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.