HXDM ETF For International Exposure in a Corporate Account

Non-North American developed markets are an important part of a globally diversified portfolio. However, they also have high dividend yields. That could present a tax drag on investment growth in Canadian Controlled Private Corporations (CCPC). Both due to the magnitude of passive income and how foreign withholding taxes interact with corporate taxes. Horizons’ HXDM ETF looks to bypass those tax issues with its swap-based corporate class structure. However, that comes with some other compromises. Do the tax savings justify them?

Corporate Foreign Dividend Tax Efficiency

The tax efficiency of investment income varies wildly depending on the corporate active income, dividends paid out, and the type of investment income received.

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Corporate Tax Efficiency States

I detailed four main states of tax efficiency for corporate foreign passive income in my previous post analyzing HXS.

An Efficient Corp is paying out enough dividends as part of regular compensation to fund the owner’s lifestyle to release all of the RDTOH refunds. A corporation with RDTOH trapping has unreleased RDTOH and the owner would have to take extra dividends at a higher tax rate to get the smaller corporate refund.

Corporations with over $50K of aggregate investment income and enough active income to get bumped into paying some tax at the general corporate tax rates have two possible states. They could be over the limit, but the owner is able to use the extra eligible dividends generated by the GRIP. That represents a 60-75% corporate tax jump partially offset by 10-15% personal tax savings. If they do not use extra eligible dividends because they are unable to displace non-eligible dividend use, it is the full 60-75% tax bump. The situation is a bit more complex in Ontario and New Brunswick where the tax bump is lower and the savings may more than compensate for that, if the eligible dividends can be used effectively. So, I will use an Ontario and BC example in that section of the analysis.

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Non-North American Foreign Withholding Tax & Corporations

I detailed how US FWT interacts within a corporation in the preceding post. If using a Canadian-listed ETF that simply holds its US-listed version (like a wrapper), then the US FWT would reduce the nRDTOH available as a refund to the corporation. Plus, on top of that, the FWT from the non-NA dividends would be non-refundable.

That non-NA FWT averages out to ~8% tax drag for the indexes used. Then, the US FWT effect is layered onto the remainder. Two layers of tax. I teach my children about withholding taxes and how bad wrappers are every year.

The same thing happens if you use a US-listed ETF directly that holds the foreign stocks. The lower MER of the US fund may partially offset that, but it comes with the hassles of a USD account and currency exchanges. So, I will be using Canadian-listed ETFs that hold stocks directly for the comparison.

A Canadian-listed ETF holding the foreign stocks directly just has the FWT of the countries where the stocks are domiciled to contend with. Tax treaties make the FWT refundable as a credit to the corporation. However, that credit also shrinks the amount of nRDTOH refund available. In the top tax bracket in Ontario, the net effect is a total tax rate of 61.25% for flowing the dividend through a corporation compared to 53.53% if it were a direct personal investment.

The ETFs: HXDM vs ZEA vs XEF vs VIU

The four main ETF providers in Canada all have ETFs that cover non-North American developed markets. Horizons’ HXDM tracks Horizons’ own EAFE total return index. It basically mirrors the MSCI EAFE index which is comprised of ~800 large-cap companies. BMO ETFs’ ZEA directly holds stocks that track the MSCI EAFE index. So, it is the most tax-efficient directly comparable conventional ETF to HXDM. Blackrock’s XEF also holds stocks directly, but tracks the MSCI EAFE IMI index. That index is slightly broader to include some smaller companies. Vanguard’s VIU holds stocks directly and tracks the FTSE All-Cap Ex-NA index of almost 4000 companies.

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Conventional ETF Comparators

I will do a comparison of HXDM to ZEA and XEF. Both have MERs of 0.22%/yr. VIU’s MER is marginally higher at 0.23%/yr – not likely a significant difference.

Even though the detrimental effect of FWT is less for non-NA dividends vs US ones, the magnitude of the dividend also matters. The EAFE indices tracked have companies that pay big dividends. The yield varies, but an average of ~3.2%/yr over longer periods of time is a reasonable estimate.

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HXDM ETF Structure Costs & Risks

HXDM has two main features that make it unique. It uses a swap contract and is also part of Horizons’ family of corporate class funds. The swap contracts allow Horizons to realize the total return of its index (capital gains and re-invested dividends) instead of holding the stocks directly or via another ETF. That means that it doesn’t collect foreign dividend income. There is no FWT, no income distributions, and just a capital gain. The taxable half of the capital gain is only taxed when the ETF is sold. That structure comes at the cost of a higher fee. Up to 0.30%/yr in swap fees. Plus, the 0.22%/yr MER. So, I will use a 0.52%/yr fee drag for the analysis.

Swap Contract Risk

The complex structure also brings some extra risks with it. There is counter-party risk because National Bank holds the contract and the amount owing grows as the index’s total return accrues. HXDM‘s current counterparty exposure sits at 18.55%. That is not very high when you consider the amount of exposure and that the probability of National Bank defaulting is low. However, if the counter-party exposure were to take off as markets take off, then Horizons could be forced to settle some contracts to manage the growing risk. That is the most serious risk (in my opinion).

Corp Class Income Management Risk

Swap income is treated as regular income for Horizons’ mutual fund corp. Not capital gains. If Horizons’ MF Corp has net zero income, then there is no tax. That is functioning as intended and can also be reduced by previous losses. Horizons’ non-capital income loss pool looks to have about 5 years of runway at its current level and burn rate. If there is net income, then the taxes within their corporation could get really nasty. We’ll have to see how Horizons manages that. They’d likely switch back to a conventional structure if the risk was growing rather than blow themselves up. The risk is if they get caught off guard.

HXDM vs ZEA or XEF in an Efficient Corporation

When the money is flowing through, private corporations are relatively tax efficient. Still, in that setting foreign dividends are not treated kindly relative to capital gains. The net fee and tax drag reduction for buying and holding HXDM vs its best competitors is 0.47%/yr.

When the HXDM is eventually sold, the “income” does flow through and is taxed as a capital gain. Capital gains are functionally tax deferral and taxed at a lower rate (50% inclusion). That gives a slight advantage compared to regular income in the corporation of 0.21%.

However, if you are able to make use of the CDA to give a tax-free capital dividend instead of other income – that lowers the current year’s tax bill considerably. To effectively use a capital dividend, you’d need enough capital gains across your portfolio to justify the accounting fees. You could harvest them while staying fully invested. However, you also need to have a use for the personal cash. It lowers the amount of money paid out of the corporation in the current year. So, it is really another form of tax deferral until you take the savings out in the future. Still, a powerful tax planning strategy and corporate-class ETFs are built for it.

HXDM in a Corp with RDTOH Trapping

It could be possible for a corporation with a high passive income and owners that require few dividends to live on to develop RDTOH trapping. In that situation, the drag on foreign dividends increases because the 50% upfront tax is not attenuated by the RDTOH refund. That 50% tax rate is applied to the large dividends from international companies to make for some serious tax drag each year. If HXDM is bought and held instead, it has a 1.2%/yr lower fee & tax drag advantage.

When eventually sold and the capital gains realized and taxed, the advantage shrinks to 0.63% that year. However, you would have also had the larger 1.2%/yr advantage for the intervening years before then. You may not be using the CDA room generated since it would worsen RDTOH trapping. However, as I have mentioned in other posts, this type of “too much passive income” problem is solved by more personal spending or investing. Using the capital dividends generated would be an efficient way to move money out of the corporation and do that.

Corporate Passive Income Limits & HXDM

When a corporation is affected by the passive income limits, dividend income is punitively taxed. Except sometimes in Ontario and New Brunswick. These developed international markets spit out a lot of income. That makes the tax advantage of HXDM potentially massive for most provinces.

Even in Ontario, where a tax anomaly usually favors conventional ETFs, HXDM has a slight advantage of 0.15% if you are taking advantage of the break in tax integration. If unable to use the extra eligible dividends, it is a 1.5%/yr advantage.

In other provinces, like BC, it can be absolutely bonkers. If unable to use the extra GRIP generated by the corporate tax bump, there are more taxes than dividends received. Punitive Canadian taxation plus the unfavorable FWT treatment. If able to take advantage of the extra personal eligible dividends, HXDM has a 0.53%/yr advantage by avoiding the income distribution. However, if you can’t use the big GRIP balance from getting bumped to the general corp tax rate, the difference is a massive 2.87%.

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Flowing the Capital Gains Through

The reality is that a corporation with enough passive income to be running afoul of the passive income limits also likely has a large enough portfolio to make annual capital gains harvesting and capital dividend usage worthwhile. That boosts corporate tax deferral. So, the main reason to avoid that would be if you expect a higher tax rate in the future. Not an impossibility with a large corporation either.

If harvesting and passing the capital gains through, HXDM has a major advantage. The extra tax deferral of using the CDA makes for a 0.4-1.7% advantage in ON and a 0.2-2.5% advantage in a province with normal tax integration, like BC.

If you had to realize the capital gains of HXDM for some reason and couldn’t use the CDA to your advantage, HXDM would still have a 0.8-1.5% advantage in BC. In Ontario, conventional ETFs would have a slight advantage if you were able to take advantage of the tax anomaly. Otherwise, HXDM would still have a 0.58% advantage.

Summary Thoughts on HXDM in a CCPC

Of all of the corporate-class ETFs, HXDM is the one that has the most potential advantages compared to its conventional peers when used in a Canadian corporation.

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HXDM in an efficiently running Corp

During the buy and hold years, there is a moderate ~0.5%/yr advantage in an efficiently running corporation. If the corporation is efficiently passing out dividends and large enough to harvest and pay out capital dividends, the advantage of HXDM is huge. In the 1.2-1.6% range for that year. Plus, the advantages in the intervening years.

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HXDM in a Corp with “too much” passive income

This is where HXDM shines. Avoiding the large dividends that international equities pay, the FWT inefficiency, and punitive Canadian taxes is a big advantage. That could be in the 0.2-1.5%/yr range depending on the province and the nuances of the passive income problem. A corporation large enough to have a passive income issue could also likely take advantage of capital gains harvesting and the CDA generated. That enables a 0.2-2.5% corporate tax deferral advantage in that year.

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What about the risks of HXDM

I think that the risk of income within Horizons’ corporate class structure is a real risk. I wrote about it here. That said, it may be a ways off and the potential advantages of HXDM are significant. There could be up to 1.5% net mutual fund corp income attributed to HXDM before the advantage in an efficient corp is undone. For a corporation experiencing passive income problems or able to take advantage of capital dividends, there is a larger margin for safety. Like 3-4% net mutual fund corp income attributed to HXDM. I would be shocked if Horizons let that happen. However, it is a risk and the Titanic was thought to be unsinkable too.

The potential advantages of HXDM might make it worth considering if you are into using a more complex ETF investing strategy. However, whether to use a complex strategy is also an important question to ask yourself. For most people, the advantages of an asset allocation ETF strategy as a whole may be better than making it complicated for one slice of your asset allocation.

None of this is specific investing advice. It is just information to help you consider your own due diligence processes. While I have tried to be complete and accurate, there is no warranty to that effect. If you do find an error, let me know so that I can investigate and correct it as needed.