The Income Tax Act defines many types of investment entities or structures for tax purposes, including mutual fund trusts (MFTs), mutual fund corporations (MFCs) and segregated fund contracts. A noticeable omission is the exchange‑traded fund (ETF). But this does not mean that an ETF is a tax‑free entity.
So how does ETF taxation work? It depends on how the fund is structured for tax purposes. Is it set up as an MFT or as an MFC? Most ETFs in Canada are MFTs, and Manulife’s ETF lineup is no exception. As such, the taxation of most ETFs closely mirrors that of traditional MFTs. This article focuses on ETFs set up as MFTs and held in non-registered accounts.
ETF income and distributions
As in an MFT, income generated on the underlying assets of an ETF retains its character when distributed to unitholders and is taxed accordingly. In other words, interest and foreign income is fully taxable income, eligible and ineligible Canadian dividends are grossed up and receive their corresponding dividend tax credits, and half of realized capital gains are taxable.
Should the ETF sustain capital losses at the fund level, these losses are used to offset realized capital gains at the fund level, and any losses that exceed realized gains in the year are carried forward by the fund. Non-capital losses realized by the ETF can be used to offset any type of income at the fund level with any excess also being carried forward. Finally, any foreign taxes paid by the fund can be flowed out to and used by investors as credits to reduce Canadian income tax owing on that same foreign income.
ETF tax efficiency
An ETF can offer greater potential tax efficiency than a traditional MFT in one or both of the following ways: lower portfolio turnover and a different mechanism for investor redemptions.
First, investment mandates for ETFs, including those using factor-based investing strategies, are often more passive than those for MFTs. With less trading activity at the fund level, there may be fewer realized capital gains to distribute to unitholders of ETFs when compared to active MFTs.
Second, all investor redemptions for an MFT are transacted directly with the fund itself. To provide the redeeming unitholder with cash, an MFT may have to sell underlying assets and realize capital gains. If these capital gains are not completely offset by the capital gains refund mechanism, the excess will generally be distributed to remaining unitholders. Generally, ETF investors sell their units over the stock exchange and realize any gain or loss without triggering transactions at the fund level. Therefore, the taxable distributions received by one investor are not affected by the transactions undertaken by other investors in the same ETF.1
Cash vs. reinvested distributions2
Income earned by the underlying investments (e.g., interest, foreign dividends, eligible dividends, etc.) in an ETF is distributed as cash to investors. Since cash distributions flow out to the investor, they do not affect the investor’s adjusted cost base (ACB). On the other hand, capital gains realized at the fund level are immediately and automatically reinvested back into the ETF, increasing the investor’s ACB. Such reinvested distributions purchase new units of the ETF, and these units are immediately consolidated with the investor’s other units so that the number of units held by the investor and the net asset value (NAV) per unit are the same as before the capital gains distribution.
The following table illustrates the mechanical differences between an ETF and an MFT.
| Description | Exchange-traded fund | Mutual fund trust |
|---|---|---|
Purchase 100 units @ $10/unit | ACB = $1,000 (100 units x $10) | ACB = $1,000 (100 units x $10) |
Current NAV = $11 | FMV = $1,100 (100 units x $11) | FMV = $1,100 (100 units x $11) |
$1/unit capital gain distribution = $100 capital gain distribution automatically reinvested | No change to NAV and number of units: NAV = $11/unit Units owned = 100 | NAV decreases by distribution, which buys more units: NAV = $10/unit ($11 – $1) Buy 10 more units with distribution ($100/$10 unit) Units owned = 110 |
Taxable amount | $100 capital gain distribution | $100 capital gain distribution |
Fair market value after reinvested distribution | $1,100 (100 units x $11/unit) | $1,100 (110 units x $10/unit) |
ACB after reinvested distribution | $1,100 (100 units x $11/unit) | $1,100 (110 units x $10/unit) |
As you can see from the table, with either type of fund the investor’s fair market value (FMV) and ACB are $1,100. The difference lies in how the ETF and MFT got there. After the capital gains distribution, the NAV of both the ETF and MFT is reduced to $10 and the $100 capital gains distribution is used to buy 10 more units. However, the number of ETF units outstanding is immediately consolidated so that the number of units held by the investor and the NAV per unit are the same as before the capital gains distribution (i.e., back to 100 units outstanding with a NAV = $11/unit).
That is why ETF capital gains distributions are sometimes called “phantom distributions” – it appears that nothing has changed. The exception is the ACB, which has increased. With the MFT, on the other hand, there is no consolidation of units so the investor ends up with more units at a lower NAV.
Summary
While ETFs may look and feel different from an MFT, from a tax perspective they are the same, albeit with differences in operational mechanics that can provide the potential for tax efficiency through lower taxable distributions than traditional MFTs
