HXEM ETF for Emerging Market Coverage in a Corp Account: There be tax savings or serpents?

Investing in emerging markets (EMM) may add another layer of diversification to a global portfolio. If taking that approach, then ETFs, like HXEM, ZEM, and XEC make that easy. Unfortunately, investing in foreign markets within a private corporation (CCPC) can come with some increased tax drag. Both from the foreign dividends and how passive income is taxed within a corporation.

Horizons’ HXEM ETF has a corporate class structure that, when working as intended, avoids taxable distributions and foreign withholding taxes. However, the corp class structure does bring other risks if the income isn’t manageable, and other compromises. Before venturing bravely to the fringes of the publicly investible markets, explore whether HXEM offers enough tax efficiency to make up for the added risk and complexity.

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

Corporate Tax Efficiency States

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

A CCPC paying out enough dividends as part of regular compensation to release all of the RDTOH refunds is an Efficient Corporation. If the corporation has unreleased RDTOH and the owner would have to take extra dividends at a higher tax rate than the RDTOH refund, that corp has RDTOH Trapping.

Corporations with over $50K of aggregate investment income and enough active income get bumped into paying some tax at the general corporate tax rate. These private corporations over the passive income limit have two possible states. They may be able to use the extra eligible dividends generated by the GRIP for personal spending instead of non-eligible ones. That represents a 60-75% corporate tax jump partially offset by 10-15% personal tax savings.

If they do not use extra eligible dividends to displace non-eligible dividend use, it is just the 60-75% tax bump. In Ontario and New Brunswick, the corporate tax bump is lower than the personal savings. A net benefit as long as you are able to use the extra eligible dividends. So, I will use an Ontario and BC example for passive income limit modeling.

Emerging Market Foreign Withholding Tax & Corporations

I detailed US FWT for corporate accounts previously. If using a Canadian-listed ETF that simply holds its US-listed version (like a wrapper), then the US FWT would reduce the nRDTOH refund available to the corporation. Plus, the FWT from the EMM dividends themselves would be lost on top of that. Recently, the EMM FWT averaged out to ~13% for the MSCI Emerging Markets index. If applicable, the US FWT effect is layered onto the remainder.

The same thing happens if you use a US-listed ETF, like IEMG, that holds the EMM stocks. However, the lower MER of the US fund may offset this slightly. Still, there is the added hassle of a USD account and currency exchanges. So, I will be using Canadian-listed ETFs that hold EMM 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 63.32% for flowing the dividend through compared to 53.53% if it were a direct personal investment. Almost a 10% higher tax rate.

xec zem fwt corp

The four main ETF providers in Canada all have ETFs that cover emerging markets. Horizons’ HXEM tracks Horizons’ own emerging markets total return index. It basically mirrors the MSCI EM Index which is comprised of ~1400 large-cap companies. BMO ETFs’ ZEM directly holds stocks that track the MSCI EM index. So, it is the most tax-efficient direct comparison of conventional ETFs to HXEM. Blackrock’s XEC also holds stocks directly, but tracks the MSCI EAFE IMI index. That index also includes some smaller companies.

Conventional ETF Comparators

Vanguard’s VEE is a wrapper ETF that holds the US-listed IEMG ETF. It covers ~5800 companies, but the structure also brings on the detrimental US FWT effects plus the loss of the other FWT. Given that FWT issue, I will do the comparison of HXEM to ZEM and XEC. Both have MERs of 0.28%/yr.

Even though the detrimental effect of FWT is slightly less than for US dividends, the magnitude of the dividend also matters. The EMM indices tracked have companies that pay moderate dividends. The yield varies, but averages ~2.6%/yr over longer periods of time.

HXEM ETF Structure Costs & Risks

HXEM has two main features that make it unusual. One is that it uses swap contracts to allow Horizons to realize the total return of its index 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 0.28%/yr MER. So, I use a 0.58%/yr fee drag for the modeling.

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. HXEM‘s current counterparty exposure sits at -18.55%. The negative number means that there is no exposure currently. However, if emerging markets were to recover and take off, then Horizons could be forced to settle some contracts to manage counterparty risk. That is the most serious risk (in my opinion) but is currently low.

Corp Class Income Management Risk

The second feature of HXEM is that it is a corporate-class ETF. So, HXEM is a share class in Horizons’ mutual fund corp. The swap income is treated as regular business income for Horizons’ corporation. If the corporate fund family has net zero income, then there is no tax. That is functioning as intended and can also be reduced by previous losses. Horizons’ 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.

Private corporations are relatively tax-efficient as long as they keep their passive income flowing out to shareholders. However, foreign dividends are still heavily taxed relative to capital gains. The net fee and tax drag for buying and holding HXEM vs its best competitors is ~0.4/yr.

When the HXEM is eventually sold, the “income” does flow through and is taxed as a capital gain. Capital gains have tax deferral until sold. There is also a slight tax reduction due to the lower tax rate (50% inclusion rate). If unable to take advantage of the excluded half of capital gains using a capital dividend, there is still a ~0.2% advantage due to the lower inclusion rate and FWT avoidance.

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 cost-effectively use a capital dividend, you need enough capital gains across your corporate portfolio to justify the accounting fees. You could harvest them while staying fully invested. However, you must also require personal cash flow. Not usually a problem for me. Lowering the amount of money required to meet after-tax personal needs using a capital dividend, is really another form of tax deferral. In this case, about a 1.3% deferral compared to using salary, or 0.9% if used to decrease non-eligible dividends used. The ultimate benefit is if you are deferring from a high personal tax rate now to a lower one in the future.

It could be possible for a corporation with frugal owners that require few dividends to live on, but have a large corporate passive income, to have RDTOH trapping. In that situation, the drag on foreign dividends increases because the 50% upfront tax is not attenuated by the RDTOH refund. If there is RDTOH trapping and HXEM is bought and held instead, at least it doesn’t add to the problem. It could even help if you switch and it lowers the passive income enough. That yields a 0.9%/yr lower fee & tax drag advantage.

When eventually sold, the capital gains realized, and taxed, the advantage shrinks to 0.35% that year. However, you would have had the larger 0.9%/yr advantage for the intervening years before then. Presumably, you would not be using the CDA 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. Using the capital dividends generated would be an efficient way to do that and boost the HXEM advantage.

When a corporation is affected by the passive income limits, dividend income is punitively taxed. Except sometimes in Ontario and New Brunswick. In Ontario, where a tax anomaly usually favors conventional ETFs, HXEM has a very slight advantage of 0.14% if you are taking advantage of the tax anomaly. If unable to use the extra eligible dividends, it is a more impressive 1.2%/yr advantage.

In other provinces with regular tax integration, HXEM potentially has a substantial advantage. If unable to use the extra GRIP generated by the corporate tax bump, there is nasty Canadian taxation plus the unfavorable FWT treatment. In the case of severe corporate bloat, there is a 2.26%/yr difference. However, that is easily attenuated by paying out more dividends to live on. Still, even with taking advantage of the extra personal eligible dividends, HXEM has a 0.44%/yr advantage by avoiding the income distribution in BC. In other provinces where tax integration for eligible dividends isn’t as favorable, it would be more.

Flowing the Capital Gains Through

A corporation with enough passive income to be running afoul of the passive income limits also other options. It is likely a large portfolio with enough annual capital gains to make harvesting & capital dividend usage advantageous. That boosts corporate tax deferral, making a higher expected future personal tax rate the main reason to avoid it. Not an impossibility with a large corporation either.

If harvesting and passing the capital gains through, HXEM has a distinct advantage. The extra tax deferral of using the CDA makes for a 0.3-1.4% advantage in ON and a 0.2-2% advantage in BC, a province with normal tax integration.

If you had to realize the capital gains of HXEM for some reason and couldn’t use the CDA to your advantage, it would still have a 0.6-1.25% advantage in BC. In Ontario, conventional ETFs, like ZEM or XEC would have a slight advantage over HXEM if you were able to take advantage of the tax anomaly. Otherwise, HXEM would still have a 0.6% advantage.

HXEM is a newer corporate class offering from Horizons. It has a potential tax advantage over its conventional peers when used in a Canadian corporation. That is pretty niche already. However, the biggest advantage is for corporations with tax efficiency troubles. A niche within a niche.

HXEM in an efficiently running Corp

During the buy and hold years, HXEM has a moderate ~0.4%/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 HXEM is large. In the 0.9-1.25% range for that year. Plus, the advantages of less tax drag in the intervening years before the capital gains harvest.

HXEM in a Corp with “too much” passive income

This is where HXEM shines. Avoiding the Canadian and FWT tax issues is a big advantage. In Ontario, due to a break in tax integration, the advantage is moderate. HXEM has a 0.3-1.5%/yr advantage depending on the causes of corporate tax inefficiency. In provinces with regular tax integration, HXEM has an advantage. In BC, it is still close due to reasonable tax integration. A corporation large enough to have a passive income issue could also likely take advantage of capital gains harvesting and the CDA generated. That offers a 0.2-2% advantage depending on how efficiently the corporation is running otherwise.

What HXEM’s special risks

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 advantages of HXEM are significant. There could be 1% net mutual fund corp income attributed to HXEM before the advantage in an efficient corp is undone. Well within the realm of possible. 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 HXEM. I would be shocked if Horizons let that happen, but it is possible.

The other risk that I would consider with HXEM is ETF closure. It only has $60MM in assets after about three years. Horizons may keep it going as part of trying to offer a full corporate class suite, but smaller ETFs are vulnerable to closure. If it were to close, it wouldn’t be terrible if you could readily pass through any capital gains using the corporation’s CDA. One way that investing via a CCPC mitigates some of the risk of these ETFs.

Don’t discount the behavioral advantages of an asset allocation ETF

The potential advantages of HXEM 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. The behavioral gap is also more real than sea serpents.


  1. Hi Mark,

    I have really enjoyed your posts over the years. Thank you for putting in all of the work and organizing and presenting complex financial topics in such a clear way.

    I was wondering if you were worried about trading volume for any of these Horizon’s funds? Specifically, the bid-ask spread can sometimes seem sort of big. Below is what I see right now on Scotia iTrade’s platform, which shows level II quotes. When I look at quotes and volume at TD Direct Investing, I see the same data as on the Scotia platform.

    HXS bids = $62.91 (100 shares), $62.90 (6,300 shares)
    HXS asks = $62.94 (100), $62.95 (6,300)
    HXS volume =14,575. Note: quotemedia (with it’s delayed info) says daily volume is already at 61,961
    HXS.U volume is 2,500 on Scotia and 5,138 on quotemedia.

    HXDM bids = $41.63 (100), $41.62 (100), $41.61 (100), $41.58 (100), $41.45 (600)
    HXDM asks = 41.67 (100), 41.73 (400), 41.74 (100), 41.75 (1,000), 41.90 (200)
    HXDM volume is 13,468 as per Scotia, but 23,950 as per quotemedia.com

    HXEM bids = $32.19 (200), $32.18 (2,500), $32.07 (200), $31.82 (400), $27.88 (100)
    HXEM asks = $32.50 (1000), $32.57 (200), $32.70 (2500), $32.81 (200), $33.03 (400)
    HXEM volume is 1803 for today as per Scotia, but I see it’s 2,979 at quotemedia

    Given that Scotia and TD are only displaying a fraction of the daily volume, would you speculate they are underdisprlaying the amount of bids and asks and perhaps if you had some bigger orders placed, you would get better/quicker fills than their level II quotes would suggest? It seems like orders for a few hundred shares would fill easily, but if you accumulated several thousand shares and then wanted to unload them, you might get into very unfavourable prices, right?

    1. Hey Diego,

      Thanks for reading. That is a great question, and perfectly timed. I actually have an article on ETF volume and liquidity coming out next Friday! One issue is, as you have shown with your data, is that it is hard to actually know the volume. The data streams we see are only partial. The ETFs actually track in different exchange data sets. I am not concerned about liquidity in and of itself. There are multiple layers at work there. The upcoming article will explain that. So, trading larger volumes of those ETFs isn’t a big deal (I have done it with six figures myself). The bid-ask spread shouldn’t change much. However, the bid-ask spread is a bit higher for these low-volume ETFs because the market markers provide that liquidity. They make money on volume. So, less volume means a bit more bid-ask spread to make their money. There are best practices to help you (will be in the article). One is to use a limit price. I do that and set the expiration for a few days later. That keeps things in check and usually fills (I hate doing things twice).

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