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Low turnover and in-kind transfers have made ETFs popular with tax-conscious investors and their advisors. Choosing an ETF over a mutual fund generally provides immediate cost and tax savings, but there are additional ways to enhance aftertax returns using ETFs.

Keep distributions low

Lower distributions generally mean higher after-tax returns because more capital is available to compound. When selecting an ETF, advisors should consider their client’s tax status.

The ETF Screener on the TMX Money website compares the tax efficiency of various ETFs, a benefit that’s estimated as the proportion spent on taxes with appropriate tax rates applied to income, capital gains, dividends and return of capital distributions.

Structural vigilance

Some ETF manufacturers embed structures into their funds to make them more tax-effective. This involves an added layer of cost. An example is Claymore’s Advantaged Canadian Bond ETF (CAB) that structures payouts as a return of capital. CAB’s 4.17% return is almost 1% lower than the 5.14% return for its benchmark, the DEX DLUX Capped Bond Index (from inception November 19, 2009 to December 31, 2010).

However, the fund’s stated MER is only 0.33%. Claymore says, “The difference in returns between the Index and ETF is principally due to fees and expenses.” The prospectus reveals the fund pays the counterparty an amount under a forward agreement up to 0.45% per annum of the forward amount.

Depending on an investor’s circumstances, the tax advantage of receiving distributions as return of capital may or may not exceed the added layer of cost in these products.

Peculiarities of withholding tax

In most cases, buying a Canadian ETF that holds U.S. ETFs means losing the withholding tax charged on the U.S. distributions. The tax is withheld on a fund level, making it impossible to claim the tax credit even in a registered account.

This amount could be meaningful, particularly for high-incomepaying ETFs like iShares U.S. High Yield Bond (XHY), which usually gives up 15% of its 7% distribution yield to tax, reducing overall investment return by over 1%.

However, a change occurred last year, as noted by iShares. The U.S. Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which was retroactive to January 1, 2010, reinstated the U.S. withholding tax exemption for qualifying income distributed by the relevant Regulated Investment Companies to foreign entities.

As a result, when any ETF manufacturer reclaims the tax, investors can get back most of the amount paid by an ETF in 2010-2011. According to iShares’ June financial statements, not only did XHY reclaim a portion of 2010’s withholding tax, but the tax on 2011 distributions amounted to 0.40% instead of the previous 15%. According to iShares, “The exemption will currently expire for tax years beginning after Dec 31, 2011.”

Watch derivative structures

Investors in a U.S.-based Rydex fund received an 87% capital gains distribution in 2008 as a result of expiring futures contracts and prevailing market volatility. Canadian derivative-based ETFs seem to be unaffected.

Horizons BetaPro commented that derivatives contracts maturing in 2012 are likely to be extended without tax consequences. In general, derivative strategies can introduce collateral and counterparty risk to ETF analysis.

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