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An Introduction to Horizons Total Return Index ETFs

Horizons ETFs believes that investors should be able to access passive index strategies in the most cost and tax-efficient way possible. For this reason, each of Horizons Total Return Index ETFs (Horizons TRI ETFs) provides passive exposure to an index or benchmark from within a corporate class structure. Each Horizons TRI ETF is a separate corporate class, meaning its shares represent a specific class within a corporate structure. This structure allows these ETFs to seek to deliver greater tax-efficiency with less tracking error than traditional passive index or benchmark ETFs. Horizons TRI ETFs primarily utilize total return swaps, and are not expected to make taxable distributions.

The Horizons TRI ETFs that utilize total return swaps aims to achieve tax-efficiency primarily by receiving the total return of the underlying index (before fees) – the value of the underlying index constituent distributions get reflected in the ETF’s share price and are not distributed to share holders. This means that an investor is generally only expected to be taxed on any capital appreciation of the ETF if, and when, the shares of their ETF are sold.

How Does a Horizons TRI ETF Work?

The majority of Horizons TRI ETFs utilize a synthetic structure, known as a total return swap.

Unlike a traditional physical replication ETF that typically purchases the securities found in the relevant index in the same proportions as the index, most Horizons TRI ETFs use a synthetic structure that never buys the securities of an index directly. Instead, the Horizons TRI ETFs receive the total return of the relevant index by entering into Total Return Swap agreements with one or more counterparties, typically large Canadian financial institutions, which provide the ETFs with the total return of the relevant index.

To gain exposure to certain indices through a total return swap, counterparties may charge the Horizons TRI ETF a swap fee (depending on the underlying asset). The Horizons TRI ETFs that provide exposure to foreign equities and fixed income securities will typically be charged a swap fee. None of the Horizons TRI ETFs that provide exposure to Canadian equities and preferred shares currently have a swap fee associated with their total return swap.

Total Return Index Cycle

Tax-Efficient Investing

Each of the Horizons TRI ETFs is a class of shares in a corporate class structure, the Horizons ETF Corp. This simply means the ETFs are collectively structured as a single corporation, rather than individually as trusts, which was the traditional structure used by Canadian-listed ETFs and mutual funds.

NOTE: While the corporate class structure used by Horizons TRI ETFs is generally referred to as a mutual fund corporation, that is simply how it is classified for tax authorities. All of the products offered by Horizons ETFs are exchange-traded funds, and not mutual funds offered via FundServ.

First established in 1987, mutual fund corporations are structured similarly to traditional corporations. Under one corporate structure, many different investment fund mandates (series or classes) can exist. In the case of Horizons ETF Corp., the different Horizons TRI ETFs are all held within the corporate structure, where each is a separate class of shares.

Within a Canadian mutual fund corporate structure, only capital gains and Canadian dividends can be distributed to investors. From a tax perspective, any other income and foreign dividends generated within any one class of the corporation can potentially be offset by income losses and expenses incurred in other class, which can, in certain circumstances, make the corporate class structure more tax-efficient than a traditional mutual fund trust.

It is a structure widely-used by advisors in Canada and end-investors, primarily in taxable accounts, to achieve more tax-efficient returns.

What Makes the Horizons TRI ETFs Corporate Class Different?

The major difference between the Horizons TRI ETFs and other corporate class funds is that our ETFs primarily hold derivatives to achieve their investment returns, although physically-replicated Index ETFs can also be held within Horizons ETF Corp.

Within Horizons ETF Corp., the Horizons TRI ETFs offer distinct tax-efficiencies for investors. The tax-efficiency to investors can be primarily achieved through our proprietary, synthetic Total Return structure, which is used by most of the Horizons TRI ETFs. There are also tax-efficiencies realized by Horizons ETF Corp. itself, when compared to a mutual fund trust structure, since the corporation can use widely-accepted corporate tax accounting options, such as the ability to use losses and expenses to offset income across all classes.

The Horizons Tax Advantage: How Our Corporate Class Works For You

The Canadian ETF universe has a large variety of traditional, physically-replicated benchmark index products that can offer investors comparatively low-cost exposure to major indices and benchmarks. However, distributions from these investment funds generally result in taxable events for investors. These taxable distributions can reduce an investor’s potential after-tax return, when compared to the potential after-tax return on investment from owning a comparable Horizons TRI ETF.

Performance Comparison Between a Horizons TRI Bond ETF and a Traditional Index Bond ETF

Horizons TRI ETFs can offer a greater after-tax return on investment when held in a non-registered account, compared to a traditional, physically-replicated index ETF.

As an illustrative example only, assuming a 3% annual distribution yield, paid quarterly, on an initial investment of $1 million, our Horizons TRI ETFs’ tax-efficient strategy could generate as much as $77,463 in after-tax savings over a 10-year period, for an Ontario investor in the highest marginal tax bracket.

It is important to note that no Horizons TRI ETFs re-characterize investment income as capital gains.

Comparison Assumption

Investment Amount $1,000,000
Annualized Yield of Underlying 3.00%
Applicable Income Tax Rate 53.53%
Foreign Withholding Tax Rate 0.00%
Distribution Frequency (Physical) Quarterly
Annualized Investment Return 0.00%
Capital Gains Tax Rate 26.76%
Total Investment Horizon (Years) 10
Annual Management Fees and Expenses
Total Return Index ETF 0.23%
Physical Investment ETF 0.09%

Canadian Bond Horizons TRI ETF vs. Traditional Physically-Replicated Canadian Bond Index ETF Tax Analysis (Illustrative Example)

  Corporate Class Traditional Corporate Class minus Traditional
Original Investment $1,000,000.00 $1,000,000.00
Constituent Net Distributions (3.0%) N/A $336,313.13 -$336,313.13
Compounded Pre-tax Investment Value $1,319,152.51 $1,336,313.13 -$17,160.62
Cumulative Pre-tax Investment Return 31.92% 33.63% -1.72%
Annualized Pre-tax Investment Return 2.81% 2.94% -0.13%
Capital Gain (Loss Carry Forward) $319,152.51 $319,152.51
Capital Gains Tax Payable $85,405.21 $85,405.21
Distribution Tax Payable $180,028.42 -$180,028.42
Total Tax Paid $85,405.21 $180,028.42 -$94,623.21
After Tax Proceeds $1,233,747.30 $1,156,284.71 $77,462.58
Cumulative After Tax Investment Return 23.37% 15.63% 7.75%
Annualized After Tax Investment Return 2.12% 1.46% 0.75%

FOR ILLUSTRATIVE PURPOSES ONLY. The above example is for Illustrative Purposes Only, over a 10-year period, using the assumptions noted in the prior page and highlights the expected after-tax performance benefits of holding a Horizons TRI ETF (HBB) versus another Canadian-domiciled physically replicated Canadian bond ETF in a non-registered account, assuming both ETFs earned/ reflected a net 3% income distribution yield (in CAD) and track the exact same universe of bonds and assumes no changes to the market value of the Index constituents. This example does not take into account any fees or expenses of the ETFs, (aside from the stated investment fees and expenses) nor any commissions, fees or expenses that would be associated with a purchase or sale of ETF units/shares. The example does contemplate the sale of the ETF units/shares at the end of the period and the expected tax liability that would result. *Both ETFs are held by an Ontario resident investor in the highest tax bracket, who would have a marginal tax rate of 53.53% in 2021.

Who Should Consider Corporate Class?

Investors using a Non-Registered Account – Enjoy the Benefits of Tax Deferral

Canadian investors that have already made the maximum allowable contributions to their registered investment accounts and tax-free savings accounts (TSFAs) who are seeking to invest more, will likely have to do so through a non-registered account.

Unlike registered accounts and TFSAs, non-registered accounts don’t typically provide the same taxation benefits and could require you to pay taxes on any distributions you’ve received on an annual basis. As the Horizons TRI ETFs are not expected to make distributions, an investor could only be taxed on any capital appreciation if their shares of the ETF are sold.

Seniors – Preventing Income from Impacting Old Age Security

For seniors receiving Old Age Security (OAS), “clawback” on OAS payments can occur if the individual is receiving income, including dividend income, greater than $79,054 (2022).

With Horizons TRI ETFs, constituent distributions are instead reflected as part of the ETF’s total return. This means that seniors seeking to ensure their OAS payments aren’t impacted by the income they receive from their investments can alternatively consider using our Horizons TRI ETFs.

In-trust Accounts – Ensure Your Nest Egg Stays Strong for Generations

For those investing for minor dependents or relatives through an in-trust account, it’s important to know that in-trust investments are typically subject to income attribution, meaning the onus to pay taxes on the income the trust generates will be on the contributor to the trust rather than the beneficiary of the trust. However, this doesn’t apply to capital gains. As the Horizons TRI ETFs are not expected to make distributions, an investor is generally only expected to be taxed on any capital appreciation if their shares of the ETF are sold.

Small Business Owners – Tax-Efficiency for Corporate Accounts

If you’re a small business owner looking to invest with your corporate account, it’s important to know that passive investment income can reduce your Small Business Deduction (SBD) tax credit, at a rate of $5 for every $1 of investment income above the $50,000 threshold.

Horizons TRI ETFs offer small business owners a way to potentially grow their corporate account portfolios without negatively affecting their SBD tax credit.

Horizons Total Return ETFs

The information contained herein reflects general tax rules only and does not constitute, and should not be construed as, tax advice. Investors situations may differ from those illustrated. Investors should consult with their tax advisors before making any investment decisions.

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