Tax Bergs: Risk for Corporate Class Funds

Horizons corporate class ETF structure is extremely tax efficient. However, that is contingent on there being no net income in their mutual fund corporation. When things are working as intended, there is no corporate tax and no personal tax, except on the included half of capital gains when units are sold. That is efficient tax deferral and tax reduction compared to paying annual taxes in a high personal tax bracket or on passive income in a private corporation.

In the preceding post, I showed that Horizons’ mutual fund corporation booked a lot of losses in 2020. That makes for smooth sailing in terms of absorbing income without a net taxable event. However, they have been gradually burning up that loss pool since then.

While still off in the distance, there is the potential for a tax-berg hazard from net positive corporate income. Like an iceberg, it may seem like a small amount of tax on the surface. However, it could be a ship-sinker beneath the surface. Horizons are pretty clever managers. I think that it is unlikely that they would be caught unawares without making some course corrections. However, markets can be foggy and pilot error is possible. We’ve seen that movie before. So, let’s at least develop some situational awareness.

Disclosure: I use a number of Horizons’ corporate class ETFs and I don’t plan on jumping ship any time soon. The tax efficiency is just too luxurious for me to pass up on. However, I do check out where the lifeboats are any time I am aboard a ship. Nothing is unsinkable.

Mutual Fund Corporation Income Tax

If the mutual fund corporation is able to offset income with expenses, then there is no corporate tax and no distributions. So, no personal tax either until the shares are sold and a favorably taxed capital gain is realized. When steaming ahead as planned, corporate class funds are awesome for tax deferral and reduction. That changes when there is net income in the mutual fund corporation.

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How could there be net income?

This was thoroughly described in the preceding post. However, here are the highlights. There can be dividends or interest income received regularly. In Horizons’ corporation, several ETFs (HULC, HXQ, HSAV) have direct holdings and generate income regularly.

The other swap-based ETFs only generate fully taxable derivative income when the swap is settled. Either strategically to book a loss or to manage counter-party risk. Counter-party risk is the chance of default if markets have risen a lot and the bank (mostly National Bank) owes Horizon money a big debt on paper. So, swaps offer tax deferral and the freedom to make some subjective management decisions. However, they can still generate income.

Horizons also has high-fee short-term-trader-oriented ETFs. They act as an expense sump but are only a small part of the corporation.

All of those moving parts make it difficult to predict if or when there could be net corporate income. However, we can look at the sum of all of those moving parts. The non-capital loss pool. When it is used up, further income becomes taxable. Horizons booked a large loss in 2020, but have been slowly eroding the loss pool since then.

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Taxation of Net Income in a Mutual Fund Corporation

When the mutual fund corporation has no net income, it is very efficient. However, when there is net income, flowing it through a mutual fund corporation is generally much less tax-efficient than directly through a conventional ETF trust structure. The income is taxed at the general corporate tax rate. Horizons’ mutual fund corporation is domiciled in Ontario. The usual net general corporate tax rate for Ontario is 26.5%. However, mutual fund corporations are not eligible for the 13% Federal general tax reduction. That increases their effective corporate tax rate to 39.5%. Ouch. Nasty tax-berg.

That corporate income tax does generate GRIP. So, what is left of the income could be distributed as eligible dividends. However, the tax on those dividends would be higher than not making a distribution. Instead, the after-tax value of the income could be added to the net asset value (NAV) of the shares. When the shares are sold, that increased NAV would translate into a capital gain. A capital gain is usually more tax efficient.

The left panel in the chart below shows how income flows when the mutual fund corporation is functioning as intended. Super efficient. The two panels on the right show how net income can be distributed using dividends or retaining the residual income as share value. When the mutual fund corporation has net income, even moving it out as a capital gain has a higher total tax burden than the highest personal tax rate on income. A total of 55.7% vs 53.53% in Ontario. Since keeping the income as an increased NAV/share is more efficient than making distributions, the rest of my modeling will use the NAV approach.

The Tax Hit Relative To Conventional ETFs

There is no doubt that corporate class ETFs are very tax efficient compared to conventional ETFs when they have no net corporate income. However, the impact of a corporate class fund hitting a tax-berg by realizing net non-capital income could be catastrophic when you compare it to conventional investment funds.

Conventional ETFs use a mutual fund trust structure. In a trust, net investment income is simply passed through and taxed in the hands of the unit holders. There is no tax in the trust and the character of the income is unchanged.

Flow through of net income with a corporate class fund is only a little bit worse than interest or foreign income via a trust. Eligible dividends could flow efficiently through a mutual fund corporation if they were received as eligible dividends. However, if they had been captured via a swap contract, then they would now be regular business income. Even in highly taxed Ontario, the worst net tax rate on eligible dividends is only 39.34% vs 55.70% through a mutual fund corp using swaps. If the income from settling a swap could have been capital gains instead, then it is brutally worse. More than double!!!

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SWAPs Are Like Speed For The Corp Class Ship

One of the aspects that makes Horizons’ corporate class ETFs so innovative is that they use swap contracts for most of their total return index funds. That has the advantage of better control over the timing of income.

They don’t receive recurrent income payments, but only realize income when they settle swaps. So, that allows them to strategically harvest losses by settling some contracts in the red. It also allows them to defer realizing income until the future when they eventually settle contracts with gains.

That may keep the Corporate Class Ship powering through the waters and steering efficiently. However, it requires pretty nimble management at the helm. And every captain knows that they don’t control the ocean. Just like the equity markets.

As markets rise, the swap liabilities rise for the counterparty. If Horizons does start to settle more positive swaps to reduce counterparty risk, realizing net income in the process, that derivative income makes the damage worse. Like higher speed when colliding with a tax-berg. Normally, most of the return of an index is capital gains and a little bit comes from dividends. Derivative income is much more highly taxed than capital gains – as regular income.

For example, the S&P 500 may have a total return of 10% in a year. About 8% of that came from capital gains and 2% from US dividends. With a swap contract, all of that 10% would be considered income. So, what could have been an 8% capital gain with a conventional ETF (taxed at 26.77% in the top Ontario tax bracket) is now 8% taxed at 55.70% when fully passed through the mutual fund corporation and personal taxes. Hitting a tax-berg at high-speed is a ship sinker.

Net Income Amount & Allocation

Net income in a mutual fund corporation is taxed unfavorably. Brutally so, if it came from a swap that otherwise would have been mostly eligible dividends and capital gains. Here’s looking at you HXT, HXE, HEWB, HXH, HLPR, and HXF. Or even a few foreign dividends and mostly capital gains. Like HXS covering the S&P 500 total return index. However, it is not just the tax rate on income that matters. It is also how much net income there is in the corporation and how it is assigned to the different share classes.

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A Sudden Massive Net Income Hit Seems Unlikely

Horizons would only settle swaps when they need to. Plus, they have many swap contracts to choose from for any given index. So, it is not all or nothing. While it is possible that Horizons could be forced to settle a bunch of swaps in a massive market spurt upwards, a gradual burn seems more likely.

They would be managing the balance between excessive counter-party risk vs taking income to reduce it. In a massive market rally, I would suspect that National Bank would be doing just dandy. They hold the swaps and the risk of them defaulting would be very low. The managers at Horizons aren’t dummies. So, they would not likely drive their ship into a tax berg due to counter-party exposure to a healthy major bank.

There could be a very small amount of net income relative to a conventional ETF covering the same index. For example, perhaps a 1% income in HXT compared to the 3% eligible dividend that a conventional ETF tracking the TSX60 may give. That 1% income taxed at 55.70% would still be less than 3% taxed at 39.34%.

The current consumption of Horizons’ non-capital loss pool is about 2.18%/yr – even though markets have advanced much more than that. It is unclear which ETFs generated that net income. If it was from ETFs that normally would have paid over 2% of interest or foreign dividend income, it may not be too much worse than a conventional ETF even if they do hit net taxable income in the mutual fund corp.

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Who gets to swim with the tax anchor?

Considering how a corporate-class ETF would fare relative to its conventional counterparts, also assumes that Horizons will assign net income in the mutual fund corporation proportionately to the funds that generated the net income. On page 101 of this prospectus, it says:

The Company may establish a policy to determine how it allocates income, capital gains and other amounts in a tax efficient manner among its Corporate Classes in a way that it believes is fair, consistent and reasonable for all Shareholders, with the general intent that allocations to each of the Corporate Classes track the performance of the corresponding portfolio, but subject to the foregoing paragraph. The amount of dividends, if any, paid to Shareholders
will be based on this tax allocation policy.

Horizons ETF Prospectus, Aug 25th, 2023

High derivative-income-producing swap ETFs could be the ones covering the fastest-growing markets, forcing swap settlements to manage counterparty risk. Not necessarily the ones covering markets that pay the largest dividends or interest. Horizons tracks the income and expenses down to the ETF level. However, it is really hard to know where the risk of actually realizing income is. Both within the corporation as a whole, and at the individual ETF level.

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Who goes down with the ship?

Another reason why swaps could be forced to settle and realize more taxable income is if there were massive money outflows from the ETFs. The swaps with lower tax liabilities would likely be settled first. That would reduce the NAV of the related ETF.

However, as swaps with larger income are realized, that would accelerate the income tax liability and NAV reduction. Kind of like the Titanic started taking on water until a critical point was reached and it snapped in two. Plummeting to the bottom. Sucking down anyone who didn’t get far enough away in advance. While this is theoretically possible, Horizons does have contingency plans that they say would be activated and prevent this sort of catastrophe long before it could materialize. This requires some faith in Horizons’ managers because those plans are confidential.

Don’t Panic. But be prepared.

I have probably scared some people by discussing what could happen if things go terribly wrong. As I mentioned at the beginning of the article, I do use some of these corporate class ETFs. When working well, which they are currently, the tax efficiency in a personal or corporate taxable account relative to conventional ETFs can be large. Even net of fees. However, the advantage is not large for all ETFs. There are risks for the future, as pointed out in this article, but also pretty concrete rewards in the present.

I also don’t think that there is a reason to panic. Horizons still has plenty of open water ahead with their non-capital loss pool. They have also proven to be proactive and innovative at the helm in the past. The main concern with their previous swap structure was legislative risk and they had a plan in place to deal with it seamlessly.

Even though I use these ETFs, I am keeping my eye on the horizon to spot any tax-bergs looming. I also want to know where the lifeboats are. Just in case. That way, I can be prepared to recognize danger and react calmly and effectively. My intent with this series of articles is for you to also develop situational awareness. These ETFs can be amazing for tax deferral and reduction. Until they aren’t. The best way to prepare for rare/unlikely, but catastrophic scenarios is to do emergency drills. In the next post, we do that by examining what the impact of net income in some different corporate class ETFs could look like. Some are more vulnerable than others.

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Acknowledgments

This series of posts has complex material. I would like to thank Benjamin Felix (Head of Research, PWL Capital) for helping me to identify issues, understand nuances, and find data. I am also grateful to the folks at Horizons ETFs for answering our tough questions as honestly and completely as possible. This post is not endorsed by anyone and any errors are my own. I try to be accurate and complete, but this is complex material. If I get something wrong, please let me know (with references if applicable) so that I can fix it.