Advantaged ETFs refers to exchange-traded products that use derivatives such as forward agreements to transform one form of distributions (often interest income) into another (such as capital gains or return of capital) that is lightly, if at all, taxed. For example, an investor holding the iShares Advantaged Canadian Bond Index Fund (TSX: CAB) in a taxable account will have received capital gains and return of capital equal to the income generated from a portfolio of Canadian Government and corporate bonds (less fees and expenses). Capital gains are taxed at half the marginal rate. If the investor had instead directly held the portfolio of bonds, the interest income would have been taxed at the investor’s marginal rate.

Budget 2013 proposes to put a kibosh on what it calls “character conversion transactions” such as the ones employed by Advantaged ETFs.

Character conversion transactions link a derivative investment with the purchase or sale of an otherwise unrelated capital property to form a derivative forward agreement. If the derivative investment were made separately from the purchase or sale of the capital property (i.e., as a cash-settled derivative financial instrument), any income from the derivative investment would be taxed as ordinary income.

To ensure the appropriate tax treatment of the derivative-based return on a derivative forward agreement, Budget 2013 proposes to treat this return as being distinct from the disposition of a capital property that is purchased or sold under the derivative forward agreement. This measure will apply to derivative forward agreements that have a duration of more than 180 days. Whether a particular property is held on income or capital account is largely a factual determination and is unaffected by this measure.

ETFs Affected by the Change

iShares Canada put out a press release saying that seven funds in its ETF line up will be impacted by the changes proposed in the Budget. It is interesting to note that all these ETFs used to be traded under the Claymore brand name. They are:

iShares Advantaged Canadian Bond Index ETF (CAB)
iShares Advantaged Convertible Bond Index ETF (CVD)
iShares Advantaged U.S. High Yield Bond ETF (CHB)
iShares Advantaged Short Duration High Income ETF (CSD, CSD.U)
iShares Global Monthly Advantaged Dividend Index ETF (CYH)
iShares Broad Commodity Index ETF (CBR)
iShares Managed Futures Index ETF (CMF, CMF.A)

ETFs Not Affected by the Change

Horizons also put out a news release saying that the Budget proposals are not expected to impact the popular Horizons S&P/TSX 60 Index ETF (HXT) because the ETF makes no distributions and hence there is no re-characterization taking place. Horizons confirmed that the Horizons S&P 500 Index ETF (HXS) is also not expected to be affected by the move. Nevertheless, investors should weigh the risk of an adverse change in tax treatment of swap-based ETFs against the tax advantage of earning total returns.

See also: Canadian Financial DIY’s and Canadian Couch Potato’s takes on this topic.

This article has 7 comments

  1. Thanks for the info. So does this mean that these iShares ETFs are the only ETFs affected by the 2013 budget rule change?

    • @WJ: Among iShares ETFs, these appear to be the only ones affected by the change. If you are holding XIU, XSB, XBB or other traditional ETFs there is no change in tax treatment.

  2. Pingback: Dividend Link Roundup Time | The Dividend Guy Blog

  3. Hi CC, thanks for the link … and I think I found another one – investment fund First National Mortgage Investment Fund (FNM.UN) which uses the same forward agreement structure to turn water into wine, er mortgage interest income into capital gains. The Prospectus on Sedar shows this on page 21 of the pdf.

  4. update, just found this press release from the company denying it will affect FNM.UN http://www.theglobeandmail.com//globe-investor/news-sources/?date=20130401%20&archive=cnw&slug=C9677 Sounds too good to be true to me though.

  5. I agree with your comments about swap based ETFs. They’re a good deal for retail investors, for Horizons and for the counterparty providing the swap (National Bank?). These good deals come at the expense of the government. Since the government sets the rules, I wonder how long this will persist.

    Once you get around $80K per year, capital gains starts to be taxed less than Canadian dividends. And when it comes to foreign dividends, capital gains are always taxed at a lower rate. With these swap based ETFs, there is also tax deferral. And you don’t need to worry about foreign withholding taxes and whether you’ll get credit for them.

    So from a tax point of view, it’s not surprising that Horizon’s ETFs are popular. And the more popular they are, they more likely the government will act. Will they be victims of their own success?

    However, foreign domiciled swap based ETFs complicate the issue. If the government forbids domestic swap based ETFs, one can use foreign swap based ETFs. Can the government prevent Canadian investors from purchasing such ETFs?

    • Just an addendum to my previous post…

      If the government bans swap based ETFs, there will be capital gains tax to pay. These ETFs may turn from being tax efficient to tax inefficient.