ETF provider is converting funds to a corporate class structure in order to continue offering its popular tax-efficient strategies
In the 2019 federal budget, the Government of Canada directed new changes to the rules governing investment funds, including the elimination of the ‘allocation to redeemers’ process. This practice was widely used by ETFs in Canada, where taxable distributions of income and capital gains could be allocated to the market makers that create and redeem units of ETFs when they redeemed units directly from an ETF provider. The federal government held the view was that this practice could have tax leaks, particularly if market makers were not paying tax on the distributions being tagged to them in the redemption process.
With the proposed changes, providers like Horizons ETFs Management (Canada) have re-evaluated their ETFs that use a derivatives-based structure, where ‘allocation to redeemers’ was a common practice. Horizons ETFs decided to convert affected ETFs – 44 funds and roughly $5 billion in AUM – into a corporate class structure. Of these 44 ETFs, 15 are plain-vanilla index strategies, known as Total Return Index ETFs, which had become popular with investors with large taxable investment accounts (i.e. non-registered accounts and corporate accounts), since they have never paid taxable distributions.
“Our tax-efficient Total Return Index ETFs, which use derivatives contracts, tag any income realized on the settlement of those contracts to the market makers, who redeem directly with us in the primary market,” says Mark Noble, SVP of ETF strategy at Horizons ETFs. “With the proposed legislative changes, we wanted to have an investment structure that would allow us to continue to provide the tax deferral benefits of these ETFs without having to rely on tagging the income to the market makers. With this new corporate class structure, where the ETFs are held in one corporation, we have the ability to pool losses and gains and offset any income that would occur in the strategy, and we expect this to allow us to continue the same level of tax benefits offered by the TRI ETFs currently.”
Corporate class structures are not that common in the ETF industry but are very common with mutual funds. According to Strategic Insight, approximately $155 billion is invested in corporate class mutual funds and ETFs in Canada.
“Even though ETFs are structured slightly differently than mutual funds, they are regulated the same way,” Noble says. “There is no issue with an ETF using a corporate structure similar to a mutual fund. We are proposing to move to a corporate structure to continue to offer benefits such as no anticipated taxable distributions, deferral of income and compounded tax benefits on multiple asset classes like fixed income and US/Canadian/international equities.”
Even with the change, Noble says it will be business as usual for unitholders. “For the end unitholders, we do not anticipate any difference in how they will be taxed,” he says. “It is the same ticker, the same strategy and the same management fees. In fact, there may actually be some circumstances where we reduce the management fees on a number of the ETFs. It just means that the ETFs themselves are using a corporate structure.”
One thing current unitholders must be aware of is the potential for a tax rollover upon the conversion. There is an option where investors who hold their units in a taxable account can use Section 85 of the Canadian Income Tax Act to roll over units, essentially deferring any tax consequences. They simply need to submit a form, along with Horizons, when they complete their 2019 income taxes.
“In order for units to roll over into the corporate structure, units will be sold and then rolled into the structure, with unitholders receiving new shares in exchange,” Noble says. “For anyone in a gain situation, that would result in a taxable capital gain. Existing unitholders, or those who buy before the conversion, can make that election so they can defer realizing capital gains and the resulting tax on that market appreciation until they sell the units.”
Horizons ETFs is communicating with its unitholders, and to date, the proposed conversion has been well received. “I think when the legislation originally came out, third-party observers thought we would have to close these ETFs, but that was never the case,” Noble says. “We had been exploring this structural change even before the legislation had been announced. The legislation just made it clear that we needed to make this transition.”
Noble thinks that completing this conversion will pave the way for other ETF providers to adopt similar structures. “We have a reputation for trailblazing in the Canadian ETF industry, so other providers will watch how we do with the conversion,” he says. “If it is successful, which we think it will be, I think we will see others follow suit and more corporate class ETFs coming to market.”
Noble notes that by establishing the corporation, Horizons has another option when it launches new funds. “It gets easier to determine, when we launch an ETF, if we want to put it in the corporate ladder or launch as a trust,” he says. “It is another arrow in our quiver in terms of making more efficient use of product structure based on the strategy and goals of our ETFs.”
The only potential caveat that Noble sees is if the government were to implement negative changes that would cover all corporate class funds. But doing that would affect every major asset management company in Canada and create broader negative industry impact.
With the changes, Noble stresses that once the rollover happens, the funds will act and look the same as before. He says that the primary thing advisors need to be aware of is the Section 85 election.
“If their clients are a current unitholder, pre-conversion date, they need to be aware of the option to make the Section 85 rollover, but that doesn’t need to be made until they file taxes,” he says. “We have a website available and resources online to complete the requisite forms. After that, these ETFs will look and act the same as they did before, and unitholders get to enjoy the after-tax benefits of using them.”
As Horizons ETFs prepares to make the change before December 1, Noble feels that its tax-efficient ETFs will continue to be a strong tool for taxable investors.
“These ETFs remain the most tax-efficient way for investors, outside of registered accounts, to defer income and control when they pay tax,” he says. “We saw a lot of momentum in this product suite heading into 2019, particularly with high-net-worth investors and corporate accounts. We anticipate that momentum back online in 2020.”
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