ETF Taxation: The Basics, Distributions and Dispositions

The basics

Unlike mutual fund trusts and mutual fund corporations, exchange-traded funds (ETFs) are not specifically defined in the Canadian Income Tax Act (ITA).¹ The term “ETF” is more colloquial in nature and is used to describe a specific type of investment that’s structured as a mutual fund trust or mutual fund corporation for tax purposes, but is traded on an exchange the way stocks are.

For investors, the taxation of ETFs depends on whether the fund is held within a registered plan or a non-registered account. If held within a registered plan – i.e., Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), Registered Education Savings Plan (RESP), Registered Disability Savings Plan (RDSP) – income earned within the plan accrues on a tax-deferred basis and is not taxed until withdrawn from the plan, at marginal tax rates for the year. In the case of a Tax-Free Savings Account (TFSA), amounts earned accrue and can be withdrawn tax-free. For non-registered accounts – the focus of this article – ETF taxation normally results from a distribution or disposition.

Distributions

Similar to traditional mutual funds, a distribution occurs when an ETF earns income or gains from securities held within the fund and the amounts are paid to investors. Depending on the structure of the ETF (i.e., trust or corporation), the tax characteristics of the distribution would normally be as follows:

Trust structure:

• Other income
• Foreign income
• Eligible and non-eligible dividends
• Capital gains
• Return of capital

Corporate class structure:

• Eligible and non-eligible dividends
• Capital gains dividends
• Return of capital

ETF distributions may consist of any combination of the above and, except for return of capital (ROC), are reportable and taxable on an investor’s income tax return, normally for the year in which the distribution is paid. ROC distributions are not taxable but reduce the adjusted cost base (ACB) of the investor’s units or shares, resulting in capital gains tax (or a reduced capital loss) when the units or shares are sold. ETF distributions are often paid in cash but may also be reinvested within the fund. Where distributions are reinvested, it’s important to be mindful of required adjustments to cost bases in order to avoid double taxation. For more information, see our related blog, “ETF Taxation: Phantom Distributions.”

The following table provides a summary of how the different types of ETF distributions are taxed to Canadian investors for Canadian tax purposes.²

To assist with tax reporting, ETF investors normally receive a T3 or T5 tax slip from the brokerage where they purchased the investment. A T3 slip is issued for ETFs structured as mutual fund trusts. T5 slips are issued for ETFs structured as mutual fund corporations. Non-resident investors would receive an NR4 tax slip regardless of whether the ETF is a mutual fund trust or corporation. The slips, which are normally issued by the end of February of the following calendar year, indicate the characteristics of the ETF’s distributions for the year, providing investors with the tax information they need to report and calculate taxes payable for their distributions.

Dispositions

A disposition occurs when an investor sells ETF units or shares in non-registered accounts. When this occurs, the difference between the investor’s adjusted cost base (plus outlays and expenses, if any) and sale proceeds is normally a capital gain (or loss)⁴ reportable for tax purposes for the year of sale. To assist investors with tax reporting for the disposition of ETF shares, financial institutions are required to issue T5008 tax slips with applicable disposition details. T5008 tax slips are normally issued by the end of February of the following calendar year. Here’s an example of a tax calculation for an ETF disposition:

Colleen purchased 100 units of CI GAM ETF at $10.00/unit ($1,000 investment). Three months later, she purchased another 100 units of the same ETF at $14.00/unit ($1,400 investment). Colleen now has 200 units of CI GAM ETF, having invested a total of $2,400. Her ACB is $12.00 per unit, calculated as $2,400/200 units.

Subsequently, Colleen sold all units of CI GAM ETF at $15.00/unit, realizing a capital gain for the year. At tax filing time, she calculates her capital gain as follows:

Capital gain/unit = $3.00 ($15.00 - $12.00)

Total capital gain = $600 (200 units sold x $3.00/unit)

Let’s assume Colleen had no commissions and no capital losses to offset her gain. In this case, 50% of Colleen’s capital gain (or $300) would be taxable at her marginal tax rate for the year of sale.

ETF taxation vs. traditional mutual funds

ETFs and traditional mutual funds both provide exposure to a basket of securities that offer market diversification and access to a broad range of investments. Their primary difference is in how they are bought and sold. But is one more tax efficient than the other?

With traditional mutual funds, units are bought and sold directly from the fund. When investor redemptions are high, it could force portfolio managers to sell securities within the fund in order to cover the redemptions, potentially triggering capital gains for investors through distributions. This differs from ETFs, where units are traded directly by investors on an exchange. With ETFs, selling activity by investors doesn’t always result in fund redemptions, reducing the potential for taxable distributions to investors.

Also, the type of fund purchased (i.e., active or passive) can influence tax efficiency. Many ETFs are passively managed and track a specific benchmark or index. Index funds tend to have lower turnover rates than actively managed funds, which reduces the potential for taxable capital gains. Actively managed ETFs, on the other hand, would be similar to actively managed mutual funds in this regard, and may result in greater trading activity by a portfolio manager.

¹ There is a reference to “ETF units” for purposes of allocation to redeemer rules (section 132(5.31) of the federal Income Tax Act).
² Non-registered accounts. Income and gains earned in registered accounts are not immediately taxable.
³ Capital gains dividends may be paid from ETFs structured as mutual fund corporations.
⁴ Capital gains/losses occur when property is held on account of capital. In some cases, property can be considered inventory triggering business income (or losses) on sale.