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.”
TORONTO – Canada’s main stock index was down more than 200 points in late-morning trading, weighed down by losses in the technology, base metal and energy sectors, while U.S. stock markets also fell.
The S&P/TSX composite index was down 239.24 points at 22,749.04.
In New York, the Dow Jones industrial average was down 312.36 points at 40,443.39. The S&P 500 index was down 80.94 points at 5,422.47, while the Nasdaq composite was down 380.17 points at 16,747.49.
The Canadian dollar traded for 73.80 cents US compared with 74.00 cents US on Thursday.
The October crude oil contract was down US$1.07 at US$68.08 per barrel and the October natural gas contract was up less than a penny at US$2.26 per mmBTU.
The December gold contract was down US$2.10 at US$2,541.00 an ounce and the December copper contract was down four cents at US$4.10 a pound.
This report by The Canadian Press was first published Sept. 6, 2024.
TORONTO – Canada’s main stock index was up more than 150 points in late-morning trading, helped by strength in technology, financial and energy stocks, while U.S. stock markets also pushed higher.
The S&P/TSX composite index was up 171.41 points at 23,298.39.
In New York, the Dow Jones industrial average was up 278.37 points at 41,369.79. The S&P 500 index was up 38.17 points at 5,630.35, while the Nasdaq composite was up 177.15 points at 17,733.18.
The Canadian dollar traded for 74.19 cents US compared with 74.23 cents US on Wednesday.
The October crude oil contract was up US$1.75 at US$76.27 per barrel and the October natural gas contract was up less than a penny at US$2.10 per mmBTU.
The December gold contract was up US$18.70 at US$2,556.50 an ounce and the December copper contract was down less than a penny at US$4.22 a pound.
This report by The Canadian Press was first published Aug. 29, 2024.
The crypto market has recently experienced a significant downturn, mirroring broader risk asset sell-offs. Over the past week, Bitcoin’s price dropped by 24%, reaching $53,000, while Ethereum plummeted nearly a third to $2,340. Major altcoins also suffered, with Cardano down 27.7%, Solana 36.2%, Dogecoin 34.6%, XRP 23.1%, Shiba Inu 30.1%, and BNB 25.7%.
The severe downturn in the crypto market appears to be part of a broader flight to safety, triggered by disappointing economic data. A worse-than-expected unemployment report on Friday marked the beginning of a technical recession, as defined by the Sahm Rule. This rule identifies a recession when the three-month average unemployment rate rises by at least half a percentage point from its lowest point in the past year.
Friday’s figures met this threshold, signaling an abrupt economic downshift. Consequently, investors sought safer assets, leading to declines in major stock indices: the S&P 500 dropped 2%, the Nasdaq 2.5%, and the Dow 1.5%. This trend continued into Monday with further sell-offs overseas.
The crypto market’s rapid decline raises questions about its role as either a speculative asset or a hedge against inflation and recession. Despite hopes that crypto could act as a risk hedge, the recent crash suggests it remains a speculative investment.
Since the downturn, the crypto market has seen its largest three-day sell-off in nearly a year, losing over $500 billion in market value. According to CoinGlass data, this bloodbath wiped out more than $1 billion in leveraged positions within the last 24 hours, including $365 million in Bitcoin and $348 million in Ether.
Khushboo Khullar of Lightning Ventures, speaking to Bloomberg, argued that the crypto sell-off is part of a broader liquidity panic as traders rush to cover margin calls. Khullar views this as a temporary sell-off, presenting a potential buying opportunity.
Josh Gilbert, an eToro market analyst, supports Khullar’s perspective, suggesting that the expected Federal Reserve rate cuts could benefit crypto assets. “Crypto assets have sold off, but many investors will see an opportunity. We see Federal Reserve rate cuts, which are now likely to come sharper than expected, as hugely positive for crypto assets,” Gilbert told Coindesk.
Despite the recent volatility, crypto continues to make strides toward mainstream acceptance. Notably, Morgan Stanley will allow its advisors to offer Bitcoin ETFs starting Wednesday. This follows more than half a year after the introduction of the first Bitcoin ETF. The investment bank will enable over 15,000 of its financial advisors to sell BlackRock’s IBIT and Fidelity’s FBTC. This move is seen as a significant step toward the “mainstreamization” of crypto, given the lengthy regulatory and company processes in major investment banks.
The recent crypto market downturn highlights its volatility and the broader economic concerns affecting all risk assets. While some analysts see the current situation as a temporary sell-off and a buying opportunity, others caution against the speculative nature of crypto. As the market evolves, its role as a mainstream alternative asset continues to grow, marked by increasing institutional acceptance and new investment opportunities.
