Horizons ETFs Management Canada Inc. plans to restructure about half of its assets into corporate-class funds, including its flagship $1.9-billion Horizons S&P/TSX 60 Index ETF, after the federal government moved earlier this year to close a tax loophole being used by certain exchange-traded funds.
Horizons announced after markets closed on Friday that the proposed change, which will affect about $5.2-billion of its overall $10-billion in assets under management, will not create tax consequences for unitholders of the affected funds. Horizons says unitholders will have the same tax efficiencies under the new corporate-class structure, and that investment mandates, fees and tickers of the funds affected will stay the same.
“All of the same benefits that exist today will continue,” Horizons Canada chief executive Steve Hawkins said.
A corporate-class structure is set up like a company and can hold multiple investment fund classes. The structure enables the fund to share expenses and spread profits and losses from the different fund portfolios across the underlying funds in a way that’s more tax-efficient for unitholders. Corporate-class funds are targeted to investors who want to own investment funds in a non-registered account, often when they’ve used up their contribution room in tax-free savings accounts and registered retirement savings plans.
Citing “unfair tax advantages,” the federal Liberals proposed 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.” (ETFs are a type of mutual fund trust.)
The budget proposal has yet to be passed, and Ottawa recently deferred the section related to capital gains, which has a wider impact, amid pushback from the industry. The government appears to be moving ahead with the income allocation part of the proposal, which would prevent funds that use derivative transactions from deferring tax or converting fully taxable ordinary income into capital gains.
The income allocation part of the proposal targets swap-based ETFs – also known as total return ETFs – that don’t directly hold any securities, but provide the same performance as an index through what’s known as a “total return swap” agreement 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.
Ottawa’s proposed changes affect 15 of Horizon’s index total return ETFs, as well as 29 other products 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.
In June, BMO Nesbitt Burns Inc. closed its funds that would be affected by Ottawa’s proposed changes, saying they were “no longer commercially feasible to continue” and that the move was “in the best interests of shareholders.”
Purpose Investments Inc. launched the first corporate-class series of ETFs in Canada in 2013, and today about half of its funds use this structure, including its flagship equity fund, Purpose Core Dividend Fund.
Horizons had been contemplating switching to corporate-class structure even before the federal government announced the changes in its budget this year amid “rumblings” Ottawa wasn’t happy with how the total-return structures were being used, Mr. Hawkins says.
Under Horizon’s proposed reorganization, units of each of the affected ETFs will be exchanged for a corresponding class of shares of a new mutual-fund corporation. The restructured funds will then be “on a level playing field with other currently existing corporate-class mutual funds and corporate-class exchange-traded funds," the company says.
Horizons is hoping to complete the restructuring before year-end. It would require regulatory and unitholder approvals. Horizons is expected to have a unitholder vote in the coming weeks, and doesn’t expect much opposition.
“It’s in their best interest going forward to vote for this change," Mr. Hawkins said. "If they keep things as is, the trust would become taxable and we would have to make taxable distributions. The reason people want these products is efficiency.”
Horizons said the move will be done through a section of the Income Tax Act, in a transfer known as a Section 85 rollover, to prevent a taxable event. The strategy is often used in corporate reorganizations or during mergers and acquisitions.
“Any corporate action can create anxiety with an investor, but we will be holding their hands through the entire process,” Mr. Hawkins said. “This reorganization will not be taxable event for clients. That’s the big consideration here.”