Canadian-listed ETFs with US exposure aren’t as prone to tax consequences as their structure might suggest
While most ETFs offered in the US market are completely self-standing, Vanguard offered its ETFs as a new share class of an already-existing index portfolio. With that, it was able to launch those ETFs with large economies of scale and low expense ratios. But there’s one question: how’s their tax efficiency?
As a new paper from PWL Capital notes, investors in US-listed Vanguard pooled funds face a different situation from those invested in ETF-only structures.
“One shareholder [in an ETF-only structure] selling ETF shares at a big profit cannot ‘socialize’ their taxable gain to the remaining shareholders, as the ETF shares will either be sold to another investor on the open market or be redeemed in kind by the ETF provider,” explained Raymond Kerzerho, director of Research at PWL Capital and author of the report.
With the Vanguard portfolios, ETF shareholders indirectly hold securities in a common portfolio, along with mutual-fund unitholders and institutional shareholders. When a member belonging to one of the latter two groups disposes of their shares, it could trigger a cash redemption that’s financed by selling securities directly from the portfolio. The result: a possible large taxable gain that could be funneled in part to ETF shareholders.
This has implications for several of Vanguard’s Canadian-listed ETFs — specifically, the ones that hold units of its US-listed ETFs. Canadian ETFs that hold a US-listed Vanguard ETF could be impacted by a large capital-gains distribution in that underlying fund. “[U]nder Canadian tax law, capital gain distributions in a foreign ETF are taxable at the full, ordinary income-tax rate,” Kerzerho said, noting that investors holding such Canadian ETFs in taxable accounts ought to understand that risk.
But he went on to say that “the risk posed by Vanguard’s multiple-share-class structure is extremely remote.” Citing a research paper by Morningstar, he said that moving from passive mutual funds to passive ETFs results in a marginal reduction in capital-gains distributions. Vanguard’s integration of passive mutual funds and passive ETFs under the same structure, therefore, is not likely to result in much larger capital-gains distributions compared to ETF-only structures.
He also noted that US regulations, unlike those in Canada, allows fund companies to cherry-pick securities lots when investors redeem shares. That means Vanguard is theoretically able to improve their tax efficiency by selectively redeeming high-cost shares to mutual-fund investors in cash, and choosing low-cost shares for ETF shareholders’ redemptions. In case a mutual fund or institutional shareholder moves to redeem more than 1% of the portfolio’s assets or $250,000, the firm also has the discretion to redeem shares in-kind.
“Vanguard has a stellar historical record when it comes to capital-gains distributions,” Kerzerho continued. Looking at capital-gains distributions for key US-listed Vanguard ETFs, as well as Canadian-listed ETFs that hold them, he said there’s been a notable absence of major distributions since their inception.
“Any significant capital gains distributions [in the Canadian-listed ETFs] have resulted from currency-hedging transactions rather than the multiple-class-share structure,” he said.
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