ETFs and capital gains

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

DOWNLOAD PDF

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

"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 your clients, the more important it is that the 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.

"An advisor needs to check," adds Nairne. "[The ACB calculation] isn’t always automatically adjusted. If an investor holds the funds over several years, the ACB might have to be adjusted several times."

The brokerage firm is responsible for providing all tax reporting on ETFs. That’s unlike mutual funds, where the fund company provides a lot of services. Investors receive a T3 directly if a capital gains (or other) distribution occurs.

Composition matters

If an underlying stock is purchased in a merger, the index composition needs to be rebalanced to ensure the ETF continues to replicate the index. This can lead to significant underlying stock redemptions, triggering a series of capital gains that must be distributed to the fund.

Graham Westmacott, a portfolio manager at PWL Capital, emphasizes the need to closely examine the underlying assets to determine if they truly represent the index. If the index is tracking through derivatives, there is often a counterparty risk associated with the derivative, and the ETF may suffer losses if the counterparty defaults.

"Some providers act as their own counterparty; and whether they are taking profit from the derivative trade or the ETF will impact the investors," he says.

Bond ETFs typically pay out interest as a monthly dividend, which is taxed as regular income. As a result, they should be held in registered accounts. Any capital gains are paid out as an annual distribution.

But these ETFs don’t offer automatic diversification; some could be heavily weighted to one or two companies. "You need to pay attention to how much debt you are exposed to from one particular company in the investment basket," says Westmacott. "Are you safe investing in a fund that carries a great deal of debt from one bond provider?" Real-estate ETFs can offset the taxable portion of distributions with capital cost allowances from depreciation of the properties in the underlying REITs.

Westmacott says that gives real-estate ETFs an extra degree of freedom.

"If the REIT basket experiences a return of capital from property depreciation," he says, "it is able to net it off to reduce the resulting taxable distribution."

Capital gains realizations can be triggered by corporate actions in an underlying stock. If an ETF tracks a large-cap index and an underlying stock no longer meets that definition, the stock would have to be sold. The market maker would take the primary capital gains hit, but it could be passed on to ETF investors in the form of a fully taxable cash distribution.

U.S.-based ETFs

While U.S. ETFs traded on Canadian exchanges are subject to our tax rules, it’s possible for a Canadian to own U.S. ETFs traded on the NYSE without using a holding company.

Nairne says advisors must scrutinize the setup of the ETF, because some are not typical trusts but rather structured as notes or grantor trusts, and the tax treatment can be different. While the fees are lower, foreign dividends from such ETFs do not qualify for the dividend tax credit afforded to Canadian companies.

More important, however, is the fact that U.S.-based ETFs are considered foreign property by the CRA and need to be included in the annual Foreign Income Verification Statement filing if foreign property exceeds $100,000.

Also, the IRS considers ETFs or stocks held on an American exchange to be U.S. assets for U.S. estate tax purposes. These investments can result in a large, unanticipated estate tax exposure if an individual owns assets in the U.S. in excess of the exemption limit.

"People think about their condo in Florida, but may not be aware that the U.S. ETFs and stocks are considered U.S.-[domiciled] assets as well," says Nairne.

"Advisors need to be diligent about the composition of the portfolio and determine if any ETFs or stocks held on U.S. exchanges are in excess of exemption limits."

The more affluent your clients, the more important it is that the advisor is doing a tax screen on potential investments.”

Since most capital gains distributions are done at year-end, investors can avoid distributions by divesting before December 31, or waiting to buy until January. Westmacott says people focus on ETFs’ short-term tax implications, when in reality product quality is more important for long-term investors.

"Investors need to ensure that the people responsible for their investments are not just selling, but are also capable fiduciaries suggesting products based on portfolio objectives," Westmacott says. "The future investment return to investors is much more influenced by suitability, quality and fees.

"Worrying about tax efficiency on a product you only plan to hold for six months is a waste of energy. ETFs provide an efficient way to hold a particular asset class when it would be prohibitive to try to hold all the underlying stock. Because they have a lower turnover, you are deferring capital gains on the eventual sale, which makes them inherently tax-efficient," concludes Westmacott.

Lisa MacColl is a Ontario-based financial writer.

Back to ETFs In Depth mainpage >>