and also have an opportunity to introduce a large sum of money (400k) to it. What are some strategy options you’d recommend, as I know there are tax implications etc. My wife and I have about 15 years left until retirement (no pensions) and given the limited time, I’d like it to be as efficient as possible.
Thanks so much!
Don
Dan,
$1.2MM to invest in non-registered, self-directed retirement portfolio. Looking for tax efficient options.
Will not be drawing from this account for several years until RRSP’s are tapped out (8-10 years)
SWAP based investments under regulatory scrutiny or are they (even if Horizons “restructures”!?!?)
Should non-registered portfolios not be a total return strategy to mitigate risk?
At ages 65-72, we are planning on having only non-registered investment income, and TFSA, for tax efficiency until CPP at age 70
Like the simplicity of XBAL/VBAL portfolios (as with RRSP’s) but in non-registered, auto rebalancing triggers sales, dispositions, thus taxes…just how inefficient would such an approach be?
Your input would be invaluable.
@Mark: Overall, yes, a total-return strategy is likely to be more tax-efficient than one that favours income over capital gains. This is usually the case, except perhaps for those in a very low tax bracket with a portfolio full of Canadian dividend-paying stocks. That would be tax-efficient but, of course, poorly diversified.
One-fund portfolios are not necessarily “optimal” in a taxable account, but they can still be a good choice, especially since the bookkeeping and ACB tracking will be easier with one fund rather than four or five. I would not be too concerned about realized capital gains within the funds due to rebalancing. As long as these ETFs have healthy cash flows (new money coming in) they will be able to avoid having to sell assets to rebalance. I would expect significant capital gains only following a very dramatic market move. And even then, you would have had the same problem yourself if you used individual ETFs instead.
Dan,
Thank you very much for your reply. The one-fund vs. individual ETF point raises another two questions;
1/ Does XBAL or VBAL track ACB for you as TD e-Series index funds would? ie when T3/T5 issued?
2/ During future withdrawal years (SWP) would it be more efficient to W/D once, quarterly? Perhaps a two part question as this affects both trading fees and amount of holding taxes?
Thank you for your input!
@Mark:
1. Any time you use ETFs, you’re responsible for tracking the ACB yourself. That is one of the advantages of mutual funds, where this is done at the fund level.
2. I suppose this depends on the details, but in general, it’s probably best to hold one year’s worth of cash flow in an investment savings account (which trades like a mutual fund and can be used to set up an automatic withdrawal) and then just top this up once a year. The more you can automate, the smoother things will run.
Dan,
What is a investment saving account. Could you further elaborate.
@Aslam: https://canadiancouchpotato.com/2010/10/12/parking-cash-in-your-portfolio/
Thanks Dan. It was a great help.
Hi Dan,
Any updates about this section 85 election? I help my elderly parents with their portfolio which includes HBB in a non-registered account and I do not want them to miss an important deadline regarding this joint election, but I have not heard anything about this except in your article. Thanks!
@Dan D: I’m afraid I don’t have any updates. I’ll reach out to Horizons, as I’m curious, too.
Can anyone please provide instructions on what I need to do in order to avoid taxation as a unitholder of these Horizons swap based ETFs? I consulted the Horizons website but I dont understand anything they are saying. Thank you.
I’m also waiting to hear about the Section 85 election, I haven’t received any material yet from Horizons.
Regarding the new structure, will HXT still trade as an ETF or a Mutual Fund? This affects my purchase fees moving forwards, I couldn’t find the answer thus far.
The horizons website now has a portal to sign up for the SECTION 85 ELECTION information. You leave your email and they will email you pertinent information. As people find out more information it would be nice if we commented here or if Dan could update the blog post.
https://www.horizonsetfs.com/Section-85-Election
Also pages 5 and six of this circular go into more detail of the procedure to file the Section 85
https://www.horizonsetfs.com/horizons/media/pdfs/corporateclass/Circular.pdf
The portal is now open and the questionnaire is active. Having a guide to file the Section 85 would be great!
I’m confused about this part from Horizon’s FAQ:
Q11. I filed the Joint Tax Election to obtain a full tax-deferred rollover on the disposition of
my Merging ETFs Units. Do I have to report the disposition on my tax return for the period that
includes the disposition of the Merging ETFs Units?
A11. Yes. You must report the disposition of Merging ETFs Units even though you elected to
obtain a full deferral of any capital gain that might otherwise arise on the disposition of your
Merging ETFs Units pursuant to the Mergers. Your proceeds of disposition for Canadian income
tax purposes will be equal to the Elected Amount set out in box B on page 3 of the federal Joint
Tax Election (and equivalent box on a Québec Joint Tax Election).
Are they seeing that I need to put the full (technically unrealized) capital gain in my Schedule 3? If so, how is my tax software going to accurately calculate my tax owing since it doesn’t have information contained in form T2057 that has already been submitted?
I am filling out the Joint Tax Election questionnaire now, available through Horizon’s portal. I am hoping I can do this on my own….well, possibly with your help, but at least not having to pay for legal advice :)
I am stuck on Question 8: “Do you own an undivided interest in the Merging ETFs Units with another party?” My husband and I have HXS shares in a joint non-registered iTrade account at Scotiabank. Pretty straight forward. Do you know if Q8 applies to us? Thanks!
@Lyn: This is not tax or legal advice, but a joint investment account is considered an “undivided” interest. Spouses with joint accounts should both file the election separately.
Yes, I aware that we both have to file an election. Thanks for the quick response!
@Dan: Thank you for another great article! I do intend to stay invested in HBB units; but failed to make the section 85 election yet. Is it too late to do so now? My TD account shows DISP and ACQ transactions as of 2DEC2019. Please help
@Melwin: The “reorganization” of the ETFs took place in late November, but it is definitely not too late to make the election. I would encourage you to do so before the end of the year, however.
Here’s Horizon’s tax Election site: https://www.taxelection.ca/Horizons/
I’m not sure if it was something to do with swap funds but the book value (usually the same as ACB) seems to be completely wrong on my WebBroker. Make sure to calculate the ACB yourself. I don’t remember the deadline for the election (dec 25 maybe?) but its coming real soon so don’t wait too long. The form has complex wording but not so bad to fill out
Thank you Dan!
@Ian: It looks like when the reorganization happened in late November, some brokerages (but not all) reset the book value to that day’s market value. As you note, if you’re making the election, you should use the original book value, which you should be able to find on your October 31 statement, assuming you made no additional unit purchases since that date.
If I hold the ETF jointly with a spouse and we want to declare equal contribution to the purchase (50/50), in declaring the number of units and ACB, do we both put in half the total units and ACB that we hold. E.g., 1000 units of HXT at $30,000 ACB. I declare 500 units at $15,000 on my questionnaire and my spouse declares 500 units at $15,000 on her questionnaire. Can you please confirm my understanding?
Also, what is the deadline to mail to CRA the Joint Tax Election form?
@David: You should consult a tax advisor about your specific situation. But in general a joint investment account is considered an “undivided interest,” which means that if that if there are 1,000 units, you and your spouse each own 1,000 units jointly: you do not own 500 each. So on the election both spouses should report the entire holding and the total book value of the holding; they should not divide by two.
The filing deadlines are explained on the website. It’s best to get this done before the end of 2019.
I tried getting clarification from Horizons on this. Their response was: If a Merging ETFs Unitholder co-owns the Merging ETFs units and each legal owner in a particular unit is distinct, then the methodology you noted is correct (ie., splitting the units and ACB).
I guess the question is whether my spouse and I are considered one or separate legal owners. That was the confusing part for me. Obviously, based on what you said, I’m wrong.
Thanks @Dan that makes so much sense. I have been recording my ACB manually and that’s what I used on the form. The different Book Value threw me a curveball. Thanks for explaining the reason why it appeared off
I wanted by warn others, Questrade’s book value/ACB is incorrect! As Dan has reported before its important to maintain you’re own calculation.
I reverse engineered their number. They have a mistake with split transactions with fractional shares. I’ve reported this to Questrade but I have not received an ETA for the fix.
I own jointly with my wife several Horizons ETFs, which have been merged in the new Horizons MFC. The Merging ETFs are in a taxable joint investment account and I am in Ontario, so I have selected my wife as a co-owner of undivided interest in Q 8, as per the Tax Instruction Letter.
I only co-own an undivided interest in the Merging ETFs with my wife, so I have submitted only one Questionnaire, including both our information (wife as a co-owner).
The instructions for completing the questionnaire (Schedule B) state that for co-owners of divided interest both co-owners should submit their own Questionnaire and the percentages they own.
However, for co-owners of undivided interest (applicable for joint investment account in Common Law province of Ontario) it does not specify if both co-owners should submit the Questionnaire.
Should my wife complete the Questionnaire for the same Merging ETF units as well and list me as a co-owner? I assume so, but need confirmation.