A Question & Answer Primer
Investors often have a wide range of questions about the passive investment income offered by Harvest Equity Income ETFs. From the nature of their call option strategies, to the focus on large-cap stocks held in these ETF portfolios, this article will help to answer some investor questions about Harvest ETFs.
The yield on a Harvest Equity Income ETF is high compared to the stocks in the portfolio – is that sustainable?
The distribution generated for each ETF is made up of the dividends earned on the holdings and premiums from writing covered calls, less fees, expenses, and taxes. You can read about covered call options here to learn how they generate income. Each month the portfolio management team at Harvest determines how many covered call options need to be ‘written’ to generate the monthly net cash flow required for each of the Harvest ETFs. There are many variables that go into this calculation and we discuss some of them below.In simple terms: the ETF is actively managed to ensure sufficient cash flow generation available from the dividends and option premiums to meet monthly distributions.
How are withholding taxes accounted for on the dividends earned by the stocks in the portfolio? Is the withholding tax payable by the unit holder?
The withholding tax is a percentage of the underlying dividend paid by the portfolio holdings and is paid at source. In the monthly determination of how many covered calls are required, the portfolio management team uses a dividend net of withholding tax and net of any fees in the calculation to determine a true amount of net cash flow to be generated to meet the monthly distribution. For most Canadian individuals there are no incremental withholding taxes payable or reclaims to be filed associated with the underlying dividends received, however for corporations, professional corporations or other special situations that may arise, individuals ought to consult with their tax advisors.
Are Harvest ETF distributions eligible for the Canadian Dividend Tax Credit (CDTC)?
Most Harvest Equity Income ETFs hold primarily US equities, which would not be eligible for the Canadian Dividend Tax Credit. The notable exception is the Harvest Canadian Equity Income Leaders ETF (HLIF:TSX) – which holds a portfolio of exclusively Canadian dividend-paying companies. For that ETF, there may be a portion of the total net distribution paid to the investor that could be eligible for the CDTC. In addition to HLIF the Harvest Equal Weight Global Utilities Income ETF (HUTL:TSX), the Harvest Global RIET Income ETF (HGR:TSX), and the Harvest Energy Leaders Plus Income ETF (HPF:TSX) have Canadian positions that may result in a small portion of each ETF’s annual distribution being considered eligible for the CDTC.
Can you explain how your tax factors for distributions have been treated as ROC (Return of Capital) and are you just giving me my money back or “grinding” the net asset value?
Firstly, we will differentiate the earning of the monthly cash flow from the tax categorization of that cash flow. There are many variables that go into the calculation, and we believe that this relatively complex discussion is best outlined in a simplified and generalized example. Individual circumstances may vary, and investors should consult an advisor for their particular circumstance.
Here is an example that is for illustrative purposes only:
From a tax perspective, the covered call option premium (cash flow received from writing a call option) is considered a capital gain. Consider 3 different scenarios:
- An ETF with a NAV of $10 and during the year generates $1 in option premium. This $1 is paid over the course of the year as a distribution. All else equal, the investor would receive the $1 of cash flow during the year and on their tax receipt it would be treated as a capital gain. The NAV (all else equal) would be $10.
- Conversely, if an ETF had a NAV of $10 and no option premium was generated and still paid $1 in a distribution. All else equal, the investor would receive the $1 of cash flow during the year and on their tax receipt it would be treated as a return of capital and the NAV (all else equal) would be $9 at the end of year. In this scenario, it was not just a ROC from a tax perspective, but this also would be encroachment of capital, ie. actually getting your money back at the expense of a decline in the NAV and this is often referred to as “Grinding”.
There are several situations however where an unrealized loss becomes a realized loss in an ETF such as when a stock is sold at a loss. While this has no impact to the NAV of the ETF, there may be the ability to carry forward that tax loss. This can be utilized against the option premium earned and that can change the tax treatment despite the cash flow being generated to pay the distribution.
- An ETF with a NAV of $10 which generates $1 in option premium and pays $1 in a distribution during the year. If the ETF had tax loss carry forwards or has realized losses during the year, then for tax purposes, that could be applied to the capital gain and the $1 would be treated as return of capital. The amount of the return of capital reduces the adjusted cost base of the units held. When the investor chooses to sell their holding, they would have to pay a $1 capital gain, however the investor has deferred that proportion of the capital gain into the future until when they choose to sell their position.
The above example is intended to answer the question if there is sufficient cash flow that can be generated – why from a tax perspective one may see a proportion of ROC. There are many other variables that need to be considered: unrealized gains/losses on underlying securities, foreign currency movements, realized gains and losses from hedging, and option premium taxation amongst several other considerations.
While the cash flow is generated for the distribution, the fluctuations in the net asset value up and down are impacted by many variables not least the day-to-day movements in the underlying securities that have an impact on the net asset value. The key is that through the options strategy, cash flows can be generated each month sufficiently to meet the required cash flows for the distribution.
Many of Harvest ETFs have had distributions characterized as ROC for tax purposes, however the portfolio managers conduct a monthly review of each portfolio to determine the required net cash flow amounts for the monthly distribution and write options to generate monthly cash flows. Investors should consult with their advisors about their specific situations.
What makes the Harvest covered call strategy stand out?
Harvest is one of the largest covered call strategy providers in Canada. Specific to the Harvest strategy is the active & flexible monthly determination of how many options are required, how many and when to write each option to generate the net cash flow required for the distribution. Harvest believes this is a key objective – to actively generate monthly cash flows. Harvest has a maximum 33% on any position written and a detailed primer on the Harvest strategy can be found here.
For informational purposes only. The information contained herein is not intended to provide financial, investment or tax advice. Investors should seek professional advice from qualified advisors when considering tax and investment decisions.
Commissions, management fees and expenses all may be associated with investing in Harvest Exchange Traded Funds (managed by Harvest Portfolios Group Inc.) The ETFs are not guaranteed, their values change frequently and past performance may not be repeated. Please read the relevant prospectus before investing.