Horizon’s Total Return Index (TRI) ETFs use a swap structure. That makes them very tax-efficient by tracking the total return of an index (capital gains plus interest/dividends) and only paying it all as lightly taxed capital gains when sold. Tax deferral and reduction. The complex swap structure also made them unique in Canada and very beneficial to high-income investors. A perfect target for the T2 Legislator.
Unsurprisingly, that triggered the Trudeaunator Government’s typical Gatling-gun-precision legislative response. This legislative risk was the most anticipated risk of using a swap ETF. The intent of the initial legislation was to force these ETFs to payout taxable income annually. However, the collateral damage of that legislative change potentially impacts all mutual funds and ETFs operating as trusts – as described last week.
Rise of the Resistance
Earlier this year, the tax advantages of the TRI swap ETFs looked to be terminated. However, just this month, the much anticipated Terminator Resistance was released for PS4 and XBox. Concurrently, Horizon’s human resistance mounted a response and morphed the Swap ETFs from individual “mutual fund trusts” into a group of Corporate Class ETFs. Coincidence?
Younger-me would have spent the last week blowing up cyborg assassins. Instead, older-slower-reaction-time-me spent the week wading through the nitty-gritty details of the Corporate Class ETF changes at Horizon. Some of these ETFs have an excellent risk premium for the big-savers or big-earners that must use a non-registered personal account, invest through a corporation, or income split using both (like my wife & I do). However, we wouldn’t want to take the risk of using this innovative fund structure unless it is robust and not just a stop-gap solution until the next Legislator sequel.
My immediate questions about the corporate class ETFs:
- How does corporate class work compared to a regular ETF?
- How well do the funds in the corporation gel together?
- What would distributions look like and how likely are they to occur?
- Is this just a round of Tax-Whack-A-Mole or is it robust?
I am honestly pretty excited about what I found, but you should form your own conclusions if you are considering these products.
Disclosure: We have held HXDM, HBB, and HXX in our portfolio at various times. I don’t have any at present, but I likely will again in the future. I have no other financial relationship with Horizon at the time of writing this.
What is the difference between Corporate Class and regular Mutual Fund Trusts?
Mutual Fund Trusts
Regular mutual funds and ETFs are legally “mutual fund trusts“. Each ETF is a separate fund trust. As a trust, they must distribute all income received each year to their unitholders. They use allocation to redeemer methodology to do this. This is to avoid double taxation of capital gains for investors redeeming units. The Federal Government recently made changes that will also ensure some capital gains are taxed as soon as possible for existing investors that don’t sell their units. That is logistically very difficult to implement. Hence, ETFs and mutual funds that make regular distributions have been given a one year reprieve while the potential splatter caused by this Gatling-gun approach is explored.
Mutual Fund Corporations
A mutual fund corporation side-steps this impending issue completely because it is a totally different business model and legal entity. Allocation to redeemer methodology does not apply to “Mutual Fund Corporations.” The reason is that they are not a trust, holding investments and passing income through to the trustees. They are a corporation.
Each ETF in the corporation is a different class of shares or “series”. This allows them to have different values and make different distributions. So, for the end-user, it looks basically the same as any other ETF. However, behind the scenes, they are all part of the single large corporation.
Investment income is fully taxed as business income at the General Corporate rate. Excess income can be dispensed as eligible dividends. Just like every other regular Canadian large business. Our imperfect tax integration means that the combined personal and corporate rate is higher than if the money were earned personally. Music to the taxman’s ears.
So, if poorly organized, a mutual fund corporation may not have much of a tax advantage. In fact, there is a tax inefficiency favoring the government. This makes it a less attractive target for the Trudeaunator. The key to a corporate class structure being tax efficient is how it is organized to offset investment income with expenses between its family of funds and between fiscal years. This makes understanding the details of the corporation’s business model vital.
How are Horizon’s Corporate Class ETFs organized?
The swap contract structure is maintained.
The Trudeaunator Government’s objection to the swap ETFs was the use of allocation to redeemer methodology to re-assign income to their market makers. Not the swap contracts. Swap contracts offer a number of advantages like low tracking error, lower costs for Canadian indexes, and avoidance of foreign exchange and withholding taxes on dividends for non-Canadian indexes. These synthetic ETFs are also routinely used to index some difficult to access markets like commodities. So, Horizon is keeping the synthetic swap structure.
How does the swap structure affect business income?
The value of the total return swap contract increases or decreases in size as the total return of the tracked index changes. However, the income or loss will only be realized when a swap contract is settled or partially settled. That could happen for a number of reasons.
When is a swap settled – triggering a gain (income) or a loss (expense)?
Horizon and National Bank could voluntarily settle the swap.
This is actually partially how Horizon will manage income. For example, if the swap is at a significant loss, then Horizon will settle it, book that loss, and then get a new contract. That loss can then be carried forward. So, when income is realized later, it can be offset by the previous expense to reduce or nullify taxable income. Analogous to tax-loss harvesting of capital gains by individual investors. However, an important difference is that “superficial losses” can apply to capital gains. In contrast, this is business income.
This will be helpful if a swap is forced to settle, or partially settle, at a less advantageous time.
A swap could also be forced to settle or partially settle.
One way that this could happen is if the contract is downsized. If the funds keep growing, this is avoided. However, it could easily happen if a large client redeems a big chunk of shares while the swap is in a positive marked-to-market position.
Another trigger to settle a swap would be if the counter-party exposure exceeds 10%. That could happen if there is a large market move. The most violent market movements tend to be down – which would be booked as an expense. While less common, a huge rise in an index would trigger income.
It is very likely that eventually there will be some net income in one fund or another. However, the corporate structure has another layer with which to manage that. The funds don’t exist in isolation, as they do as trusts. The income and expenses are pooled amongst the entire mutual fund corporation.
Pooling Expenses and Income: Horizon’s Secret Recipe
Through the pooling of income and expenses, the income generated from the investments can be used to pay expenses. Expenses from the higher-fee funds can also be used to offset the income from less expensive funds. A gain in one fund can be offset by a loss in another.
Of course, the obvious concern would be the balance between income and expenses. If expenses (fees) are raised to prevent net income, that would be a loser for investors. If there is excess income, then the corporation would pay tax on that. Same as losing money to a fee – except the government gets it instead. Horizon feels confident that their income and expenses will largely balance out. Being a skeptic, I pushed them on this and in the end, I think this is where things get interesting.
The TRI ETFs are baked in with the BetaPro ETFs. Some commodity ETFs are sprinkled on top. Like a loaf of bread.
I like the doughy middle of the loaf.
The TRI ETFs could generate some hefty income/gains and have reasonably low fees. This is the approach I like.
Like the warm doughy center of a loaf of bread.
However, low-fees could spell “distributions” in a corporate structure.
The Horizon TRI swap ETFs are passive index trackers. Their fee range is competitive: 0.03% for the Canadian HXT and 0.25% for HBB (Canadian bonds). The swap structure is very cost-effective for REITs and preferred shares, making their MERs about half that of traditional ETFs. Fees for the funds covering foreign markets are slightly higher (0.30% to 0.50%). This is competitive with regular ETFs when you factor in foreign exchange and the heavy taxes on foreign dividends. The downside of this low-fee investing approach in a corporate class structure is that it is hard to offset that income with expenses.
How do corporate class mutual funds and other corporate class ETFs manage distributions?
Most corporate class mutual funds have little difficulty consuming income due to their higher active management fees. There are also some other corporate class ETFs, like from CI First Asset and Purpose Investments. The CI First Asset funds have low MERs (0.15% & 0.25%), but only cover Canadian large-cap equity (CSY) and Canadian Short-term Bonds (FGB). The Purpose Investment funds have a broader selection and a more active management approach with higher fees (0.5-1.5% range). Despite those fees, they still make regular distributions. At least the distributions are tax-efficient eligible dividends or return-of-capital.
Others like the crust.
So, for the corporate income and expenses to balance out without raising expenses, Horizon’s TRI swap ETFs are going to be bedfellows with some other funds that have significant expenses by their very nature. Their BetaPro line of ETFs and commodities ETFs.
The BetaPro ETFs are designed for active traders.
They provide daily contracts for leveraged investing (2X bull leverage), shorting the market (inverse), leveraged shorting of the market (2X bear), and a volatility index ETF.
I don’t invest this way. I mostly take the passive index investing route. However, many people do try to win at market-timing. One reason that I don’t is that I can’t tell the future precisely enough to time short-term entry and exit points well. That is vital because the contracts required to invest with leverage and shorting are an extra expense. This expense drags on performance if the ETF is held for a significant period of time.
If you can time well enough to make an outsized profit, then great! I cannot. Few can.
Commodity markets can be difficult to trade and have more fees.
This is actually one of the areas where derivative contracts are the norm. If you want to trade in this space, there will be contractual costs for doing so.
The mix of funds makes for a complimentary buffet that will appeal to different palates.
The traders using BetaPro or trading in commodities are going to incur those expenses as part of their investment plan and pay for that via their management fees. It is a cost of doing business for their strategy and these funds have an MER in 0.75%-1.5% range. Further, the inverse funds that short the market will have the fees, but not generate income from interest or dividends.
I wish the traders success in their endeavors. Mostly, I am pleased that they are potentially enabling my TRI ETF tax-reduction and deferral by allowing me to negate income without my management fees going up.
The fact that the BetaPro, within the family of funds, bet on opposite sides of the market also seems helpful. When one is generating income, the other side is generating a loss. This offsetting of gains and losses both now and on future income gives great flexibility to manage net income (and therefore distributions). For a corporate class structure to be really efficient, expenses and income need to be generated by different funds at different times.
Altogether, I think this mix of funds together into a corporate class structure is appetizing.
It addresses one of my biggest concerns (income not offset by expenses) while not really penalizing anyone with extra fees that they wouldn’t already be paying for their investment strategy. For a market to work, there must be people with different beliefs and approaches. In this case, some like the doughy center and some like the crust. To each their own, but together we are minimizing the leftovers that the tax-hounds will gobble up.
What if corporate expenses don’t offset income?
Only time will tell if the mix of funds and expenses in the corporate class will be able to avoid net income. If there is net income, then it may become necessary to distribute that. This would be less frequent and in smaller amounts than a regular ETF, but it could happen.
Any income-leftovers would be taxed at the general corporate rate. Horizon’s corporation will be domiciled in Ontario for a combined Federal/Ontario tax rate of 26.5%. This is much lower than personal tax rates. So, this amounts to tax deferral until the retained earnings are dispensed as eligible dividends. Good tax planning and management maximizes that opportunity.
Will the government simply unleash the tax hounds on Corporate Class Funds?
I honestly think that nothing is safe from a desperate government. However, I think this structure is much more resilient than the previous one.
No longer a lone wolf, but part of the pack.
The previous swap ETF fund trust structure was more complex and relied on nuances of the allocation to redeemer methodology. Horizon was the only one doing it and the benefits were mainly for highly-taxed high-income investors. Easy prey as a tax-the-rich-using-a-loophole political gesture.
Multiple companies use corporate class funds with $157 billion invested in them. That is a much tougher adversary as a pack than the ~$5 billion that the Horizon funds rolled into the corporate structure were on their own. Horizon is quick to point to this as implicit security. However, corporate class mutual funds have been on the legislative menu before.
There was a recent attack in 2017. The Federal Government legislatively ended the ability to move between different series in a corporate class fund without triggering capital gains. They are not immune. However, there are some good reasons why the government continues to tolerate the corporate class structure. These carry more weight to me.
Why I think the corporate class structure is more robust.
It is a straight forward corporation. This would make it hard to target without impacting how other financial corporations operate. Not impossible, but difficult. A major move against financial corporations would also make Canada an outlier in the world. Investment capital outside of registered accounts has wings. It would fly away. So, there would be significant collateral damage.
Plus, I don’t think there is a strong motivation to go after this structure. The reason that I say this is that the investment income is being fully taxed as income. Not, the half-rate of capital gains. Not the lower rate of eligible dividends. Income. As mentioned earlier in the article, tax integration makes this less tax-efficient than directly investing. It only becomes tax-efficient if the business is well managed. It is hard to believably spin a business that is managing its finances well as “tax-avoiding”.
Of course, collateral damage, flight-of-capital, and fuzzy political spin hasn’t stopped governments before. There are many sequels in the Legislator franchise already.
Everyone will have a different threshold for risk and reward. Will this meet yours?
Risk and reward are joined at the hip with investing. The potential reward of decreased tax drag on tax-exposed investments by using corporate class ETFs is easy to mathematically model. The risk of further legislative aggression is much more difficult to quantify. However, I will spend some upcoming posts modeling what this could look like. Brace yourself for the online Corporate Class Swap ETF vs Conventional ETF Simulator.