Avoid capital gains tax on ETFs

While the structure of an ETF often makes taxes less concerning vis-à-vis a comparable mutual fund, ETFs can still trigger capital gains.

So Michael Nairne, CFP, CFA of Tacita Capital in Toronto, advises looking carefully at a fund’s underlying index composition to minimize your taxes.

“An ETF focused on a narrow band of securities that sees a great deal of turnover will frequently generate gains. This can lead to a year-end capital gains distribution,” he says. Conversely, a broad index has less turnover and, therefore, lower risk of distributions.

“The more affluent [you are], the more important it is that [your] advisor is doing a tax screen on potential investments,” he adds.

Further, ETFs that employ covered calls trigger a stream of capital gains that are distributed by the fund. When a mutual fund makes a taxable distribution, there is corresponding reduction in Net Asset Value per Share (NAVPS). Hence, whether the distribution is by way of cash or reinvestment of additional units, it’s easy to track the Adjusted Cost Base (ACB) of the investment.

ETFs sometimes make taxable year-end notional distributions, which are neither cash distributions nor reflected in the reinvestment of additional units. So unitholders don’t see change in the number of units they hold, and the underlying NAVPS doesn’t change either. These notional distributions are reported by the custodial firm or dealer, but the ACB could be under-reported unless the custodial firm or dealer adds the notional distribution to the investment’s ACB.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.