Tax changes lead Horizons to propose converting ETFs to corporate-class funds

The synthetic ETFs primarily use derivative arrangements to achieve their investment objectives — a methodology the Department of Finance targeted in its 2019 federal budget.

The 2019 budget proposed to disallow allocations of ordinary income to redeeming unitholders if the unitholders’ redemption proceeds are reduced by the allocation. This would apply to all mutual fund trusts for tax years beginning after March 18, 2019. The Department of Finance confirmed these intentions by releasing draft legislation on July 30.

Had the synthetic ETFs continued to operate as normal after the 2019 tax year, doing so could have resulted “in taxable distributions to the unitholders of the ETFs in respect of periods after their 2019 taxation years,” Horizons said in a release from March.

ETFs within a mutual fund corporation are not considered mutual fund trusts, meaning the so-called “allocation to redeemers” rule changes do not apply. Merging the ETFs into a new mutual fund corporation would “substantially reduce the likelihood of [income] distributions” and allow the ETFs to maintain their existing benefits, Horizons said in a release issued Friday.

The merger would also create operational efficiencies, said Steve Hawkins, president and CEO of Horizons. For example, the new corporation would only have to file one tax return instead of 44, and could use one custodian instead of three.

For these reasons, Horizons had been considering reorganizing the synthetic ETFs prior to the 2019 budget’s proposals, Hawkins said. “We already knew it was going to be more efficient to have [the synthetic ETFs] in a corporate-class structure,” he said. The budget “just sped up the timeline.”

In Friday’s release, Horizons said the reorganization should not have “retroactive taxable implications to unitholders.” Nor should the reorganization be a taxable event, so long as unitholders make the appropriate election under Section 85 of the Income Tax Act to exchange their units for shares of the new mutual fund corporation. Horizons said it will help unitholders file that election free of charge.

Hawkins said any costs associated with the reorganization would not be passed to unitholders.

The proposed reorganization is subject to shareholder and regulator approval, but Horizons expects it to happen before the end of 2019. Go here to see the full list of affected Horizons ETFs.

Concerns with the legislation

While Horizons has found a solution for its synthetic ETFs, Hawkins noted lingering concerns with the allocation to redeemers rule changes for the industry as a whole.

“The draft legislation is going to disadvantage any ETFs or mutual funds that use derivatives actively as part of their investment strategy,” said Hawkins, who’s also chair of the Canadian ETF Association (CETFA). “U.S. ETFs have the ability to still use the [U.S.] capital gains refund mechanism, which is similar to the allocation to redeemers methodology, to reduce portfolio tax implications. The proposed tax changes would eliminate the ability for Canadian ETFs to manage the taxable implications of the underlying portfolios to the same extent that mutual funds and U.S. ETFs can.”

If the draft legislation is enacted as is, “there will be a lot of ETF players that might have to change the way they run their operations and become mutual fund corporations,” Hawkins said.

A major disadvantage of a mutual fund corporation over a mutual fund trust is that income distributions are less tax-efficient within a corporation. “Income is taxed in the corporation, and at a higher level,” Hawkins said. This would be particularly problematic for fixed-income ETFs in a mutual fund corporation.

(Since it’s unlikely that Horizons’ synthetic ETFs will distribute income, this disadvantage does not apply to Horizons’ corporate-class structure, Hawkins said. Shareholders who redeem their corporate-class shares will realize capital gains.)

The draft legislation is out for comment until Oct. 7, 2019.

The Investment Funds Institute of Canada (IFIC) expressed support for the draft legislation, telling Investment Executive earlier this month that “our hope [is] that it will” pass “because it has been the result of discussions between industry and Finance [Canada] trying to create an approach that addresses Finance’s concerns, but also takes the industry’s operational concerns into account.”

CETFA will be working with IFIC to submit further comment on the legislation, Hawkins said.