Another tax loophole is closed for income investors

For investors who hold fixed income in non-registered accounts, the combination of low yields and high taxes can easily result in negative returns after inflation. The financial industry can’t raise rates or control the CPI, but they have been creative when it comes to creating products that minimize taxes.

A number of popular bond funds, for example, use derivatives that recharacterize fully taxable interest as lightly taxed capital gains. (Others use a similar structure to convert foreign dividends, which are also fully taxable.) But the 2013 federal budget takes aim at this sleight-of-hand, putting an end to what are known as “character conversion transactions.” The proposal is likely to affect many retirees and income-oriented investors.

Moving forward

Funds with this complicated structure often have the term “advantaged” in their name. iShares offers five such ETFs with more than $1.1 billion in combined assets, including the popular iShares Advantaged U.S. High Yield Bond Index Fund (CHB). The family of O’Leary Funds—owned by CBC personality Kevin O’Leary—also includes “advantaged” products covering both bonds and global dividend stocks.

To understand how these funds work, let’s use CHB as an example. Although this ETF is designed to get exposure to U.S. high-yield bonds, the fund actually purchases a portfolio of non-dividend-paying Canadian stocks. It then enters a “forward agreement” with a counterparty (in this case, TD Bank) that sells these stocks short and uses the proceeds to buy a portfolio of high-yield bonds. The counterparty is then obligated to deliver the return of that bond portfolio to investors in the fund.

Yes, it’s wickedly complicated. But the upshot is that investors who hold CHB capture the returns of U.S. high-yield bonds without directly holding any bonds at all, and the income they receive from the ETF is characterized as return of capital, or as capital gains. The fund currently yields about 7%, and none of that income is taxed as interest, so the appeal is obvious.

Time for Plan B

Investors no doubt remember the day in the fall of 2006 when federal finance minister Jim Flaherty changed the rules governing income trusts. Retirees, in particular, had enjoyed years of tax-advantaged income from these trusts, but the government estimated it was losing hundreds of millions a year in revenue. “Advantaged” funds that use forward agreements are nowhere near as popular as income trusts were, but by closing this loophole the government expects to increase tax revenues by $175 million over five years.

All of this is a reminder that advisors who use tax-advantaged strategies need to be prepared for Ottawa to put its foot down. It’s not clear yet how fund providers will react to the proposed changes, but income investors should be ready with a Plan B. Foreign dividend stocks are best kept in RRSPs, and for those who need to keep fixed income in nonregistered accounts, the most tax-efficient choice is usually GICs.