This column won’t cover all aspects of ETFs and taxes. It can’t. That’s the domain of textbooks and experts (like the one we spoke to). But it does offer an overview of ETF tax benefits and considerations. It largely focuses on the taxation of ETFs held in non-registered investments but does discuss registered accounts for some circumstances. It also addresses a manageable administrative aspect of ETF taxation; namely, tracking the impact of reinvested capital gains distributions, known formally as “notional distributions,” or colloquially as “phantom distributions” on the adjusted cost base (ACB) of investments. If you’ve lacked “phantom fluency” (and maybe refrained from using ETFs because of it), this column shows that it shouldn’t be a stumbling block.
Mutual funds, ETFs and taxes
With mutual funds, investors buy/sell units directly from the fund. If enough unitholders choose to redeem units, the fund’s portfolio manager may be compelled to divest some holdings to raise the necessary cash with which to pay the redemptions, thus potentially triggering capital gains for all unitholders of record. Similarly, if a portfolio manager decides to sell specific holdings to crystallize a gain, the same outcome occurs: a taxable event for everyone. In both cases, the taxable activity occurs within the fund itself.
However, purchases and sales of an ETF’s units by individual investors does not affect other owners because the units are traded between investors on an exchange, and their value typically does not fluctuate dramatically from normal trading activity. Also, most ETFs are managed passively based on an index with only quarterly rebalancing. So, the turnover rate on portfolio investments of ETFs is generally lower compared to actively managed mutual funds, which diminishes the likelihood of triggering capital gains. Actively managed ETFs may incur capital gains rates comparable to some mutual funds, but it depends on turnover, and they’re still often available at a lower MER relative to mutual funds.
Trusts versus corporations: the tax implications
How Canadian ETFs are structured (whether as trusts or as corporations) impacts their taxation.
Most ETFs are structured as trusts and therefore enjoy various tax-related and other benefits. Like their mutual fund peers, ETFs pass on capital gains, interest, dividends, foreign income and return of capital (ROC) to their investors, which may create tax obligations or adjustments to ACB. An ROC is deemed “a non-taxable event” but does reduce an investment’s ACB and, therefore, impacts the calculation of capital gains and losses when units are eventually sold. This has an impact on the taxes an ETF investor may pay.
Though they are still in the minority, ETFs structured as corporations provide specific tax management benefits and have growing appeal for investors. Why? Within a corporate structure, for example, realized capital losses of one class can be used to offset realized capital gains of another class The corporate structure therefore potentially reduces the level of capital gains distributable to investors.
In defining an ETF investment strategy for your clients, the tax implications of each structure should be a factor in your decision-making.
“Phantom distributions” — not really so scary
Because of their nickname, phantom distributions may conjure up negative sentiments that inhibit advisors from exploring ETFs, but they are really quite benign. “Phantom” simply refers to distributions that affect an investment’s ACB but are not actually paid in cash. Here is how they work.
Most ETFs make capital gains distributions that are reinvested and immediately reconsolidated, creating “notional” or “phantom” distributions. These phantom distributions increase an investor’s ACB of their investment in an ETF, thus reducing the capital gain (or increasing the capital loss) when these holdings are eventually sold; therefore, distributions that affect an investment’s ACB need to be tracked to avoid paying taxes twice: once on the distribution itself and again on the embedded gain when the investment is sold.
ACB tracking should not be a barrier to ETF investing. ETF providers publish their distributions by issuing news releases and by reporting through CDS Clearing and Depository Services. Many financial firms’ back offices (probably yours) have in-house solutions to calculate and track ACBs. If you operate on a fee-for-advice model or your clients engage in DIY investing, you may want to remind them to calculate their ACBs and mention that online tracking resources are available.
What about withholding taxes?
How an ETF gains exposure to international equities affects foreign withholding taxes and therefore the ETF an advisor would prudently recommend.
Generally, any type of foreign investment — whether held in a mutual fund or ETF — is subject to withholding taxes, and tax treaties between Canada and other jurisdictions determine the applicable rates. Whether an investment is open or is held in a registered account, withholding taxes may apply with varying financial effects and remedies. The two most likely scenarios an advisor will encounter are: a Canadian-listed ETF holding foreign stocks directly and a Canadian-listed ETF holding foreign stocks indirectly through a U.S.-based ETF. Regarding the former, withholding tax is recoverable if the ETF is held in an open account — but not in a registered account. And regarding the latter, only U.S. withholding tax is recoverable, but not if it’s in a registered account.
Choosing the right fund structure and account type in which to hold international ETFs is essential because it can impact the level of withholding taxes your client is exposed to.
Don’t go it alone: seek out tax expertise
The tax obligations of ETF investing should not deter you from recommending ETFs any more than the taxes payable on mutual funds would. Expertise available within or beyond your firm can complement what you uniquely bring to your clients. CETFA applied this thinking to writing this column.
Theo Heldman is a CPA, CA and CFA charterholder with deep investment sector experience at the executive level. Now serving as an independent board director and an advisor to boards and associations, his insights materially informed this piece.
We asked Theo to summarize his thoughts about ETFs and taxes. Here’s what he told us: “You owe it to your clients to check out ETFs because they can be used as a foundational tool for optimizing client portfolios. There are many Canadian-listed ETFs that offer a variety of investment mandates and exposure to foreign markets, and although there are always tax considerations when investing, ETFs can be more tax-efficient than traditional mutual funds. And while phantom distributions may appear complicated at first, they’re really not. They are manageable, and they shouldn’t prevent you from using ETFs for the benefit of your clients.”
At the CETFA, we could not agree more.
More China coal investments overseas cancelled than commissioned since 2017
More China-invested overseas coal-fired power capacity was cancelled than commissioned since 2017, research showed on Wednesday, highlighting the obstacles facing the industry as countries work to reduce carbon emissions.
The Centre for Research on Energy and Clean Air (CREA) said that the amount of capacity shelved or cancelled since 2017 was 4.5 times higher than the amount that went into construction over the period.
Coal-fired power is one of the biggest sources of climate-warming carbon dioxide emissions, and the wave of cancellations also reflects rising concerns about the sector’s long-term economic competitiveness.
Since 2016, the top 10 banks involved in global coal financing were all Chinese, and around 12% of all coal plants operating outside of China can be linked to Chinese banks, utilities, equipment manufacturers and construction firms, CREA said.
But although 80 gigawatts of China-backed capacity is still in the pipeline, many of the projects could face further setbacks as public opposition rises and financing becomes more difficult, it added.
China is currently drawing up policies that it says will allow it to bring greenhouse gas emissions to a peak by 2030 and to become carbon-neutral by 2060.
But it was responsible for more than half the world’s coal-fired power generation last year, and it will not start to cut coal consumption until 2026, President Xi Jinping said in April.
Environmental groups have called on China to stop financing coal-fired power entirely and to use the funds to invest in cleaner forms of energy, and there are already signs that it is cutting back on coal investments both at home and abroad.
Following rule changes implemented by the central bank earlier this year, “clean coal” is no longer eligible for green financing.
Industrial and Commercial Bank of China, the world’s biggest bank by assets and a major source of global coal financing, is also drawing up a “road map” to pull out of the sector, its chief economist Zhou Yueqiu said at the end of May.
(Reporting by David Stanway; Editing by Kenneth Maxwell)
Bank of Montreal CEO sees growth in U.S. share of earnings
Bank of Montreal expects its earnings contribution from the U.S. to keep growing, even without any mergers and acquisitions, driven by a much smaller market share than at home and nearly C$1 trillion ($823.38 billion) of assets, Chief Executive Officer Darryl White said on Monday.
“We do think we have plenty of scale,” and the ability to compete with both banks of similar as well as smaller size, White said at a Morgan Stanley conference, adding that the bank’s U.S. market share is between 1% and 5% based on the business line, versus 10% to 35% in Canada. “And we do it off the scale of our global balance sheet of C$950 billion.”
($1 = 1.2145 Canadian dollars)
(Reporting by Nichola Saminather; Editing by Leslie Adler)
GameStop falls 27% on potential share sale
Shares of GameStop Corp lost more than a quarter of their value on Thursday and other so-called meme stocks also declined in a sell-off that hit a broad range of names favored by retail investors.
The video game retailer’s shares closed down 27.16% at $220.39, their biggest one-day percentage loss in 11 weeks. The drop came a day after GameStop said in a quarterly report that it may sell up to 5 million new shares, sparking concerns of potential dilution for existing shareholders.
“The threat of dilution from the five million-share sale is the dagger in the hearts of GameStop shareholders,” said Jake Dollarhide, chief executive officer of Longbow Asset Management. “The meme trade is not working today, so logic for at least one day has returned.”
Soaring rallies in the shares of GameStop and AMC Entertainment Holdings over the past month have helped reinvigorate the meme stock frenzy that began earlier this year and fueled big moves in a fresh crop of names popular with investors on forums such as Reddit’s WallStreetBets.
Many of those names traded lower on Thursday, with shares of Clover Health Investments Corp down 15.2%, burger chain Wendy’s falling 3.1% and prison operator Geo Group Inc, one of the more recently minted meme stocks, down nearly 20% after surging more than 38% on Wednesday. AMC shares were off more than 13%.
Worries that other companies could leverage recent stock price gains by announcing share sales may be rippling out to the broader meme stock universe, said Jack Ablin, chief investment officer at Cresset Capital.
AMC last week took advantage of a 400% surge in its share price since mid-May to announce a pair of stock offerings.
“It appears that other companies, like GameStop, are hoping to follow AMC’s lead by issuing shares and otherwise profit from the meme stocks run-up,” Ablin said. “Investors are taking a dim view of that strategy.”
Wedbush Securities on Thursday raised its price target on GameStop to $50, from $39. GameStop will likely sell all 5 million new shares but that amount only represents a “modest” dilution of 7%, Wedbush analysts wrote.
GameStop on Wednesday reported stronger-than-expected earnings, and named the former head of Amazon.com Inc’s Australian business as its chief executive officer.
GameStop’s shares rallied more than 1,600% in January when a surge of buying forced bearish investors to unwind their bets in a phenomenon known as a short squeeze.
The company on Wednesday said the U.S. Securities and Exchange Commission had requested documents and information related to an investigation into that trading.
In the past two weeks, the so-called “meme stocks” have received $1.27 billion of retail inflows, Vanda Research said on Wednesday, matching their January peak.
(Reporting by Aaron Saldanha and Sagarika Jaisinghani in Bengaluru and Sinead Carew in New York; Additional reporting by Ira Iosebashvili; Editing by Sriraj Kalluvila, Shounak Dasgupta, Jonathan Oatis and Nick Zieminski)