How to make accountants smile

Low turnover and in-kind transfers have made ETFs popular with tax-conscious investors and their advisors. Choosing an ETF over a mutual fund generally provides immediate cost and tax savings, but there are additional ways to enhance aftertax returns using ETFs.

Keep distributions low

Lower distributions generally mean higher after-tax returns because more capital is available to compound. When selecting an ETF, advisors should consider their client’s tax status.

The ETF Screener on the TMX Money website compares the tax efficiency of various ETFs, a benefit that’s estimated as the proportion spent on taxes with appropriate tax rates applied to income, capital gains, dividends and return of capital distributions.

Structural vigilance

Some ETF manufacturers embed structures into their funds to make them more tax-effective. This involves an added layer of cost. An example is Claymore’s Advantaged Canadian Bond ETF (CAB) that structures payouts as a return of capital. CAB’s 4.17% return is almost 1% lower than the 5.14% return for its benchmark, the DEX DLUX Capped Bond Index (from inception November 19, 2009 to December 31, 2010).

However, the fund’s stated MER is only 0.33%. Claymore says, “The difference in returns between the Index and ETF is principally due to fees and expenses.” The prospectus reveals the fund pays the counterparty an amount under a forward agreement up to 0.45% per annum of the forward amount.

Depending on an investor’s circumstances, the tax advantage of receiving distributions as return of capital may or may not exceed the added layer of cost in these products.

Peculiarities of withholding tax

In most cases, buying a Canadian ETF that holds U.S. ETFs means losing the withholding tax charged on the U.S. distributions. The tax is withheld on a fund level, making it impossible to claim the tax credit even in a registered account.

This amount could be meaningful, particularly for high-incomepaying ETFs like iShares U.S. High Yield Bond (XHY), which usually gives up 15% of its 7% distribution yield to tax, reducing overall investment return by over 1%.

However, a change occurred last year, as noted by iShares. The U.S. Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which was retroactive to January 1, 2010, reinstated the U.S. withholding tax exemption for qualifying income distributed by the relevant Regulated Investment Companies to foreign entities.

As a result, when any ETF manufacturer reclaims the tax, investors can get back most of the amount paid by an ETF in 2010-2011. According to iShares’ June financial statements, not only did XHY reclaim a portion of 2010’s withholding tax, but the tax on 2011 distributions amounted to 0.40% instead of the previous 15%. According to iShares, “The exemption will currently expire for tax years beginning after Dec 31, 2011.”

Watch derivative structures

Investors in a U.S.-based Rydex fund received an 87% capital gains distribution in 2008 as a result of expiring futures contracts and prevailing market volatility. Canadian derivative-based ETFs seem to be unaffected.

Horizons BetaPro commented that derivatives contracts maturing in 2012 are likely to be extended without tax consequences. In general, derivative strategies can introduce collateral and counterparty risk to ETF analysis.

Tax-loss harvesting

ETFs provide exposure to various asset classes with similar risk profiles. This creates an opportunity for tax-loss harvesting.

For example, an owner of iShares S&P/TSX 60 (XIU) with an unrealized capital loss could sell and immediately buy iShares S&P/TSX Capped Composite (XIC), harvesting a valuable tax credit while staying invested in Canadian equities.

While the two ETFs are similar in terms of performance (save a “Nortel effect” where one stock outperforms the rest of the index, when the capped XIC would perform very differently), they track separate indices.

To avoid swapping ETFs based on the same underlying index, an advisor could use a risk model to identify “risk twins,” or ETFs that could be used interchangeably. Another example is BMO S&P/TSX Equal Weight Oil & Gas Index (ZEO) and iShares S&P/TSX Capped Energy Index (XEG).

More risk twins can be found in the table below.

Examples of risk twins for taxloss harvesting

Twin 1	Twin2
iShares S&P/TSX 60 Index Fund (XIU)	iShares S&P/TSX Capped Composite Index Fund (XIC)
iShares S&P/TSX Capped Composite Index Fund (XIC)	Horizons BetaPro S&P/TSX 60 Index ETF (HXT)
Horizons BetaPro S&P/TSX 60 Index ETF (HXT)	iShares S&P/TSX 60 Index Fund (XIU)
Horizons BetaPro S&P/TSX 60 Index ETF (HXT)	Claymore Canadian Fundamental Index ETF (CRQ)
iShares S&P/TSX Capped Energy Index Fund (XEG)	BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO)
iShares S&P/TSX Capped Financials Index Fund (XFN)	BMO S&P/TSX Equal Weight Banks Index ETF (ZEB)
iShares S&P 500 Index Fund (CAD-Hedged) (XSP)	BMO US Equity Hedged to CAD Index ETF (ZUE)
Claymore Broad Emerging Markets ETF (CWO)	iShares MSCI Emerging Markets Index Fund (XEM)
iShares MSCI Emerging Markets Index Fund (XEM)	Claymore BRIC ETF (common class) (CBQ)
iShares DEX Universe Bond Index Fund (XBB)	Claymore Advantaged Canadian Bond ETF (CAB)
Claymore Gold Bullion ETF (CGL)	Horizons BetaPro COMEX Gold ETF (HUG)

In any core/satellite portfolio,a passive core could generate tax losses to offset realized capital gains from active satellite strategies.

ETFs offer after-tax opportunities in addition to their inherent tax efficiencies. Some synthetic ETFs (an ETF that uses derivatives) offer investors and their advisors effective ways to manage tax but also introduce new risks. Carefully managed, ETFs offer ways to create tax flexibility that can make investors’ accountants smile.

Ioulia Tretiakova is Vice President and Director of Quantitative Strategies at PÜR Investing Inc., a software development firm specializing in disruptive strategies for investors, their advisors and pension plans. PUR is a registered portfolio manager.