Comparing Tax Characteristics of US Equity ETFs

In our last post we examined how to calculate Canadian income taxes for one US large cap equity ETF. Today, we compare its tax characteristics with those of four other popular ETFs in the same category and find some dramatic and significant differences.

The US Large Cap Equity ETFs - Our five ETFs all hold US Large Cap Equities. Four are traded on the TSX in Canada and one is traded in the USA:

• BMO US Equity Hedged to CAD Index ETF (TSX: ZUE)
• iShares US Fundamental Index Fund (also C$ hedged; formerly under the Claymore brand) (TSX: CLU)
• Horizons S&P 500 Index (C$ Hedged) ETF (TSX: HXS)
• iShares S&P 500 Index Fund (CAD-Hedged) (TSX: XSP)
• iShares S&P 500 Index Fund (not hedged; traded in USA on NYSE: IVV)

The ETFs display large differences in tax types of income - A quick look at the table below showing the 2011 breakdown of distributions by the five ETFs reveals a large variation in the taxable types of income. This is despite all ETFs having the same investment objective to track US large cap equity and four out of five being similar in doing currency hedging.

Three patterns of taxable income -

1) Foreign income only - The US-traded IVV distributed only foreign income in 2011. In fact IVV will only ever distribute foreign income to a Canadian investor since dividends from US companies do not receive the lower rate of dividends from Canadian companies. Foreign income is taxed at the highest marginal rate, the same rate as interest. IVV never distributes capital gains (see its historical distributions here).

2) Good deferred capital gains only - Horizon's HXS has distributed no taxable income at all in 2011 and should not normally ever do so due to its construction as a total return swap. The dividends from the underlying S&P 500 index are never actually explicitly received, instead being implicitly and automatically received and reinvested, so a holder of HXS only is liable to tax upon sale of his/her HXS holding. Since there are no distributions, only capital gains tax applies at the time of eventual sale. The tax-deferred reinvested compounding of dividends is a big plus for HXS, which is especially advantageous in a taxable account where taxes normally apply every year. The higher the S&P 500 dividend yield the greater the benefit for HXS holders. HXS' transformation of US dividends from high tax rate foreign income into deferred lower tax rate capital gains is legitimate and accepted by Canadian tax authorities. The Horizons HXS webpage explains the swap and the tax advantages in more detail.

3) Bad immediate capital gains plus foreign income - BMO's ZUE has a big element of capital gains in 2011 while none of the others do. However, the two funds with a longer track record, CLU and XSP, both have had several years of large capital gains attributed and distributed to shareholders for tax reporting as seen in the table below. In 2010, XSP had a large distributable capital gain resulting from its currency hedging activities as the iShares 2010 distributions press release noted. ZUE and CLU are subject to the same capital gains exposure from hedging.

This type of capital gain is not cash received by the investor but is reinvested in the ETF. In a taxable account, that would create a large capital gains tax liability in the years when they occur. An attributed immediate taxable capital gain is bad because the taxation is immediate but the investor only gets the benefit later on when the ETF is sold and the capital gain at that time is less by virtue of the higher Adjusted Cost Base. In effect the capital gain has been brought forward for taxation but the investor only receives it later on.

The sporadic recurrence of large capital gains reinforces the importance of updating the Adjusted Cost Base (ACB) for CLU, XSP and ZUE held in a taxable account. If the reinvested capital gains net of return of capital (shown in the blue text cells in the above table) are not added to ACB the investor ends up paying tax twice - once in the year of receipt on the T3 slip and again in the year of the holding's sale through a too-low ACB (since declarable gain = sale amount - ACB).

Foreign tax paid hurts XSP, CLU and ZUE in tax-deferred accounts - The red highlighted cells in the bottom part of the first table above indicates where the tax deducted in the USA by US authorities is irretrievably lost to Canadian investors. The foreign tax is neither avoidable nor claimable as a tax credit or partial payment against Canadian income tax owing. By contrast the US-traded ETF IVV, when held in an RRSP or other recognized retirement account, such as a LIRA, LIF, LRIF does not have any foreign withholding tax levied against it. IVV holdings in a TFSA or RESP do not escape the foreign tax levy since the US government does not recognize these as retirement accounts. HXS avoids US foreign tax altogether by virtue of its construction using a swap.

Taxes are important but not the only point of comparison amongst ETFs - Other fees and costs, currency hedging effects and risk factors also come into play over and above the tax angle when deciding which ETF is best. For instance we took an in-depth look at XSP and HXS side by side in which the final answer was not categorical. We also explored the pros and cons of investing through Canadian-traded vs US-traded ETFs for identical asset classes where we found a raft of factors in addition to taxes to consider.

Bottom line:

• HXS wins the prize for best tax characteristics - it works extremely well in any type of account and only generates lower tax rate deferred capital gains and no highest tax rate foreign income in taxable accounts
• IVV is best held in a retirement account where it works just as well as HXS and much better than XSP, CLU and ZUE. It is not good to hold IVV in a TFSA or RESP. In a taxable account there is at least a tax credit to offset Canadian income tax against the annual distribution.
• CLU, ZUE and XSP do not find an ideal resting place in any type account. The deferral of taxes in registered accounts gives that location an edge despite unrecoverable unavoidable loss of the foreign withholding tax paid.

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.