The concept of Return of Capital (ROC) can sometimes trip up even savvy advisors and investors. In taxable accounts, it’s important to understand how ROC impacts taxes payable, and when. In tax-sheltered accounts such as RRSPs and TFSAs, this discussion is not applicable.
ROC adjusts an ETF’s original purchase price down,
potentially affecting future capital gains taxes when the ETF is sold
Tax-Efficiency through the Return of Capital
Adjusted Cost Base (ACB): ROC requires investors to reduce the cost basis (or price) that the ETF was purchased for by the cumulative amounts of ROC received since purchase.
Investors do not typically pay tax on ROC distributions. Tax is payable on Capital Gains, Eligible Canadian Dividends and Foreign and Other Income.
| Positives | Negatives |
| ROC can help to maintain stable distribution, which allows for easy planning of cash flow needs | Administrative efforts to record ACB decreases |
| ROC distributions are not typically* taxed, making them the most tax-efficient form of distribution | Reduces the net asset value (NAV) of the ETF, which reduces assets available to generate returns |
*Should the ACB be reduced to 0 over time, any future ROC distributions would be taxed as capital gains.
Covered Call investors are seeking monthly income above what can be generated by non-Covered Call market beta solutions. Income investors understand they are potentially giving up some positive market performance in return for higher monthly income. They also understand that these strategies can lead to some of the monthly distributions including their money back in the form of ROC. Covered Call investors could benefit from the tax deferral effect of ROC distributions.
Investors who are seeking full exposure to markets and themes can benefit from core beta products, which may have some distributions and Corporate Class Total Return ETFs (TRI ETFs) which are not expected to make taxable distributions.
Why does Horizons ETFs distribute ROC on covered call solutions?
- Consistent with the income needs of covered call investors
- Consistent with offering innovative solutions in a tax-efficient way
- Consistent with our ETF Distribution Policy
No Crystallization + no Capital Gains to Pay Out = ROC:
Underlying Holdings Are Up: If the ETF Manager does not sell the positions (crystallization), there are no capital gains to pay out. This leads to distributions that are ROC.
Options Exercised: If gains from premiums are limited by being exercised, the ETF Manager will have to buy them back with no capital gains attributable to the ETF. When call options are exercised and there is no crystallization (as explained above), the ETF Manager will buy the options back with no corresponding capital gains attributable to the ETF, this leads to distributions that are ROC. Tax-efficient capital gains are received if written call options expire worthless.
TRI ETF Holdings: Covered Call ETFs can hold a TRI ETF for its exposure goals. Since no dividends or income are received, positions can be sold down to . If the positions are not sold down, there will be no capital gains to pay out which will lead to distributions that are ROC.
What is Bad ROC? All ROC is generally non-taxable immediately, as it reduces the ACB of an ETF. If a covered call ETF is consistently not generating enough income and dividends and options premiums received are not enough to complete the distributed amount, ROC may be distributed to make up the difference.
This can happen over short periods where a covered call manager seeking total return performance identifies strong underlying market conditions and chooses to write fewer call options to participate more in the performance of the underlying holdings. This can also happen when there is a sustained change in options premium volatility, leading to lower premiums. In such cases where this is expected to persist for a longer period, the ETF distribution amounts will be reevaluated per the ETF’s Distribution Policy.
DISCLAIMER
Commissions, management fees and expenses all may be associated with an investment in exchange traded products (the “Horizons Exchange Traded Products”) managed by Horizons ETFs Management (Canada) Inc. The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. Certain Horizons Exchange Traded Products may have exposure to leveraged investment techniques that magnify gains and losses and which may result in greater volatility in value and could be subject to aggressive investment risk and price volatility risk. Such risks are described in the prospectus. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the relevant prospectus before investing.
The Horizons Total Return Index ETFs (“Horizons TRI ETFs”) are generally index-tracking ETFs that use an innovative investment structure known as a Total Return Swap to deliver index returns in a low-cost and tax-efficient manner. Unlike a 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 ETF receives the total return of the index through entering into a Total Return Swap agreement with one or more counterparties, typically large financial institutions, which will provide the ETF with the total return of the index in exchange for the interest earned on the cash held by the ETF. Any distributions which are paid by the index constituents are reflected automatically in the net asset value (NAV) of the ETF. As a result, the Horizons TRI ETF receives the total return of the index (before fees), which is reflected in the ETF’s share price, and investors are not expected to receive any taxable distributions.
The payment of distributions, if any, is not guaranteed and may fluctuate at any time. The payment of distributions should not be confused with an Exchange Traded Fund’s (“ETF”) performance, rate of return, or yield. If distributions paid by the ETF are greater than the performance of the ETF, distributions paid may include a return of capital and an investor’s original investment will decrease. A return of capital is not taxable to the investor, but will generally reduce the adjusted cost base of the securities held for tax purposes. Distributions are paid as a result of capital gains realized by an ETF, and income and dividends earned by an ETF are taxable to the investor in the year they are paid. The investor’s adjusted cost base will be reduced by the amount of any returns of capital. If the investor’s adjusted cost base goes below zero, investors will realize capital gains equal to the amount below zero. Future distribution dates may be amended at any time. To recognize that these distributions have been allocated to investors for tax purposes the amounts of these distributions should be added to the adjusted cost base of the units held. The characterization of distributions, if any, for tax purposes, (such as dividends/other income/capital gains, etc.) will not be known for certain until after the ETF’s tax year-end. Therefore, investors will be informed of the tax characterization after year-end and not with each distribution if any. For tax purposes, these amounts will be reported annually by brokers on official tax statements. Please refer to the applicable ETF distribution policy in the prospectus for more information.
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.
Certain statements may constitute a forward-looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward-looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events or otherwise, unless required by applicable law.
This communication is intended for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase exchange traded products (the “Horizons Exchange Traded Products”) managed by Horizons ETFs Management (Canada) Inc. and is not, and should not be construed as, investment, tax, legal or accounting advice, and should not be relied upon in that regard. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors should consult their professional advisors prior to implementing any changes to their investment strategies. These investments may not be suitable to the circumstances of an investor.
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Published March 25, 2024