Canadian Financial DIY: Budget Shoots Down Tax Advantaged Swap and Forward-based ETFs

Friday, 22 March 2013

Budget Shoots Down Tax Advantaged Swap and Forward-based ETFs

Expect to see a few ETFs disappearing in the next few years. The federal budget delivered yesterday by Minister Flaherty announced that the clever conversion of interest into capital gains (or temporarily, return of capital) through the use of forward contracts or swaps would soon become invalid. The Investment Executive article on the proposed measure makes it clear existing funds that have to renew at some point get caught as well. If I am not mistaken, that would cover pretty well all such funds as the prospectuses I have read include a fund termination date, which would require renewal / extension at that time.

Some of the funds whose days would appear to be numbered:

all of the former Claymore, now iShares, Advantaged ETFs that Canadian Couch Potato listed and described here.
various Horizons ETFs like the Horizons S&P/TSX 60™ Index ETF ( symbol: HXT), which I will need to remove as the Canadian equity component from my cap-weight portfolio contest at the bottom of this page, and the Horizons S&P 500® Index (C$ Hedged) ETF (HXS)

Of course, it's a loss for investors when tax benefits are pulled away. On the other hand, with all the moving parts to figure out in such ETFs, which does not necessarily result in a better choice for the investor, as I discovered in this post on HowToInvestOnline comparing one of the iShares Advantaged ETFs to a plain old GIC, maybe it's not such a big loss after all. Chasing investments merely for tax reasons is generally a bad idea.

... addendum
Horizons has put out a press release saying its fund HXT will NOT be affected by the tax change. The press release does not mention HXS but it works the same way as HXT as a total return swap. The budget document itself on page 353 of the pdf refers to transactions that change ordinary income into capital gains which HXT as an equity fund does not primarily do, so maybe HXT and HXS will escape. We'll have to keep monitoring to see exactly how this pans out.
... addendum 2
BlackRock says in a press release that the rule change will affect several of its funds - CAB, CVD, CHB, CHB.U, CYH, CBR, CMF and CMF.A

4 comments:

Tracking Error said...: The press release suggests HXT will not be affected because it has never made a distribution and doesn't expect to. Should it make a distribution, however, then perhaps it will be as income/dividends?; 24 March 2013 at 20:56
CanadianInvestor said...: TE, I'm not sure anyone can be certain of the outcome. The budget speech is not the law/regulation so maybe the feds will be sure to include HXT, maybe they will let it escape. When you make the rules, you can make the results come out as you wish.; 24 March 2013 at 22:20
Canadian Capitalist said...: I looked up your post after reading the press releases from iShares and Horizons. It appears that Horizons expects HXT not be affected by the Budget measure because (a) its derivative contracts are of the swap variety and (b) it does not distribute income.

Still, I think that tax changes should be considered a risk in holding HXT.; 26 March 2013 at 17:14
CanadianInvestor said...: CC, The thing that gets me is that the budget also says the funds it is after could already be pursued under existing law and the new action merely makes it easier. Perahps the biggest protection for HXT is that it merely transforms what is mainly dividend income into capital gains, which in some tax brackets is taxed less and in others more. So maybe the CRA would not think there is enough tax to gain to be worth roping in HXT, though the indefinite deferral of paying tax is another tax leakage. HXT's implicit automatic costless reinvestment is certainly worthwhile as evidenced by its outperformance in 2012 of its physical iShares counterpart XIU by 8.1% vs 7.8%; 26 March 2013 at 19:03