Tuesday, 22 March 2011

Tax Champion ETFs of 2010

The main Canadian ETF providers have now published the tax breakdown of 2010 distributions for their ETFs:
The other provider Horizons has not yet published the final 2010 tax breakdown for its ETFs.

With the tax breakdown we can compare results and see which ETFs produce the most after-tax bang for each buck distributed. For those investors who hold ETFs in taxable accounts there is a crucial distinction between whether the ETF throws off the most highly taxed ordinary income and foreign income, or much less taxed dividends and capital gains or not-at-all taxed return of capital (ROC). The exact tax rates vary by province and by the investor's taxable income level (see the excellent tables of personal tax rates on TaxTips.ca).

Our comparison uses a middle of the income scale Ontario taxpayer with a taxable income between $65k and $74k. At that income level, dividends are, apart from ROC of course, a more tax-efficient type of distribution than capital gains. At the highest income levels, the relationship reverses and capital gains get taxed less than dividends. Our results change a bit but the tax champion ETFs remain quite consistently the same. So, with further ado,

The Results: 2010 ETF Tax Champions
(click on table below to expand)

Gold Medallist: The champion Canadian ETF of 2010 in after-tax net cash distribution in the pocket of the investor is the Claymore Canadian Financial Monthly Income ETF (TSX symbol: FIE). FIE will have managed to deliver an amazing 99 cents after-tax out of every dollar in distributions to the investor - only 1 cent going in taxes to the government! The secret of that success is that almost all of the distribution consisted of ROC (dare we say that FIE ROCks!?). We have previously discussed ROC and the crucial difference between good and and bad ROC. FIE is a brand-new fund, having started up in April 2010, so it is no surprise that a big chunk of its distributions could come in the form of good ROC as growth of the fund and the unit creation process transformed dividends into ROC. We should anticipate that given the portfolio holdings of FIE, in future years there will be a lot more distribution income in the form of dividends and even ordinary interest income.

The other reason we rate FIE tops is that it provided a substantial level of income (4.9% yield), expressed roughly as a yield - total distributions as a percent of the year-end ETF price.

Silver Medallists, with 90+% of distributions staying in the hands of the investor after tax added to a healthy distribution yield:
Bronze Medallists, which netted 80% or more after-tax to the investor - see the ten other bronze medal tax-efficient ETFs in the table.

Before we get too excited and go merrily off buying these funds wily-nilly, we should keep in mind other factors that influence whether these ETFs might be good investments:
  • Sustainability and repeatability of the tax breakdown - Consider, as we discussed regarding FIE, that special factors may change the future breakdown. For funds with a longer track record, such as XDV, check prior years' distributions (in XDV's case, they look quite stable). Consider the type of holdings and the fund objectives - are the holdings primarily dividend payers that will consistently generate mainly dividend income?
  • Return from capital gain (or possible loss) in the fund price - Distributions are not everything. Preferred share-based ETFs may be vulnerable to fall with interest rate rises. Common equity-based ETFs may be vulnerable too in the short term but able to respond over time. Some of the ETFs in our table will most likely generate only capital gains, both for distributions and ETF unit value, e.g. gold and base metals ETFs but that return can vary a lot year to year with market conditions.
  • Portfolio fit - Each ETF fits somewhere in the asset mix and we should consider how much of each asset class to hold in our portfolios - see our discussions on investment policy, asset allocation, diversification and here. There are also other ways than distributions to generate income from a portfolio, such as simply selling assets - see our post on generating cash by rebalancing.
Tax Reporting - Though brokers will send out to its investor clients T5s and T3s with the actual amounts of the various distributions for preparing the individual 2010 income tax return, the tax breakdown info from the providers also allows us to do another necessary task, the updating of Adjusted Cost Base as we explained in ETFs and Mutual Funds - Calculating Capital Gains.

Congratulations again to the Claymore Canadian Financial Monthly Income ETF on its gold medal. Long may it continue to be so beneficial to taxable investors.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

1 comment:

Canada Income Tax Forms said...

Hi friends,

ETFs are more tax-efficient due to their construction and the way the IRS classifies them. There are capital gain taxes to be paid on the profitable sale of an ETF. Thanks a lot.