Sep 202015
 

So you own a few ETFs and you’re ready to optimize your accounts. Especially you rich chumps and chumpettes with taxable accounts! Well swap ETFs are a crazy scheme with the primary benefit being tax savings. I mean, what’s with these governments! How dare they use our hard earned money to pay for roads, schools, and fundamental basic services! Even the so called “Tax Free Savings Account” is subject to some foreign withholding taxes.

Never fear, your crazy uncle has a scheme for those taxes!

 


Get to the point! What’s a swap ETF?

Well let me break it down for you wizards. A swap ETF essentially turns dividends or interest income into capital gains. Why would you want that? Because foreign dividends and interest are taxed at your full income tax rate, meanwhile capital gains are only half that. If you make over $138,586 your federal tax rates will be like so:

Investment Federal Tax
Capital Gain (Canadian or foreign) 14.5%
Foreign Dividend (Counts as “other income”) 29%
Bond income (Canadian or foreign) 29%

Source: Taxtips.ca

The ratio of capital gains tax to foreign dividend tax will be the same 1:2 no matter what your income. However, Canadian dividends come with a fancy dividend tax credit, so don’t bother using a swap ETF for them.

 


Seems reasonable, but how does it work?

First, you buy the ETF from a custodian like Horizon. They throw your cash into a big pile of money at their headquarters which earns some interest (<2%). Next they tempt a third party bank with that interest “hey, want this interest? All you have to do is invest your own money in <S&P500, bond index, whatever> and give us whatever the index does. We have this massive pile of cash to cover any losses so don’t worry”. The third party, in this case the National Bank of Canada, tracks the index with their capital and delivers the returns to the custodian, who eventually gets it back to you.

The dividend/capital gain conversion comes from National Bank reinvesting their dividends, and passing on the value as a higher unit price.

 

Ok….. Can you dumb it down a shade?

  1. You buy 10 units of xETF at $20 each, with MER of 0.07%
  2. Horizon puts your $200 in their cash account at, lets say 1% interest
  3. Horizon tells the National Bank to add ten units to their index fund account
  4. A year passes, and the index goes up 8% and gives a 2% dividend for 10% total
  5. You sell 10 units of xETF, now worth $219.85 (10% return minus 0.07% MER)
  6. National Bank delivers $20 to Horizon to cover your 10% return (10% of $200)
  7. Horizon pays National Bank $2 from the 1% interest
  8. Everyone profits!

On your $200 investment, you earned $19.85, Horizon earned $0.15 from their MER, and National Bank earned $2.

If the index went down 10% instead, Horizon will have to pay National Bank $20 to cover the loses. They use your money though, so they don’t care. And they still charge you a MER, so you are down to $179.87. In this case you are -$20.13, Horizon is still up $0.13, and National Bank is up $2. It’s a pretty good deal for them isn’t it? Profit no matter what the market does. Don’t worry, National Bank’s $2 isn’t subtracted from what you earn, so you get excellent market exposure for the price of the MER.

Some swap ETFs charge other fees such as swap fees. These get pretty complicated but they are usually not more than 0.3%, and they shouldn’t discourage you from using a swap ETF.

 


What’s the catch?

Counterparty risk. What if National Bank ends up being a deadbeat and can’t deliver the return? You can kiss your return goodbye. But wait! Horizon is holding your $200 investment in a cash account! That’s not at risk is it? Nope! In fact Horizon can even give that interest to you instead of the deadbeat counterparty.

To further reduce risk, Horizon is required by law to not let the counterparty own more than 10% of what is promised to you. This means if your index gains more than 10% Horizon will find additional counterparties. Lets hop they aren’t ALL deadbeats!

 


Ok I’m convinced, should I sell all my ETFs and switch to swap ETFs?

Calm down there junior! There’s a time and place for everything. Remember what Professor Oak taught you. Are any of your dividends going to be taxed at your full rate? Remember the table above and I’ll mention the two best cases for buying a swap ETF:

  1. Holding bonds in your taxable accountHBB Horizons CDN Select Universe Bond ETF will replace that pesky 29% tax with 14.5% on your interest income. What’s that? You bought the bonds to generate cash? Why not sell a few shares to generate an income? or disregard this post and put them in an RRSP or your TFSA.
  2. Holding US or foreign dividend ETFs in your taxable account –  HXS Horizons S&P 500® Index ETF  or HAZ Horizons Active Global Dividend ETF will replace the 29% dividend tax with a 14.5% capital gains tax. The latter is an actively managed ETF (isn’t that an oxymoron?) and thus has higher fees (0.8% MER), but Horizon doesn’t yet offer a passive international ETF.

There are a lot of other reasons to use swap ETFs that have to do with withholding tax, tracking error, tax deferment. I won’t get into them here because I can tell you are confused already. Check the links at the bottom of the page to learn more and for now lets end with an example:

$20,000 divided evenly into two bond funds, a non swap – ishares XBB, and a swap – HBB. Let’s assume their return is identical, but non-swap pays a distribution of 2.89% (which is what they reported for the past year). And lets assume you will pay a 29% distribution tax and 14.5% capital gains tax.

Swap, HBB  No Swap, XBB
1 Year Capital Gain 4.51% 1.62%
Distribution 0%  2.89%
Return from $10,000 $451  $451
Taxes Payable $65.40  $88.89
In your post-tax pocket $385.60  $362.11

 

The swap ETF wins by $23.49. Sure it doesn’t seem like much, but remember that small gains become big gains over time! After 25 years the difference will be over $1,400. And remember that distributions will be taxed every year, but your HBB will only be taxed when you sell, deferring your tax indefinitely.

 


TL;DR

Consider using a swap ETF to reduce taxation on bond income or foreign dividends.

If you want more information check out these resources that I used for writing this article:

Understanding Swap Based ETFs – Canadian Couch Potato
Education Report: Swap-Based Exchange Traded Funds (Warning: it’s a pdf)

Disclaimer: I own shares in HXS

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  8 Responses to “SWAP ETFs – YOUR CRAZY UNCLE PROMISES TAX SAVINGS”

  1. I like Uncle Buck.

     
  2. […] satisfy as many criteria as possible. The obvious first choice is my old friend the dividend-free Swap based ETF. Horizon has three solid […]

     
  3. Hey, thanks for this. I am just starting out with ETF investing and started reading about how ETFs are taxed. I started learning about Adjusted Cost Base and the need to track distributions and re-investments. It just sounds way too exhausting. So much for being a couch potato. Then I stumbled upon swap based products, but didn’t really understand what they were until I read your dumbed down explanation. Thank you!

     
    • Yea I agree with you, ACB can be very complex and swap ETFs are a nice way to simplify taxes.

       
      • But risk is another thing. Swap-based ETFs are considered a derivative product. Since I would not own the underlying equities I would be at risk of losing some or all of my money if the counterparty fails to live up to it’s obligations, or if the gov’t passes legislation to change those types of products.

         
        • That’s not exactly true. Your initial investment is held by Horizon and only your returns are held by the counterparty (since they’re the ones actually doing the investing). If the counterparty were to default or disappear then all you’d lose is your return which can’t be more than 10% thanks to regulations from Canada.

          If there were new legislation that made Swap ETFs illegal or something the downside would be the same as an ordinary ETF closing – forced realization of capital gains (or loses) and the tax obligations that come with it.

          The risks are marginally higher, but in my opinion they are worth it for the simplicity of calculating ACB and further delaying your distribution taxes by removing dividends.

           
  4. Don’t forget HXT if you want to hold the TSX60 in your taxable account. With HXS, HXT, HAZ and HBB, one could build a very tax efficient couch potato style portfolio.

     
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