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Horizons ETFs Assessing Impact of Proposed Federal Tax Changes

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Nov 17, 2010
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Horizons ETFs Assessing Impact of Proposed Federal Tax Changes

Horizons ETFs has determined that the exchange traded funds listed on the table below (the "ETFs") could be impacted by the changes after their 2019 taxation years.
https://www.newswire.ca/news-releases/h ... 19953.html

The party is over folks !
145 replies
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Dec 24, 2007
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Give me a break .... there are tax changes in every budget and all taxpayers have to change how they operate.

investment funds have been avoiding taxes for years by using derivative contracts to turn investment income that would otherwise be treated as ordinary income into tax-preferred capital gain. The government finally decided to shut it down rather than wait for a court decision on cases that have been dragging on for years.

The sky is not going to fall.
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Jun 28, 2018
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Baskin tweeted about this yesterday not long after the release. Interesting.
The Distracted Investor

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Jun 19, 2009
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Is there an excerpt in the budget that they're specifically referring to? Would be interesting to read up on it. Hopefully the changes will be minimal.

Edit: never mind, just read a few more articles. Sounds like they're targeting total return swaps directly i.e called them out by name lol
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Dec 26, 2013
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are these swap based ETFs?
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Example HXT Horizons S&P/TSX 60 Index ETF is swap based.
Does not physically hold the underlying constituent securities of the Index. Instead its return is delivered via swap agreements with acceptable counterparties...
www.horizonsetfs.com/horizons/media/pdf ... -Sheet.pdf
The Distracted Investor

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Sr. Member
Dec 26, 2013
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What does this mean for portfolios largely composed of these swap ETFs? Will there be a mass exodus or would most stay the course due to the capital gains that would be triggered.
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Jan 18, 2014
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Rouyn-Noranda
Good question. I mostly got Horizons ETFs in registered accounts when I was with Qtrade because they were commission-free, so wouldn't really matter if they started paying distributions, but I'm wondering what would be the effect of people massively selling off these ETFs.
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May 22, 2003
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Well won't it just become a regular index ETF then? While it will lose the main advantage of being a swap-based ETF, assuming their MER is equivalent to other index-ETFs, there is no compelling reason to sell/switch?

edit: article here behind paywall, but if you're quick enough, you can copy and paste the contents before it fully loads

https://www.theglobeandmail.com/investi ... ew-budget/
Last edited by notenoughsleep on Mar 20th, 2019 8:54 pm, edited 1 time in total.
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Point to a specific reference. I don't see how the federal government can change the taxation of total return swaps without significantly impacting the tax liability of public pension funds and major Canadian corporations, including Canadian banks. I didn't see anything in the budget that changed this taxation. :(

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Doug
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dmehus wrote: Point to a specific reference. I don't see how the federal government can change the taxation of total return swaps without significantly impacting the tax liability of public pension funds and major Canadian corporations, including Canadian banks. I didn't see anything in the budget that changed this taxation. :(

Cheers,
Doug
https://www.budget.gc.ca/2019/docs/plan/chap-04-en.html

Closing Tax Loopholes

In each of its previous three budgets, the Government has taken action to ensure that Canada’s tax rules function as intended and that they do not result in unfair tax advantages for some at the expense of others. Budget 2019 continues this approach by proposing measures to close tax loopholes that can result in some people paying less than their fair share. Ongoing legislative adjustments help ensure the integrity of Canada’s tax system and give Canadians greater confidence that the system is fair for everyone.

To make Canada’s tax system more fair, Budget 2019 proposes to:

Prevent the use by mutual fund trusts of a method of allocating capital gains or income to their redeeming unitholders where the use of that method inappropriately defers tax or converts fully taxable ordinary income into capital gains taxed at a lower rate.
Improve existing rules meant to prevent taxpayers from using derivative transactions to convert fully taxable ordinary income into capital gains taxed at a lower rate.
Stop the use of individual pension plans to avoid the prescribed transfer limits. These limits are meant to prevent inappropriate tax deferrals when individuals transfer assets out of certain types of pension plans.
Last edited by notenoughsleep on Mar 20th, 2019 8:56 pm, edited 1 time in total.
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May 11, 2018
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dmehus wrote: Point to a specific reference. I don't see how the federal government can change the taxation of total return swaps without significantly impacting the tax liability of public pension funds and major Canadian corporations, including Canadian banks. I didn't see anything in the budget that changed this taxation. :(

Cheers,
Doug
From the Notice of Ways and Means Motion to amend the Income Tax Act and Other Related Legislation, under Tax Measures, at the very end of the budget document:
Character Conversion Transactions
80 (1) Subparagraph (b)(i) of the definition derivative forward agreement in subsection 248(1) of the Act is replaced by the following:
(i) revenue, income or cashflow in respect of the property over the term of the agreement, changes in the fair market value of the property over the term of the agreement, or any similar criteria in respect of the property unless
(A) the property is
(I) a Canadian security (in this subparagraph as defined in subsection 39(6)), or
(II) an interest in a partnership the fair market value of which is derived, in whole or in part, from a Canadian security,
(B) the purchase agreement is an agreement to acquire property from
(I) a tax-indifferent investor, or
(II) a financial institution (as defined in subsection 142.2(1)), and
(C) it can reasonably be considered that one of the main purposes of the series of transactions or events, or any transaction or event in the series, of which the purchase agreement is part is for all or any portion of the capital gain on a disposition of a Canadian security referred to in clause (A) — as part of the same series of transactions or events — to be attributable to amounts paid or payable on the Canadian security by the issuer of the Canadian security during the term of the purchase agreement as
(I) interest,
(II) dividends, or
(III) income of a trust other than income paid out of the taxable capital gains of the trust,
There's a subsection 2 and a subsection 3 as well that I didn't copy here that seem to be a long-winded way of saying this takes effect in 2020.

It appears that Horizons has been relying on an exemption from the definition of "derivative forward agreement". The definition is being changed to ensure the agreements underlying these funds are no longer exempt. I'm no lawyer, but that's my interpretation. It looks tailored specifically to hit the Horizons Total Return funds.
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Nov 17, 2010
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notenoughsleep wrote: Well won't it just become a regular index ETF then? While it will lose the main advantage of being a swap-based ETF, assuming their MER is equivalent to other index-ETFs, there is no compelling reason to sell/switch?

edit: article here behind paywall, but if you're quick enough, you can copy and paste the contents before it fully loads

https://www.theglobeandmail.com/investi ... ew-budget/
Federal government looks to quash tax loophole for ETFs in new budget

MARCH 20, 2019

The federal government is moving to close a loophole that allows investors in certain exchange-traded funds to defer taxes, but the main provider of the products says it’s too early to know what the eventual impact of the proposed legislation will be.

Citing “unfair tax advantages,” this week’s federal budget said the proposed changes would “prevent the use by mutual fund trusts of a method of allocating capital gains or income to their redeeming unitholders where the use of that method inappropriately defers tax or converts fully taxable ordinary income into capital gains taxed at a lower rate.” (ETFs are a type of mutual fund trust.)

One of the government’s main targets is believed to be swap-based ETFs – also known as total return ETFs. These complex products don’t hold any securities directly but deliver the same performance as an index through an agreement – called a total return swap – with a financial institution. The structure is popular in non-registered accounts because no dividends or interest are received and no income taxes are payable until the units are sold, at which time the investor’s total return is taxed advantageously as capital gains.

In recent years, the federal government has cracked down on other tax-friendly investment structures, including a 2013 decision to curtail the use of “character conversion transactions” that used derivatives to turn income into capital gains, and 2016 legislation to eliminate tax-free switching between corporate-class funds. Given these recent moves, the government’s decision to target swap-based ETFs didn’t come as a surprise to the industry.

“I’m not a tax expert but my read of the budget document suggests that this structure works today because the swap-based funds rely on an exemption, which the budget indicates will no longer apply to these funds,” Dan Hallett, vice-president and principal of Highview Financial Group, said in an interview.

“At this point, it does appear as though these funds are being targeted directly. If my assessment is correct, the tax benefits of these funds will end,” Mr. Hallett said.

Horizons ETFs Management (Canada) Inc. says it is still trying to determine how the proposed legislation will affect its 15 index total return ETFs, as well as other products that use derivatives. The list of ETFs that could potentially be affected includes its largest ETF – the Horizons S&P/TSX 60 Index ETF, with assets of about $1.88-billion – and funds that use derivatives to track commodities such as oil, natural gas and gold. These include “bull” and “bear” ETFs that allow investors to make leveraged bets on underlying indexes and commodities. It’s not clear if ETFs from other companies would be affected by the proposed legislation.

The changes would not take effect until after the 2019 taxation year, Horizons said. “If the ETFs were to continue to carry on operations after their 2019 taxation years in the same manner as they do currently, the proposed legislative changes could potentially result in taxable distributions to the unitholders of the ETFs in respect of periods after their 2019 taxation years,” the company said.

Investors who hold swap-based funds needn’t panic, said Dan Bortolotti, portfolio manager at PWL Capital.

“If they are forced to shut down these funds, I would expect Horizons will look for ways to minimize the tax impact to their investors. So if you hold these ETFs in a taxable account, it probably makes sense to just take a wait-and-see approach for now. You will be able to make a better decision once we have more information,” Mr. Bortolotti said.
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notenoughsleep wrote: https://www.budget.gc.ca/2019/docs/plan/chap-04-en.html

Closing Tax Loopholes

In each of its previous three budgets, the Government has taken action to ensure that Canada’s tax rules function as intended and that they do not result in unfair tax advantages for some at the expense of others. Budget 2019 continues this approach by proposing measures to close tax loopholes that can result in some people paying less than their fair share. Ongoing legislative adjustments help ensure the integrity of Canada’s tax system and give Canadians greater confidence that the system is fair for everyone.

To make Canada’s tax system more fair, Budget 2019 proposes to:

Prevent the use by mutual fund trusts of a method of allocating capital gains or income to their redeeming unitholders where the use of that method inappropriately defers tax or converts fully taxable ordinary income into capital gains taxed at a lower rate.
Improve existing rules meant to prevent taxpayers from using derivative transactions to convert fully taxable ordinary income into capital gains taxed at a lower rate.
Stop the use of individual pension plans to avoid the prescribed transfer limits. These limits are meant to prevent inappropriate tax deferrals when individuals transfer assets out of certain types of pension plans.
I saw that, but I actually took that to mean they're looking at disallowing the use of capital gains distributions by mutual funds.

I don't think this will relate to swap-based ETF taxation. :)

Since there's no details, I think Horizons' statement means they're waiting to see the text of the legislation, which isn't public yet.

Cheers,
Doug
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Nevertheless, even if your theory holds true, the federal government is essentially shooting itself in the foot to spite its face, to borrow a cliché. The Canada Pension Plan Investment Board, Ontario Municipal Employees Retirement System, the Scotiabank Pension Plan, and numerous corporate entities and retirement plan administrators use total return swaps to gain exposure to certain segments of the market (public and private). It won't just be these Horizons funds that would be potentially hit with a tax bill, but those funds, including large pension funds, as well. :)

Moreover, since the current and prior year returns have already been accrued to the NAV, there shouldn't be any capital gains on disposition (the ETFs hold no assets that will continue to appreciate in value). All it would mean is that they may have to convert to holding the securities directly.

Cheers,
Doug
Banking & Savings: Tangerine & EQ Bank
Credit Cards: American Express SimplyCash, Rogers World Elite MasterCard, Scotiabank Scene+ Visa (was Tangerine Money-Back World MasterCard)
Investments: Scotia iTRADE | Pension: Municipal Pension Plan
Jr. Member
Jun 22, 2015
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I've been a user of these swap based products. However, I am still glad the government is ending this loophole.
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Anyone know what would likely happen to holders of HBB? I can imagine a lot of people held this in their non-registered account as the portion of their bond portfolio.
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Mar 16, 2014
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i'm thinking a foreign domiciled total return swap product may be immune to these changes?
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tdiddy23 wrote: i'm thinking a foreign domiciled total return swap product may be immune to these changes?
Can you provide examples?

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