Friends with tax benefits: How ETFs can help keep taxman at bay

They can make magic happen but beware of risks, says Jonathan Chevreau writes.

Wouldn’t it be nice if you could wave a magic wand and transform all or some of your taxable dividend flow into pure capital gains?

That’s one of the thoughts that inevitably crosses the minds of Canadians who invest in taxable (non-registered) accounts each year when it finally comes time to do their taxes.

Outside registered plans, of course, fixed income is the most harshly taxed asset, while deferred capital gains is most favourably taxed. In between are dividends.

While investors who hold equities directly can keep wishing, there is a way to effect such a transformation through the magic of exchange-traded funds (ETFs) — though it doesn’t come without some potential risks down the road.

Horizons ETFs Management (Canada) Inc. has pioneered swap-based ETFs that use derivatives to minimize taxable distributions by transmuting dividends into 100 per cent capital gains but distribute no income, according to Mark Yamada, president of Torontobased PUR Investing Inc. “Of course, it still has to go up to have a gain,” he adds, but those capital gains won’t be realized until the units are sold in the (hopefully) far future.

For example, the Horizons S&P/TSX 60 ETF (HXT) has exposure to the 60 largest stocks in Canada although technically it doesn’t “own” the underlying stocks. It also has a low Management Expense Ratio (MER) of 0.03 per cent (normally it’s 0.07 per cent, but Horizons is extending a 0.04 per cent fee rebate at until September 2018). Little wonder it has attracted almost $1.8 billion since its 2010 launch.

Yamada says the risk of swapbased ETFs is essentially that of the underlying index. “There is some counterparty credit risk but each ETF (in Canada) limits its exposure by dealer and as a percentage of total assets to 10 per cent. We calculated that the credit swap spread is more than offset by the lower MER. Some have no swap fees at all (HXT).”

In addition to HXT, Horizons offers similar swap-based ETFs in domestic sectors like energy and financials, plus U.S. ETFs tracking the S&P500 and Nasdaq indexes, international developed markets, and even a handful of U.S. and Canadian fixed income ETFs that operate under the same principles.

Horizons is currently the only swap based/total return index ETF (TRI) provider in Canada, says Karen Tsang, vice-president of Kelowna, B.C.-based Forstrong Global Asset Management Inc.

Dan Bortolotti, a Torontobased investment adviser with PWL Capital Inc., says PWL uses only plain-vanilla ETFs in client portfolios although “we would not argue with do-it-yourself investors who wanted to use them, so long as they understand the risks.”

One is the possibility Ottawa might one day disallow the structure, as happened with ETFs that used forward agreements, and more recently with corporate-class mutual funds. “If this were to happen, an investor might need to liquidate their entire holding, realizing all of the capital gains in a single year.”

Corporate class mutual funds used to minimize the switching costs of equity funds held in taxable portfolios, although the 2016 federal budget disabled tax-free switches among corporate structure funds in the same fund family. However, two Canadian ETF firms — Purpose Investments and First Asset — offer corporate class ETFs that Forstrong ’s Tsang says allow “taxable gains to be first netted with taxable expenses and losses within the fund family.”

Bortolotti says most Canadian corporate class ETFs are “actively managed and significantly more expensive than their traditional counterparts. So, while they might offer some small tax advantage, some will be lost to higher costs.”

Ed Rempel, a Markham-based fee-for-service financial planner, says withholding tax on foreign dividends of 15 to 27 per cent can be avoided by using Canadianlisted mutual funds or ETFs that hold the underlying stocks directly. Both ETFs and mutual funds have a tax advantage over portfolios of individual stocks because of the Capital Gains Refund Mechanism, which effectively allocates capital gains on stocks sold within the funds first to investors that sold the funds. Many funds and ETFs have a tax efficiency of more than 95 per cent, he says.

One place where tax-efficient ETFs may prove particularly useful is in domestic fixed income. Traditional bond funds are notoriously tax inefficient. But for investors wanting non-registered fixed-income Bortolotti and PWL colleague Justin Bender recommend such clients consider tax-efficient ETFs like the BMO Discount Bond Index ETF (ZDB) or the First Asset 1-5 Year Laddered Government Strip Bond Index ETF (BXF) for short-term exposure.

The latter holds strip bonds sold at a discount and that mature at par value, generating less taxable income than premium bonds (those trading for more than their par value). PWL found BXF’s after-tax returns are significantly greater than traditional short-term bond ETFs. BMO’s ZDB is a more traditional broad-market bond ETF with exposure to government and corporate bonds. It selects bonds slightly under par, which results in lower distributions, so its after-tax return should be slightly higher than its peers that don’t use the strategy.