Friday, 2 December 2011

Avoiding an Unpleasant Year End Tax Surprise on ETFs

A few years back we delved into the Mystery of Fund Capital Gains in 2008, explaining how it came to pass that investors holding ETFs or mutual funds in taxable accounts (i.e NOT in registered accounts such as RRSP, TFSA, RESP etc) could be liable for tax on capital gains when 2008 was such a horrible down year in markets. Investors received no cash yet there was income tax payable!

Estimated 2011 ETF Capital Gains Distributions
It's time to pay attention again this year, though the problem is not so widespread or severe as 2008. The main Canadian ETF providers have recently published their estimates in the links below of capital gains distributions for 2011 in their funds (final figures are to be published between December 15 and 19):
ETFs with a Potential Tax Surprise
We have culled the lists and picked out the half dozen ETFs that will occasion significant capital gains tax to pay in taxable accounts despite what has been in most cases a year of declining market price of the ETF. Here are the ETFs to watch out for and their estimated capital gains distribution per share:
Why Pay Attention
These ETFs all have, relative to the ETF price, a high amount of capital gains to allocate to investors but that are not actually paid out as cash since the gains stay within the fund. For example, if you own 1000 shares of XCS at the end of 2011 when the tally of shareholders to whom the gains will be attributed is taken, there would be 1000 x $0.7841 = $784.10 of capital gains to report on a 2011 tax return. A top bracket Ontario taxpayer paying about a 23% marginal rate on capital gains would owe $180 extra for gains that he/she would not see in cash.

The only consolation is that the capital gain gets added to Adjusted Cost Base of the investor's ETF holding, which means less tax to pay down the road if the shares are later sold for a gain, or if sold for an eventual loss, it would create a larger capital loss to offset other gains. But that goes against the basic principle of tax minimization, which is to defer payment of taxes.

The investor can well feel aggrieved paying taxes up front on gains that he/she has not seen. The situation feels worse when we look at the price performance in the Google Finance chart image below of these ETFs over the past year.

Only two of our list - ZJN and CDZ - are in positive territory and the others are all down significantly during 2011 up to December 2.

What Can be Done?
For an existing shareholder of these ETFs it is possible to avoid receiving the unwanted capital gains distribution by selling the ETFs on or before December 22nd (from December 23rd onwards, the shares trade ex-dividend, which means that if you sold the shares on December 23rd, you would still receive the year end distributions as the trade settlement would not occur till after the new year and you would still be on the books as the shareowner till then).

The value of doing this depends on the price you bought the shares. In a taxable account, you would need to do the usual capital gain/loss calculation (here is our post explaining how that works). If you bought ZJG at its inception in January 2010 you would be sitting on a sizeable capital gain. Triggering the big gain's realization to avoid the much smaller 2011 distribution does not make sense. However, if you had bought ZJG in January 2011 there would be a big paper loss so the sale before year end makes a lot of tax sense. This would be tax loss selling at its best. For the ins and outs of tax loss selling see this post.

For those investors who do not yet own but want to buy any of these ETFs, they are better off waiting till December 23rd.

Possible Short-Term Substitute ETFs
One tricky issue when an existing investor wants to continue owning the ETF for the long term is to properly comply with the superficial loss rule, by which the Canada Revenue Agency will deny the loss if the ETF is repurchased within 30 days e.g. by selling ZJG December 22 and buying it back on the 23rd.

One option is to wait for a month before buying back the ETF but that takes the chance that the price might rise significantly in the interim.

Another option is to substitute/buy similar, but not identical, ETFs while the 30 day period elapses. ETFs that use the identical index are a no-no but many ETFs using dissimilar indices within a sector follow a similar price price pattern, especially for a short period. That is all one really needs. Here are some matchups for our ETFs that we found using Google Finance charts to give us an eyeball validation.
In mid-March, the fund companies publish the complete final tax breakdown of all types of fund income (dividends, interest, return of capital, capital gains) to help investors prepare their taxes and track their cost base. Meantime, this advance information helps investors make decisions and take action to defer capital gains.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Anonymous said...

I have 1000 shares of CDZ purchased between sept-nov 2011 (ACB/unit of 20.35). My marginal tax rate is about 40% here in QC, trying to figure out if its better to replace with something else or sell and buy back in a month? Right now, about +3.2% up.

CanadianInvestor said...

Hi Anon, since you are up on your purchase, there's no immediate tax advantage to replacing CDZ now - you would incur a taxable capital gain on the sale to avoid the capital gain distribution. However, if you have capital losses in other investments to counter the CDZ gains, then selling CDZ may make sense. With markets being down as they have been this year, there might be some ETF in your portfolio that is below its ACB. e.g. XIU is down about 11% YTD so selling that along with CDZ, replacing both with temporary substitutes like XIC and ZDV could be a good move.

There's always a chance in 30 days that markets might have moved up smartly. In that case, selling the temporary ETFs to go back to the original ones might incur a new capital gains problem. One must weigh the chances. Keeping the temporary ones for a lot longer than 30 days might be required. I think the substitute ETFs are pretty reasonable on a quick look.