# Budget 2013 Cracks Down on Advantaged ETFs



## CanadianCapitalist (Mar 31, 2009)

Anyone care to comment on Budget 2013 proposal to crack down on character conversion transactions? 

http://www.budget.gc.ca/2013/doc/plan/anx2-eng.html



> Certain financial arrangements (character conversion transactions) seek to reduce tax by converting, through the use of derivative contracts, the returns on an investment that would have the character of ordinary income to capital gains, only 50 per cent of which are included in income.
> 
> 
> A character conversion transaction typically involves an agreement (called a forward agreement) to buy or sell a capital property at a specified future date. The purchase or sale price of the capital property under a derivative forward agreement is not based on the performance of the capital property between the date of the agreement and the future date – instead, the price is determined, in whole or in part, by reference to some other measure, often the performance of a portfolio of investments. The reference portfolio typically contains investments that generally produce fully taxable ordinary income.
> ...


iShares has already issued a press release saying that its Advantaged line of ETFs (orginally from Claymore) are impacted. Horizons has issued a press release saying that it does not expect HXT to be affected. 

http://ca.ishares.com/content/strea...pr_2013_03_25_en.pdf&mimeType=application/pdf

http://www.horizonsetfs.com/Pdf/PressReleases/20130322_HXTUnaffected.pdf

I asked Horizons for a clarification and they said that they expect HXT not to be impacted because they use (1) swap transactions and (2) HXT does not distribute income. Regardless, it seems to me that any tax change is a risk for those investing in HXT. Comments?


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## andrewf (Mar 1, 2010)

What about HXS?


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## CanadianCapitalist (Mar 31, 2009)

andrewf said:


> What about HXS?


I assumed that HXS is also not impacted (at least according to Horizons) because HXT is not. I'll try and get them to comment on this.


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## Ponderling (Mar 1, 2013)

I own a MF -Barometer Income Advantage (BCM800) that uses the income as capital gains game.
Some thing like that is outlined in the prospectus as an option for them any way.

Once I read about this new tax interprataion in TGAM I checked, and no, none of this fund is held outside of either TFSA'a or RRSP's. Whew.


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## CanadianCapitalist (Mar 31, 2009)

Ponderling said:


> Once I read about this new tax interprataion in TGAM I checked, and no, none of this fund is held outside of either TFSA'a or RRSP's. Whew.


I'm curious: What is the benefit in holding an advantaged fund in a registered account? The whole point of the financial alchemy is to transform one form of income into a tax advantaged form.


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## andrewf (Mar 1, 2010)

Not to mention that it usually is more costly than a vanilla fund, making it doubly curious to hold in a registered account.


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## OptsyEagle (Nov 29, 2009)

Yeah, I saw that. It's about time. I find it remarkable how the fund industry can come up with these things and how long it takes the Finance department to slap them for it. 

I wondered the same thing when they use to by-passed the RRSP foreign content rules with those RRSP clone funds. Before the government moved to allow 100% foreign content, just about every foreign mutual fund could be acquired in an RRSP clone format. This totally sidestepped whatever the government was trying to achieve and they got away with it for years. These forward based funds were doing the exact same thing. 

What the Finance Minister needs to do is come up with some law rendering a penalty to these companies when they decide to get too cute for their own good.


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## 1.5M (Apr 21, 2012)

I really don't understand the language used by these guys. Could someone pls. translate it into plain English. Does it also affect futures, options, options on futures and what the hell are "derivative forward agreements".


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## OptsyEagle (Nov 29, 2009)

My understanding is that many mutual funds and ETFs decided to set themselves up under a special structure. For example. They could set up a bond fund where they take the investors money and buy government bonds. The interest coupons the fund received, however, would need to be distributed through to the investor for tax purposes. If an investor was in the top tax bracket (exactly the kind of investors they were looking for since they tend to have most of the money), the investor would lose a considerable amount to taxes, since interest income is about the worst taxed return they could get, in a non-registered account.

So instead, they made an arrangement with a bank counterparty who would take the invested money and give the fund a forward contract. The forward contract would pay the exact amount back to the fund EQUAL to the return on that said bond fund. I think the bank actually invested the money in the bonds. So if that fund made 3% interest, the bank would buy back the forward contract for 3% more money. But since the fund bought it a one price and then sold it at 3% more, it was realized as a capital gain ... not interest income. 

Presto, boom, bing, bam, are we ever smart kind of thing. This had actually been going on for years.


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## AGHFX (Aug 31, 2012)

Will this include BMO's covered call ETFs?


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## OptsyEagle (Nov 29, 2009)

What if an investor actually wants the income. Do they pay tax then? God no. No sense selling anything and realizing any tax. We will just pay that investor the money from another investor and call it "return of capital". 

Bing, boom, bam. It's tax free.


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## OptsyEagle (Nov 29, 2009)

What if more investors want income then the money from new investors can supply. No problem. We will just take some funds we discontinued years ago because we lost so much investor money that it was starting to become embarrassing. Remember all those tech funds, internet funds, biotech funds. So we will just create a corporate class of fund and use the tax losses of the discontinued funds, since we couldn't pass them through to the investors, to eliminate the tax on the new funds, for years.

Boom, bing, bam. Now you see the tax .... now you don't.


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## Four Pillars (Apr 5, 2009)

OptsyEagle said:


> Yeah, I saw that. It's about time. I find it remarkable how the fund industry can come up with these things and how long it takes the Finance department to slap them for it.
> 
> I wondered the same thing when they use to by-passed the RRSP foreign content rules with those RRSP clone funds. Before the government moved to allow 100% foreign content, just about every foreign mutual fund could be acquired in an RRSP clone format. This totally sidestepped whatever the government was trying to achieve and they got away with it for years. These forward based funds were doing the exact same thing.
> 
> What the Finance Minister needs to do is come up with some law rendering a penalty to these companies when they decide to get too cute for their own good.


+1.

What I don't understand is why a company that lowers their mortgage rate to be more competitive gets a phone call from big Jim himself within the hour and then these companies which are obviously circumventing the spirit of existing rules are allowed to do this for years.


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## CanadianCapitalist (Mar 31, 2009)

OptsyEagle said:


> Remember all those tech funds, internet funds, biotech funds. So we will just create a corporate class of fund and use the tax losses of the discontinued funds, since we couldn't pass them through to the investors, to eliminate the tax on the new funds, for years.
> 
> Boom, bing, bam. Now you see the tax .... now you don't.


For a fat fee, of course.


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## Ponderling (Mar 1, 2013)

CanadianCapitalist said:


> I'm curious: What is the benefit in holding an advantaged fund in a registered account?


Well, I don't go for the advantaged part for it's own sake, but the manager must do it to sell it in and out of a registered accounts.

I'm not a big one on star managers, but the track record of this guy has been pretty good in up and down seasons, for giving modest returns and not loosing too much capital along the way. I bought into this as a bit of a more saucy holding than a bond, since the bond market returns are quite flat, and poised to get flattened even more at the first uptick of the current low interest rates at some point down the path.

I went to Barometer shortly after paying off the last of my SDRSP mortgage. The mortgage was my bond proxy for a while. The last real bond funds I had I think I sold in about 2002 when I bought out my mortgage from the bank. 

So I am hanging onto him while I feel a lot of Canada's markets are heading towards a sideways slide for a while. If I had the tea leaves to know we were posed for a tear then I would dump the MF and buy an indexed equity ETF. If REIT's had not floated so high, maybe them in the mid-term. If blue chips were not valued up the wazzo by everyone chasing yield I would be buying them raw, and not have them held as a part of a fund that gobbled up hunks quite a while ago.


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## CanadianCapitalist (Mar 31, 2009)

AGHFX said:


> Will this include BMO's covered call ETFs?


Nope.


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## CanadianCapitalist (Mar 31, 2009)

andrewf said:


> What about HXS?


Horizons says it does not expect HXS to be impacted either. However, it seems to me that these budget changes are a reminder of the risk that tax treatment of HXS and HXT could change in the future. All it would take is for the Government to legislate that distributions should be imputed to funds that employ swap agreements.


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## james4beach (Nov 15, 2012)

I think this is a good move by government. There was lots of tax alchemy there.

My philosophy has also been to avoid exotic ETFs of all forms. I avoid anything that holds derivatives, swaps, whatever. An ETF is supposed to hold a basket of liquid stocks or bonds. I want to get the pure income/dividend stream, and I want the ETF to just be a conduit for the underlying.

There have been several cases of weird surprises with exotic ETFs in the last few years. There was an American swap-based ETF family that had enormous year end distributions one year... depending on one's tax situation, this could have been disastrous for some. Similarly, commodity ETFs may be asking for trouble as governments are playing catch-up to this asset class. The tax situation of derivative & commodity ETFs is very unclear. In my view, when you add up the various structural risks for exotic ETFs (such as counter-party exposure, derivative risk) plus the TAX uncertainty risk, they should be avoided.

I would choose XIU over HXT any day, due to the vanilla construction of XIU and its traditional composition.


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## avrex (Nov 14, 2010)

I have been looking at ideas for my non-registered account and had been looking at the these Advantaged ETFs.

However, after viewing this thread and CCs article "Budget 2013 clamps down on advantaged ETFs", I won't pursue these ETFs.

We don't know what the 'actual' impact will be on these ETFs.
I'm assuming they'll either be eliminated, or if they remain, they won't be worth holding (from a tax advantaged perspective).


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## Eclectic12 (Oct 20, 2010)

OptsyEagle said:


> What if an investor actually wants the income. Do they pay tax then? ...
> We will just pay that investor the money from another investor and call it "return of capital".
> 
> Bing, boom, bam. It's tax free.


Huh? 

You will have to explain how that works. The last I checked - the only way RoC was tax free was if it was held in an RRSP or TFSA. 

My understanding is that RoC is *tax deferred* while the ACB is positive and declared on each tax return as a capital gain while the ACB is negative or zero.
http://howtoinvestonline.blogspot.ca/2010/07/return-of-capital-separating-good-from.html


So there may be an advantage to paying capital gains in the future but as long as it is reported as RoC - there are still taxes to be paid in the future.


Cheers


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## MoreMiles (Apr 20, 2011)

james4beach said:


> I think this is a good move by government. There was lots of tax alchemy there.
> 
> My philosophy has also been to avoid exotic ETFs of all forms. I avoid anything that holds derivatives, swaps, whatever. An ETF is supposed to hold a basket of liquid stocks or bonds. I want to get the pure income/dividend stream, and I want the ETF to just be a conduit for the underlying.
> 
> ...


Options and GLD / commodity ETF are all derivatives. People still use them.

Everyone, including Apple, is looking for tax efficiency. This may sometimes require complicated planning. It is for sure not for everyone.


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## james4beach (Nov 15, 2012)

MoreMiles said:


> Options and GLD / commodity ETF are all derivatives. People still use them.


There are key differences between all these things.

Yes stock options are derivatives, but they are still exchange traded derivatives. Very transparent pricing, very easy to model (Black Scholes etc), and no counterparty risk as they go through the clearinghouse.

The derivatives inside exotic ETFs -- the stuff I don't like -- are all over-the-counter (OTC) derivatives. They don't have transparent quotes, nor transparent pricing, and have counterparty risk usually against a single bank.

GLD is a tricky one as I believe it does have counterparty risk, but also holds physical assets. I'm not sure it's a derivative.
Commodity ETFs come in many varieties. Some just hold exchange traded futures contracts, so those are transparent.
Others use OTC derivatives --- those are much more dangerous.
Others (ETNs) don't even have assets, and are just unsecured debt notes.

I would sum this up by saying that generally speaking, exchange traded derivatives which you can readily get quotes for are GOOD. But over-the-counter (OTC) derivatives don't have price visibility, and are BAD. The complex and exotic ETFs generally hold OTC derivatives.


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