After-tax returns on Canadian ETFs

To help address this problem, Justin Bender spent the last several months creating a calculator for estimating the after-tax returns on Canadian ETFs. He used Morningstar’s US methodology as a starting point, but he made a number of significant changes to adapt it for Canada. The new methodology is fully explained in our latest white paper, After-Tax Returns: How to estimate the impact of taxes on ETF performance. We have also made our spreadsheet available for free download so DIY investors can experiment on their own. (The spreadsheet is protected so the formulas cannot be altered. However, we have included detailed descriptions of these formulas in the appendix to the white paper.)

The methodology is quite complex, but here’s an overview in plain English:

• We begin by recording the ex-dividend dates for all the cash distributions an ETF made during the period being considered.
• We then look up the fund’s net asset value (NAV) on each of the ex-dividend dates, as well as the NAV for the start and end dates of each performance period, and enter these into the spreadsheet.
• Using the reports available at the CDS Innovations site (which readers will remember from our earlier white paper on calculating your adjusted cost base with ETFs), we record the amounts of all the cash distributions and their character (Canadian and foreign dividends, other income, return of capital or capital gains), as well as any foreign tax paid and any reinvested distributions.
• We next make an adjustment regarding foreign withholding taxes. When ETFs report their before-tax returns, they presume these withholding taxes are lost. However, the final level of foreign withholding taxes (which is designated as “foreign tax paid” in box 34 of your T3 slip) is generally recoverable when the ETF is held in a taxable account. So we felt it was necessary to add this back.
• The spreadsheet then assumes each distribution was immediately taxed at the highest combined federal/provincial rate that applied in that year: for example, interest from bond ETFs in 2013 are assumed to be taxed at 50%, while non-eligible Canadian dividends are taxed at 39.15%. These were the rates that applied that year in Nova Scotia and Manitoba, respectively, and provide a worst-case scenario for taxable investors in Canada.
• Finally, after the tax has been deducted and the adjustments made, we assume what’s left of the distribution is reinvested in the ETF at the price on the ex-dividend date.

After explaining the methodology and providing instructions for using the spreadsheet, the white paper presents our calculations for 13 ETFs in various asset classes. We present both the before-tax returns (adjusted to add back recoverable foreign tax paid) and the after-tax performance as estimated by our calculator. We also present the fund’s tax cost ratio, a calculation designed to capture the amount of a fund’s distributions that’s lost to taxes. (This ratio was also created by Morningstar and is discussed in more detail in the white paper.)

Here are some of the more interesting findings:

Bonds. Both Justin and I have written about the serious tax inefficiencies of traditional bond ETFs, and this point is driven home with a glance at their tax cost ratios. (The higher the ratio, the less tax-efficient the fund.) Real return bonds and high-yield bonds took the biggest hit, but even short-term and broad-based bond funds were terribly tax-inefficient. The lesson: hold traditional bond ETFs in an RRSP and look for other fixed options in a taxable account, such as GIC rates or ETFs that hold discount bonds.

REITs. Income investors love REITs, but a large share of their distributions are fully taxable. In 2013, for example, the iShares S&P/TSX Capped REIT (XRE) had a pre-tax return of about –6%, but we estimate the after-tax return at –8.56%, for a very high tax cost ratio of 2.72%. Over five years, both Canadian and global REITs had tax cost ratios over 1.6%, which would cause a huge drag on returns. The lesson here is that if you can’t hold REITs in a tax-sheltered account you may not want to hold them at all.

Dividends. While Canadian dividends are often touted as tax-friendly income, our analysis showed that higher yields also mean higher taxes. The iShares S&P/TSX Canadian Preferred Share (CPD)and the iShares Canadian Select Dividend (XDV) both showed much higher tax cost ratios than theiShares Core S&P/TSX Capped Composite (XIC). That means that over a period where these funds delivered the same before-tax returns, taxable investors in XIC would keep more for themselves. Granted, XDV outperformed quite dramatically over the last five years: investors will need to decide for themselves whether that should be expected in the future.

Download the white paper and the calculator and let us know what you think. Some investors will quibble with the methodology, but we hope it will at least start a discussion on this important and neglected part of performance reporting.