Swapping

.

By Guest Blogger Scott Booth

.

Investment returns generally come in three forms. Interest Income, dividend income and capital gains from price appreciation. Capital gains get captured on your T-5008 and the taxation of them is deferred until the time a security that has appreciated in value is sold. Dividends and interest payments come in at regular intervals from stocks and bonds respectively and the taxes on these income streams are owed in the year they are received. For ETF holders these are captured on your T-3s. Don’t file until you have them.

The tax treatment and relative appeal of each component of investment returns varies by tax bracket. In low brackets, dividends get the most favourable treatment. As one’s taxable income increases and they have the pleasure of handing a larger percentage of every dollar earned over to the kind folks at the CRA, capital gains get taxed more favourably.

I’m based in Ontario, but let’s use BC tax rates as an example so as not to introduce a regional bias. Provincial realities will vary but general themes are fairly consistent across this great nation.

Combined Federal and BC Tax Brackets and Tax Rates 2023

Source: Taxtips.ca

If a BC resident has total income of less than $165,430, dividends are going to be the type of investment return with the most tax appeal.

For those in the top tax bracket, capital gains are the most efficient form of return. The CRA will expect you to pony up 53.50% of those incoming interest payments, 36.54% of those juicy dividends being paid out on a regular basis and just 26.75% of those realized capital gains.

Business owners of Canadian-controlled private corporations (CCPC) benefit from the Small Business Deduction, a program that imposes a lower corporate tax rate on small business. They enjoy lower corporate tax rates of 9%-12% (depending on province) on active business income up to $500,000. As investments within a CCPC grow, passive income rules can erode or eliminate this deduction. That erosion starts when passive income exceeds $50K/year and the benefit is eliminated if that passive income figure hits $150K/year. Income from dividends and interest can be great up to a point, and then they become punitive when invested in a corporate account. In this case, capital gains will be the preferred form of investment returns.

Generally, investors should try to shelter income bearing investments in RRSPs and stick growth and dividend focused assets in taxable accounts. When portfolio sizes grow, maintaining an asset allocation can necessitate holding income producing assets in a non-registered account. Music to Mr. Tax Man’s ears.

There are products out there that investor can utilize to manage the composition of their investment returns, notably swap-based ETFs. We’re not talking about the upside-down pineapple on a cruise ship kind of swap here. Total-return swaps and the corporate class ETFs that utilize them are the vehicles that make this possible and accessible to everyday investors.

So, what it is the total return on an asset (usually an index)?

Total return is equal to the change in the price of the asset (capital gain/loss) + the distribution (dividends/distributions/coupon payments the asset makes).

If the price of the index goes up 5% and the underlying pays a 3% dividend, the total return is 8%.
Housed within a Mutual Fund Corporation, swap-based ETFs are synthetic, meaning the investor doesn’t own the underlying securities…they are just entitled to the total return they generate.

These instruments can effectively make the unfavourably taxed distribution portion of total returns disappear, as it is rolled up in the total return. This isn’t the bad tropical island/lawless banana republic, Bernie Madoff/ S.B.F. kind of disappear. Investors receive the total return on the index, less fees and this return gets captured as a capital gain, which can be deferred until the total return etf is sold.

The tax savings from utilizing these instruments have the potential to be material.
The example below assumes the investor is in the top tax bracket in BC.

Traditional Bond ETF vs Corp Class Bond ETF Comparison

The Investor in the swap-based ETF has considerably more growth annually, picking up 70 bps, almost 50% more after tax, and only pays the tax on the gain when the investment is sold. Tax savings and deferral seem to be appealing prospects.

Investing is all about risk/reward trade-offs. There are a different set of risks associated with investing in swap-based ETFs compared to traditional ones.

Counter-party risk on the swap contracts is the obvious one, but these are big six banks that are engaged in the contracts. Pretty safe and secure.

Regulatory change is another significant risk. There is always the chance of the CRA cracking down on the corporate class structure use to avoid distributions. If there’s anything the government doesn’t like, it’s not receiving tax income. Remember Income Trusts?

Income management risk is another significant consideration with swap-based ETFs. It is critically important to their tax-advantaged status the mutual fund corporation housing them does not generate net-income within the overall corporate structure, lest they face taxation at punitive rates. The mix of ETFs within a corporate class structure will influence this (having some high cost ones in there is beneficial), as will the settlement of swap contracts and non-capital loss pools that can be used to offset income. Any investor considering these assets should ensure they understand of the associated risks and never invest in a product you don’t understand.

That having been said, it does appear that there are substantial benefits that can be realized, particularly for investors with unsheltered fixed income holdings in higher tax brackets and those with chunky corporate investment accounts.

Might be worth swapping.

Scott Booth, CFA, is a seasoned financial advisor and licensed portfolio manager. Over the past 18 years he has worked in the capital markets as an analyst, trader and advisor with major banks and now with Turner Investments.

.

About the picture: “Garth, we  love your blog and have been reading it daily for quite some time now,” writes Eric. “Always informative and most days we get some great laughs on top of the sage advice. Moved from Oakville to Waterdown a few years ago and luckily bought in one of the few gullies over the past 6 years. The main reason was to have more of a yard for our one dog and to add a second. Just added our third to the pack a couple months ago. Figured the way house prices are going it’s much cheaper to have 3 dogs than 3 kids since we won’t need to give them each a down payment 20 years from now for their first condo. The 3 Labradoodles – Oliver is red, Benjamin is the black and White and Isabelle is the brown new puppy ) Feel free to use he pic in your blog!”

To be in touch or send a picture of you beast, email to ‘[email protected]’