Déjà vu all over again

So how does ETF taxation work? It depends on how the fund is structured for tax purposes. Is it set up as an MFT or as an MFC? Most ETFs in Canada are MFTs, and Manulife’s ETF lineup is no exception. As such, the taxation of most ETFs closely mirrors that of traditional MFTs. This article focuses on ETFs set up as MFTs and held in non-registered accounts.

ETF income and distributions

As in an MFT, income generated on the underlying assets of an ETF retains its character when distributed to unitholders and is taxed accordingly. In other words, interest and foreign income is fully taxable income, eligible and ineligible Canadian dividends are grossed up and receive their corresponding dividend tax credits, and half of realized capital gains are taxable.

Should the ETF sustain capital losses at the fund level, these losses are used to offset realized capital gains at the fund level, and any losses that exceed realized gains in the year are carried forward by the fund. Non-capital losses realized by the ETF can be used to offset any type of income at the fund level with any excess also being carried forward. Finally, any foreign taxes paid by the fund can be flowed out to and used by investors as credits to reduce Canadian income tax owing on that same foreign income.

ETF tax efficiency

An ETF can offer greater potential tax efficiency than a traditional MFT in one or both of the following ways: lower portfolio turnover and a different mechanism for investor redemptions.

First, investment mandates for ETFs, including those using factor-based investing strategies, are often more passive than those for MFTs. With less trading activity at the fund level, there may be fewer realized capital gains to distribute to unitholders of ETFs when compared to active MFTs.

Second, all investor redemptions for an MFT are transacted directly with the fund itself. To provide the redeeming unitholder with cash, an MFT may have to sell underlying assets and realize capital gains. If these capital gains are not completely offset by the capital gains refund mechanism, the excess will generally be distributed to remaining unitholders. Generally, ETF investors sell their units over the stock exchange and realize any gain or loss without triggering transactions at the fund level. Therefore, the taxable distributions received by one investor are not affected by the transactions undertaken by other investors in the same ETF.¹

Cash vs. Reinvested distributions²

Income earned by the underlying investments (e.g., interest, foreign dividends, eligible dividends, etc.) in an ETF is distributed as cash to investors. Since cash distributions flow out to the investor, they do not affect the investor’s adjusted cost base (ACB). On the other hand, capital gains realized at the fund level are immediately and automatically reinvested back into the ETF, increasing the investor’s ACB. Such reinvested distributions purchase new units of the ETF, and these units are immediately consolidated with the investor’s other units so that the number of units held by the investor and the net asset value (NAV) per unit are the same as before the capital gains distribution.

The Income Tax Act defines many types of investment entities or structures for tax purposes, including mutual fund trusts (MFTs), mutual fund corporations (MFCs) and segregated fund contracts. A noticeable omission is the exchange‑traded fund (ETF). But this does not mean that an ETF is a tax‑free entity.

The following table illustrates the mechanical differences between an ETF and an MFT.

Description: Purchase 100 units at $10 per unit. Exchange-traded fund: ACB = $1,000 (100 units times $10). Mutual fund trust: ACB = $1,000 (100 units times $10), Description: Current NAV = $11. Exchange-traded fund: FMV = $1,100 (100 units times $11). Mutual fund trust: FMV = $1,100 (100 units times $11), Description: $1 per unit capital gain distribution = $100 capital gain distribution automatically reinvested. Exchange-traded fund: No change to NAV and number of units: NAV = $11 per unit. Units owned = 100. Mutual fund trust: NAV decreases by distribution, which buys more units: NAV = $10 per unit ($11 minus $1). Buy 10 more units with distribution ($100 per $10 unit). Units owned = 110, Description: Taxable amount. Exchange-traded fund: $100 capital gain distribution. Mutual fund trust: $100 capital gain distribution, Description: Fair market value after reinvested distribution. Exchange-traded fund: $1,100 (100 units times $11 per unit). Mutual fund trust:  $1,100 (110 units times $10 per unit), Description: ACB after reinvested distribution. Exchange-traded fund: $1,100 (100 units times $11 per unit). Mutual fund trust: $1,100 (110 units times $10 per unit).

As you can see from the table, with either type of fund the investor’s fair market value (FMV) and ACB are $1,100. The difference lies in how the ETF and MFT got there. After the capital gains distribution, the NAV of both the ETF and MFT is reduced to $10 and the $100 capital gains distribution is used to buy 10 more units. However, the number of ETF units outstanding is immediately consolidated so that the number of units held by the investor and the NAV per unit are the same as before the capital gains distribution (i.e., back to 100 units outstanding with a NAV = $11/unit).

That is why ETF capital gains distributions are sometimes called “phantom distributions” – it appears that nothing has changed. The exception is the ACB, which has increased. With the MFT, on the other hand, there is no consolidation of units so the investor ends up with more units at a lower NAV.

Summary

While ETFs may look and feel different from an MFT, from a tax perspective they are the same, albeit with differences in operational mechanics that can provide the potential for tax efficiency through lower taxable distributions than traditional MFTs

John Natale, LL.B., BComm, EPC, CFP
Head of Tax, Retirement & Estate Planning Services

This is also true in instances where transactions are conducted by an investor (usually the designated broker) directly with the ETF. While such transactions may trigger capital gains at the fund level, these gains can be allocated to the redeemer. Because of this allocation, the taxable distributions of other unitholders are not impacted. 2 This commentary regarding distributions relates to Manulife ETFs. Readers must confirm with other ETF providers how they administer distributions.

The persons and situations depicted are fictional and their resemblance to anyone living or dead is purely coincidental. This media is for information purposes only and is not intended to provide specific financial, tax, legal, accounting or other advice and should not be relied upon in that regard.  Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. E & O E.  Commissions, trailing commissions, management fees and expenses all may be associated with investments in the Manulife Mutual Funds and Manulife Exchange-Traded Funds (ETFs). Please read the ETF facts/fund facts as well as the prospectus before investing. The Manulife Mutual Funds and Manulife ETFs are not guaranteed, their values change frequently and past performance may not be repeated.  Manulife Mutual Funds and Manulife Exchange-Traded Funds (ETFs) are managed by Manulife Investment Management (formerly named Manulife Asset Management Limited). Any amount that is allocated to a segregated fund is invested at the risk of the contractholder and may increase or decrease in value. The Manufacturers Life Insurance Company is the issuer of guaranteed insurance contracts, annuities and insurance contracts containing Manulife segregated funds. Manulife Investment Management is a trade name of Manulife Investment Management Limited and The Manufacturers Life Insurance Company (Manulife).

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