Sunday, 30 November 2008

ETF and Mutual Fund Distributions Explained

Investors who own ETFs and mutual funds in taxable accounts (i.e. this does not apply to tax-protected accounts such as RRSPs) may be surprised and puzzled this year to receive T3 tax slips that show capital gains to be reported on their income tax return. After all, in 2008 stock markets had one of the worst years in living memory with the TSX down 35%. How could there be any gains one might ask?

Even in normal years of market advances, an investor may wonder why there are taxes to be paid if none of the investment was sold and no cash received.

The explanation revolves around distributions. Confusion arises because the word distributions is used to refer both to cash paid out to investors and to income attributed to investors for tax reporting purposes. In both cases, distributions consist mainly of capital gains, interest and dividend income generated during the year by the stock or bond holdings within the fund.

All Income Taxed as if Received by Investors
All ETFs and most mutual funds are structured as trusts, which means that to minimize taxes they pass along all income to investors to be taxed in the investors' hands. "Pass along" often means an actual cash payment to the investor but it may not.

Income Reinvested Automatically by Mutual Fund is Taxable
Mutual funds offer investors who want to reinvest income the convenient optional service of automatically buying more fund units with the profits instead of going through the complication of sending out cash only to have the money sent back to buy more units. The investor never sees the cash but receives the profits so it should not be disappointing to be required to pay taxes on the profits.

In the case of ETFs, interest and dividends are always paid in cash to investors either monthly, quarterly, semi-annually or annually. There is no option to have this income automatically reinvested as with mutual funds. The Managing Taxes document from iShares Canada explains why.

Cash Distributions May be Boosted by non-Taxable Return of Capital
It happens fairly often that funds distribute more than their income in a year. The excess is in effect paying back some of the investor's original investment and is termed a Return of Capital. This is not taxable.

Taxable Capital Gains When the Fund Sells: Investor Sees no Cash
Capital gains (or losses) arise when the fund sells and makes a profit during the year; the investor has not sold anything, the fund has. The net of all the sales during the year is calculated by the fund and the capital gains are attributed to the investor for purposes of tax reporting. Such gains are not usually paid out in cash to the investor; instead they get reinvested within the fund through new purchases.

The TSX had reached a peak in mid-June 2008, so stocks sold within a Canadian equity fund up to that point could well have made a capital gain and if few stocks were sold at a loss during the subsequent downturn before the end of the year, the fund might be reporting a net capital gain for 2008. That does turn out to be the case for instance, with the popular iShares Canadian Large Cap 60 Index ETF (symbol XIU). A press release of Dec.24 says XIU has generated a reinvested distribution of $0.14652 per share, which investors will soon see in box 21 on a T3 slip from their broker to be included on their tax return.

Taxable Capital Gains When the Investor Buys(!)
An investor who buys a fund late in the year just before the year-end capital gains distribution can end up paying tax for gains made much earlier in the year. Funds use the list of owners as of a certain date (termed the record date) to parcel out the year's gains, most often December 30th. The T3 the investor receives tells the tale. It may be better to defer the purchase till the new year. Fund companies normally publish year-end distribution estimates in advance of the record date so that investors can avoid the nasty surprise if a big capital gain is in the offing.

Taxable Capital Gains When the Investor Sells: Investor Sees Cash
A separate taxable capital gain (hopefully! or perhaps a loss) occurs when the investor sells all or part of a holding in a fund and the proceeds exceed the net purchase cost. The investor will NOT receive any T3 tax slips from the fund company to use on his/her tax return. It is up to the investor to calculate and report the gain.

Additional Info:
ETFs - iShares Canada Distribution History links for each fund - e.g. for XIU
Claymore Canada Tax Information Guide for 2007 (2008 tba) covering all its funds

Mutual Funds - follow links to fund companies at and look for Tax or Distribution info at each company's site; a typical handy guide is Mackenzie's Mutual Fund Tax Guide

As always, this post is not to be taken as advice. If you are unsure how to handle distributions, contact an accountant or other financial professional.

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