The Internet is aflame with queries about the tax status of the CPD distribution!
Even Financial Webring Forum members have taken time out from their busy schedule of complaining about how useless and expensive investment advice is to ask for investment advice (note to LTR of FWF: I don’t mean anything by that personally. I just think the concept is funny.)
So, because I am such an incredibly nice person, because I like to help out competitors who can’t be bothered to post a simple one pager on their website for the benefit of their clients, and mainly because I’m hoping that the goodwill thus earned will generate a flood of subscriptions to PrefLetter (or, even better, to the fund I manage in competition with CPD), I’ll take a stab at explaining the situation.
We must organize our materials: first the Claymore Tax Information Guide, which confirms that, of the distributions in 2007, $0.3682 was dividends and $0.2720 was return of capital. It is this “return of capital” that is causing consternation. There is some concern that the capital of the fund is being eroded; but, subject to the explanation from Claymore being accurate and there being no silly bookkeeping errors, this is not the case.
Second, we look at Claymore’s explanation (via FWF; since the post is verbatim, from a reliable poster and makes sense, I’ll accept it):
CPD does not and did not pay any distributions above its cash flow. The yield is exactly the yield on the underlying portfolio, less MER. The ROC component of the distributions is due to the structural timing of asset inflows. During the 2007, the fund saw strong asset inflows. When we get a new “creation of units” the fund’s Designated Brokers (DB’s) give the fund the basket of preferred shares, plus any cash in the portfolio from dividends paid on the Prefs since last distribution. The cash received is not allocated as “dividends paid” but rather just cash. So from an accounting perspective, this means the cash is then treated as ROC when we pay it out, even though it represents dividends paid on Pref.
Example would be $1 mm Pref. You received $10,000 in dividends on Monday. So you now have $1.01 mm in portfolio. The next day the DB buys into the fund buy delivering $1mm of Pref position, plus $10k cash. So portfolio is now $2.02 mm, with double shares outstanding.
We pay out the earned yield on portfolio of $20k to shareholders, 50% would be treated as dividends earned on portfolio, 50% treated as ROC. But 100% is actual yield.
Hope this helps clarify this. Please feel free to pass along to the blog sites discussing this. If you have any further questions, please don’t hesitate to call us or ask.
It would appear that the explanation has something to do with the creation of units … so we’ll dig up the prospectus to see how that works:
For each Prescribed Number of Units issued, a Designated Broker or Underwriter must deliver payment consisting of, in the Manager’s discretion, (i) one Basket of Securities and cash in an amount sufficient so that the value of the securities and the cash received is equal to the NAV of the Units next determined following the receipt of the subscription order; (ii) cash in an amount equal to the NAV of the Units next determined following the receipt of the subscription order; or (iii) a combination of securities and cash, as determined by the Manager, in an amount sufficient so that the value of the securities and cash received is equal to the NAV of the Units next determined following the receipt of the subscription order.
And we’ll have a look at the current basket of securities. We note that the CPD, as of 2008-4-10, had a cash component of $0.084735, representing roughly 0.48% of its NAV.
First, let’s make some simplifying assumptions: we’ll assume that there is one issue held in the fund, priced at $25 on every ex-dividend date and paying $0.25 every quarter.
At the start of the cycle, we’ll assume the fund balance sheet looks like this::
| Balance Sheet after fund payout |
| Item |
Asset |
Liability |
| Cash |
$0.00 |
|
| Securities |
$25.00 |
|
| Due to Shareholders |
|
$0.00 |
| Shareholders’ Equity |
|
$25.00 |
Just before the underlying goes ex-dividend, the fund position is
| Balance Sheet before underlying Dividend |
| Item |
Asset |
Liability |
| Cash |
$0.00 |
|
| Securities |
$25.25 |
|
| Due to Shareholders |
|
$0.00 |
| Shareholders’ Equity |
|
$25.25 |
Next, the underlying security pays its $0.25 dividend and the price drops correspondingly:
| Balance Sheet after underlying Dividend |
| Item |
Asset |
Liability |
| Cash |
$0.25 |
|
| Securities |
$25.00 |
|
| Due to Shareholders |
|
$0.00 |
| Shareholders’ Equity |
|
$25.25 |
Next, a week or two later, the fund declares its dividend:
Balance Sheet after fund dividend declared
but before payout |
| Item |
Asset |
Liability |
| Cash |
$0.25 |
|
| Securities |
$25.00 |
|
| Due to Shareholders |
|
$0.25 |
| Shareholders’ Equity |
|
$25.00 |
And then pays it out:
| Balance Sheet after fund payout |
| Item |
Asset |
Liability |
| Cash |
$0.00 |
|
| Securities |
$25.00 |
|
| Due to Shareholders |
|
$0.00 |
| Shareholders’ Equity |
|
$25.00 |
Which is back where we started, but the fund has paid its unitholders $0.25 dividend in the course of the cycle. The income statement for the fund looks like this:
| Income Statment |
| Dividends Received |
$0.25 |
| Dividends Paid |
($0.25) |
| Fund Profit |
$0.00 |
The complicating factor is clients. Damn clients! This would be such a great business if there weren’t any damn clients! For our purposes, a “client” of the fund is a major broker, who can create and destroy units by delivering the underlying security. More particularly, for our purposes, we’ll assume that units have been created AFTER the underlying security has paid its dividend but BEFORE the fund has paid its dividend. In other words, we start here:
:
Balance Sheet after underlying dividend
before fund payout |
| Item |
Asset |
Liability |
| Cash |
$0.25 |
|
| Securities |
$25.00 |
|
| Due to Shareholders |
|
$0.00 |
| Shareholders’ Equity |
|
$25.25 |
So the broker comes to the fund and says “Yo! What do I have to deliver for you to give me a unit?”. After a look at the books, the manager says “One share of the underlying and $0.25 cash.”. So this happens and then the books look like this:
:
| Balance Sheet after unit creation |
| Item |
Asset |
Liability |
| Cash |
$0.50 |
|
| Securities |
$50.00 |
|
| Due to Shareholders |
|
$0.00 |
Shareholders’ Equity
two shares! |
|
$50.50 |
and the income statement looks like this (pay attention, this is important):
| Income Statment |
| Dividends Received |
$0.25 |
| Dividends Paid |
$0.00 |
| Fund Profit |
$0.25 |
The fund wants to pay out sufficient dividends to its shareholders that it is not liable for any tax – in fact, the prospectus makes this committment:
On an annual basis, each Claymore ETF will ensure that all of its income (including income received from special dividends on securities held by that Claymore ETF) and net realized capital gains have been distributed to Unitholders to such an extent that the Claymore ETF will not be liable for ordinary income tax thereon.
So how much should it pay? Should it pay out the precise $0.25 received? Then the balance sheet will look like this::
Balance Sheet after unit creation
and dividend payout of $0.25 |
| Item |
Asset |
Liability |
| Cash |
$0.25 |
|
| Securities |
$50.00 |
|
| Due to Shareholders |
|
$0.00 |
Shareholders’ Equity
two shares! |
|
$50.25 |
In such a case, three things have happened:
- The NAVPS is now $50.25 / 2 = $25.125, an increase from the base case, despite the fact that the market hasn’t moved
- Joe Shareholder, who’s owned one share all along, got only $0.125 dividend instead of the $0.25 he was expecting
- The fund now has $0.25 cash that it should reinvest, but holy smokes, that’s going to be an expensive proposition!
Claymore has decided they don’t want to do this. Keep the dividends constant! So they pay out the expected $0.25 dividend per share to their shareholders and the balance sheet looks like this:::
Balance Sheet after unit creation
and dividend payout of $0.50 |
| Item |
Asset |
Liability |
| Cash |
$0.00 |
|
| Securities |
$50.00 |
|
| Due to Shareholders |
|
$0.00 |
Shareholders’ Equity
two shares! |
|
$50.00 |
The good parts about this are:
- The dividend rate of $0.25 per period has remained constant, just like the market
- The NAVPS of $25.00 has remained constant, just like the market. The bad part is what has happened to the income statement:):
Income Statment
After Unit Creation
And Payout of $0.50 |
| Dividends Received |
$0.25 |
| Dividends Paid |
$0.50 |
| Fund Profit (loss) |
($0.25) |
Oooh, yuck! A loss! And I’m not even sure what the tax status of that loss is … I honestly don’t know whether this could be recovered. I do know, however, that the fund’s shareholders as a group are paying tax on the $0.50 dividend paid out by the fund.
It’s much more efficient to restate the dividend as return of capital; the balance sheet will be unaffected, but the income statement will now look like this:
Income Statment
After Unit Creation
And Payout of $0.25 dividend
and $0.25 return of capital |
| Dividends Received |
$0.25 |
| Dividends Paid |
$0.25 |
| Fund Profit (loss) |
$0.00 |
And … the moment you’ve all been waiting for … the characterization of payouts:
Payout Summary
After Unit Creation
And Payout of $0.25 dividend
and $0.25 return of capital |
| Dividends |
$0.25 |
| Return of Capital |
$0.25 |
| Total Payout |
$0.50 |
I hope this helps. Ask any questions in the comments.
