The ETFs that come with tax-protection tactics

Certain ETFs can help soften the impact of taxes on dividends for specific investment situations

The ETFs that come with tax-protection tactics

Putting investment assets in non-registered accounts means exposing the returns from those assets to taxation. But in certain situations, ETF investors may still have options to minimize the impact of taxes.

“Outside registered plans, of course, fixed income is the most harshly taxed asset, while deferred capital gains is most favorably taxed,” noted Jonathan Chevreau, founder of the Financial Independence Hub, in a piece for the Financial Post. “In between are dividends.”

Citing Mark Yamada, president of Toronto-based PUR Investing, Chevreau said taxable distributions from dividends can be minimized using swap-based ETFs. The Canadian forerunner for such strategies, Horizons ETFs Management, uses derivatives to transmute dividends into 100% capital gains; it offers swap-based ETFs based on a variety of stock indexes and sectors, including the S&P/TSX 60, the energy sector, and the S&P 500, as well as some US and Canadian fixed-income ETFs that work under the same principles.

“Of course, it still has to go up to have a gain,” Yamada said, adding that gains won’t be realized until the units are sold. He also warned that swap-based ETFs come with some counterparty credit risk, though each ETF in Canada has a 10% cap (based on total assets) on its exposure by dealer — though based on his firm’s calculations, the ETFs’ low MER more than compensates for the credit swap spread, and some have no swap fees at all.

Another risk, according to PWL Capital investment advisor Dan Bortolotti, is that the federal government could disallow the structure, as it has already with corporate-class mutual funds and ETFs that used forward agreements, at some point. “If this were to happen, an investor might need to liquidate their entire holding, realizing all of the capital gains in a single year,” he said.

Investors looking for added tax efficiency could also turn to corporate-class ETFs from Purpose Investments and First Asset, which Forstrong Global Asset Management vice president Karen Tsang said allow “taxable gains to be first netted with taxable expenses and losses within the fund family. But Bortolotti contended that most Canadian corporate-class ETFs are “actively managed and significantly more expensive than their traditional counterparts.”

Those that face withholding tax on foreign dividends could avoid 15% to 27% of the hit by using Canadian-listed mutual funds or ETFs that hold the underlying stocks directly, said fee-for-service financial planner Ed Rempel from Markham. That’s because of the Capital Gains Refund Mechanism, which effectively allocates capital gains on stocks sold within the funds first to investors that sold the funds.

As for domestic fixed-income investors, Bortolloti and fellow PWL advisor Justin Bender suggested the use of tax-efficient ETFs such as the BMO Discount Bond Index ETF (ZDB) or the First Asset 1-5 Year Laddered Government Strip Bond Index ETF (BXF) for short-term exposure.