Although ETFs and mutual fund trusts have many similarities, ETFs have unique taxation aspects when they’re held in non-registered accounts. This article compares ETFs and mutual fund trusts. Corporate-class mutual funds are taxed differently, so they’re not discussed.
Similar to mutual fund trusts, ETFs distribute interest, foreign income, dividends and capital gains to shareholders. And, as with all mutual funds (trust or corporate structure), ETF distributions may be reinvested or paid out in cash. However, a reinvested ETF distribution is not used to purchase more units. Instead, it increases the adjusted cost base. In doing so, the distribution is treated for tax purposes as a capital gain and it’s recorded on a T3 tax slip under “re-invested distribution per share.”
A mutual fund trust also reports distributions on Form T3. No matter whether the distribution is reinvested or paid in cash, the nature of the distribution would be taxed as interest, dividend, foreign income or capital gain. When the distribution is made, the ACB of the mutual fund trust decreases by the amount of the distribution. If the full distribution is reinvested, it is then added to the adjusted cost base of the mutual fund holding; the ACB change is net zero.
The tax treatment of distributions will also differ depending on the country in which the ETF is based. Tax withheld on the distribution may be claimed by Canadian taxpayers as a foreign tax credit when filing their returns.
Distributions made by Canadian ETFs to shareholders can consist of:
- non-taxable return of capital, which reduces the adjusted cost base;
- reinvested distributions, which increase the adjusted cost base;
- capital gains, which are 50% taxable;
- Canadian dividends, which are eligible for the dividend tax credit;
- interest or foreign income, both of which are 100% included in taxable income; and
- capital losses.
Mutual fund trusts distribute all of the above except capital losses.
If an ETF pays out a distribution in cash, the distribution will be taxed depending on what type it is in the above list.
Treatment of capital gains
When investors in mutual funds (trusts or corporate structures) sell or redeem units or shares, the fund portfolio manager may have to liquidate some of the fund’s holdings, meaning capital gains or losses. Investors holding the mutual fund may receive a capital gains distribution at year-end, though this would be minimized by the capital gains refund mechanism used within the fund to lower the tax impact and avoid double taxation.
By comparison, ETFs are traded on an exchange, so one shareholder’s action has less impact on other investors than a mutual fund redemption would. (Capital gains are generally more applicable to equity ETFs than fixed-income ETFs, so these comments refer to equity ETFs.)
Capital gains may also be created when a fund portfolio manager sells a portion of the underlying securities to change the asset allocation of the fund. A mutual fund investor who has only recently purchased units can still receive a taxable capital gains distribution. The ETF investor would not experience this, however, as the securities in an ETF portfolio are exchanged in-kind for fund shares, and new fund shares are created through in-kind exchanges for securities.
Treatment of capital losses
Another specific tax feature of ETFs is that capital losses at the portfolio level flow through to the investor and can be used to offset capital gains realized from other investments. This is different from mutual fund trusts, which trap the loss within the trust itself for use in future years. This also differs from corporate-class mutual funds, which use capital losses within one fund to offset capital gains in other funds within the mutual fund corporation and thereby reduce the investor’s taxable distributions.
Calculating the ACB of an ETF
Investors holding ETFs in their non-registered portfolios will have to keep track of their adjusted cost base (ACB). The ACB is calculated as follows:
ACB = total purchase price (including commissions) + reinvested distributions – return of capital
Return of capital will be shown on the investor’s T3 and should not be included in income for tax purposes.
Both ETFs and mutual fund trusts can distribute interest and foreign income, which highly taxed investors may not want. Corporate-class mutual funds, by comparison, only distribute Canadian dividends or capital gains. Consider these tax implications when building portfolios for clients.
- The capital gains refund mechanism is a special formula in the Income Tax Act that allows an investment fund to retain some of its net realized capital gains in a year rather than distribute all gains to its investors. The formula looks at the redemptions in the fund as well as portfolio turnover to lower the amount of realized gains that are due to redemptions. The capital gains that arise on the liquidation of units will be taxed as a gain or loss in the investor’s hands, so the mechanism reduces the potential for double taxation.
- Distributions made by foreign ETFs to Canadian shareholders are usually considered foreign dividends, and are 100% taxable. Even if distributions from U.S. ETFs are categorized as capital gains or return of capital for U.S. taxpayers, they will still be considered foreign income for Canadian taxpayers and, consequently, fully taxable.