Generating Tax Efficient Cash Flows Using Covered Calls

August 24, 2020

A Question & Answer Primer

The yield on a Harvest Equity ETFs 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. We have a separate piece on covered calls located here. Each month the portfolio management team at Harvest determines how many covered calls are needed 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, however 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 by the ETF. 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 is 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)?

Generally, No. However, if the Harvest ETF holds Canadian investments that are eligible, there may be a portion of the total net distribution paid to the investor that could be eligible for the CDTC. Currently within the Harvest income ETF’s only the Harvest Equal Weight Global Utilities Income ETF and the Harvest Energy Leaders Plus Income ETF have Canadian positions that may result in a small portion of each ETFs annual distribution be 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 done 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 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 and 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 sell 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, 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 unique?

Harvest is one of the largest covered call strategy providers in Canada. Unique to the Harvest strategy is the proprietary 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.

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Disclaimer

You will usually pay brokerage fees to your dealer if you purchase or sell units of the Fund(s) on the TSX. If the units are purchased or sold on the TSX, investors may pay more than the current net asset value when buying units of the Fund(s) and may receive less than the current net asset value when selling them. There are ongoing fees and expenses associated with owning units of an investment fund. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. An investment fund must prepare disclosure documents that contain key information about the fund. You can find more detailed information about the fund in these documents.

Certain statements in the Harvest Blog are forward looking Forward-looking statements (“FLS”) are statements that are predictive in nature, depend upon or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “intend,” “plan,” “believe,” or  “estimate,” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS.

FLS are not guarantees of future performance and are by their nature based on numerous assumptions, which include, amongst other things, that (i) the Fund can attract and maintain investors and have sufficient capital under management to effect their investment strategies, (ii) the investment strategies will produce the results intended by the portfolio managers, and (iii) the markets will react and perform in a manner consistent with the investment strategies. Although the FLS contained herein are based upon what the portfolio manager believe to be reasonable assumptions, the portfolio manager cannot assure that actual results will be consistent with these FLS.

Unless required by applicable law, Harvest Portfolios Group Inc. does not undertake, and specifically disclaim, any intention or obligation to update or revise any FLS, whether as a result of new information, future events or otherwise.

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