Exchange traded funds taxation: déjà vu all over again

The Income Tax Act (Canada) defines many types of investment entities or structures for tax purposes, including mutual fund trusts (MFTs), mutual fund corporations (MFCs), and segregated funds. A noticeable omission, however, is an exchange-traded fund (ETF). This doesn’t mean that an ETF is a tax-free entity. In fact, the term ETF describes an investment with specific features and its use is more commercial or colloquial in nature.

So how does ETF taxation work? It depends on how the fund is structured for tax purposes. Most ETFs in Canada are MFTs. As such, the taxation of ETFs closely mirrors that of traditional MFTs. Let’s look at how ETFs are set up as MFTs and held in non-registered accounts.

ETF income and distributions

Like 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, Canadian dividends are grossed up and receive their corresponding dividend tax credits, and half of realized capital gains are taxable.

If an ETF sustains capital losses at the fund level, these losses are used to offset realized capital gains at the fund level or are carried forward by the fund if the losses exceed realized gains in the year. Non-capital losses realized by the ETF can be used to offset any type of income at the fund level with any excess being carried forward.

Finally, any foreign taxes paid by the fund are reported on a prorated basis and used by investors as credits to reduce Canadian income tax owing on that same foreign income.

ETF tax efficiency

An ETF offers potential tax efficiency over a traditional MFT in one or two ways:

• less portfolio turnover—Investment mandates for ETFs tend to be more passive than MFTs. While this includes traditional passive strategies like indexing, it can also include active investment strategies such as smart beta with a systematic approach. 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.
• investor redemptions—All investor redemptions for MFTs 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 aren’t 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 generally aren’t impacted by the transactions of other investors in the same ETF.¹

Cash vs reinvested distributions

Income earned by underlying investments (i.e., interest, foreign income, Canadian dividends, etc.) in an ETF are distributed² as cash to investors. Since cash distributions are paid to the investor and not automatically reinvested, they don’t impact 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 is the same as before the capital gains distribution. This chart illustrates these mechanical differences:

As you can see from the chart, with either method, the investor’s fair market value (FMV) and ACB is $1,100. The difference lies in how the ETF and MFT got there. After the capital gains distribution, the NAV of the ETF is reduced to $10, and the $100 capital gains distribution is used to buy 10 more units, like with the MFT. 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 is the same as before the capital gains distribution (i.e., back to 100 units outstanding with a NAV of $11/unit). That’s why ETF capital gains distributions are sometimes called phantom distributions—it appears that nothing has changed. The exception being the ACB, which has increased.

The MFT also issues new units with the reinvested distribution, which increases the number of units held by the investor proportionally to the ratio of the distribution to the current unit price (1/10 in the example above). However, with the MFT, there’s no consolidation of units, so the investor ends up with more units at a lower NAV.

Finally, return of capital (ROC) distributions, if any, reduce an investor’s ACB in both MFTs and ETFs. With either investment, if the ACB is reduced to zero, ROC distributions are treated as capital gains for tax purposes.

Selling units and an investor’s ACB

When an investor sells units in either an MFT or an ETF, the ACB is needed to determine the capital gain or loss on the sale. The items that affect an investor’s ACB in an MFT and ETF are:

• purchases and redemptions—Purchases increase the ACB and redemptions reduce the ACB. An investor’s ACB is based on the average cost of units held.
• reinvested distributions – Increase the ACB to avoid double taxation of the reinvested income upon sale.
• distributions of ROC – Reduce the ACB. If the ACB is reduced to zero, future ROC distributions are taxable as capital gains.

While the factors affecting an investor’s ACB are the same for MFTs and ETFs, disposition of each holding is executed differently. When an investor disposes of units from an MFT, the units are redeemed by the fund in exchange for cash to the investor. When an investor disposes of ETF units, they’re generally sold on the exchange like an individual stock. The tax result for the investor is the same—a capital gain or loss that’s calculated by comparing the proceeds of disposition (net of redemption costs) with the ACB.

ETFs have the potential for reduced taxable distributions

While ETFs may look and feel different than MFTs, from a tax perspective they’re the same, albeit with differences in operational mechanics that can provide the potential for lower taxable distributions than traditional MFTs. This is good news for investors who are new to ETFs. They combine a trading experience that’s similar to trading stocks, with the familiar tax reporting requirements of MFTs. This should bring investors peace of mind and comfort with adding ETFs to their own portfolios while offering the potential for greater tax efficiency.

1 This also applies when transactions are conducted by investors (usually the designated broker) with the ETF directly. While such transactions may trigger capital gains at the fund level, these gains can be allocated to the redeemer, subject to certain restrictions.2 The commentary regarding distributions relates to Manulife ETFs. You must confirm with other ETF providers how they administer distributions.