Taxation of Reinvested Capital Gains in Canadian ETFs
A New Box?
ETFs have seen exponential growth over the last decade. They offer a low cost and efficient way to provide diversification. While they may be excellent building blocks for a portfolio, the tax implications of distributions for ETFs held outside of registered accounts are often misunderstood. Canadian ETF distributions can be in the form of dividends, return of capital, capital gains, reinvested distributions, other income, and foreign income. ETFs are structured as Trusts, so all income is reported in various boxes on a T3 slip.
Dividends from Canadian corporations are subject to a gross up and offsetting dividend tax credit (DTC). “Eligible” dividends are grossed up by a factor and included an income in box 50, with a DTC included in box 51. “Ineligible” dividends, which are uncommon in ETFs, are grossed up by a lower factor and included in box 32, with a lower DTC in box 39.
Interest income is included in box 26 under the heading of Other Income and is 100% taxable. This is a catch-all box for anything not listed in other boxes.
Foreign income is 100% taxable and included in box 25, regardless of the type: this includes foreign dividends and interest, return of capital and capital gains. There also may be foreign tax paid, which is included in box 34. This is tax that is withheld by the country of origin (either US or international depending on the ETF structure), and is recoverable by claiming the foreign tax credit.
Return of Capital (ROC)
ROC is a non-taxable cash distribution, as it is considered to be giving you back money you advanced in the first place. Accordingly, ROC is broken out separately in box 42 and is a reduction to the adjusted cost base (ACB) of your investment. The result is that when you sell the ETF, you will have either a larger capital gain, or smaller capital loss.
Capital gains distributions can take two forms, cash and non-cash. Both amounts are reported in box 21 and are taxable at 50%, similar to capital gains on dispositions when you buy and sell securities directly. Cash distributions may be made throughout the year. Non-cash distributions are made near year-end and are retained and immediately “consolidated” with the previous outstanding units of the ETF. There is no change in the value of your ETF holding: both the number of shares you own and the share price remain unchanged. ETF providers on the Toronto Stock Exchange (TSX) publish their annual reinvested capital gains distribution information in December. This information may appear on your following January or February brokerage statement, depending on your brokerage firm’s policy.
These non-cash capital gains distributions should be added to the ACB, thereby decreasing your capital gain, or increasing your capital loss, upon actual disposition. Cash distributions have no impact on your ACB.
Note that foreign-listed ETFs (typically NYSE) only distribute capital gains in cash.
Mutual funds distribute capital gains in a different fashion, but the result is the same: no change in the value of your holding.
The amount in box 21 combines the cash plus non-cash capital gains distributions during the year. The result is that box 21 has a mix of the two different tax treatments of distributions, one which does not affect the cost base (“cash”) and one that does (“non-cash”). This is where mistakes are often made: the whole amount in box 21 likely is not an ACB adjustment. In order to properly calculate the adjusted cost base of an ETF, one would need to look up the reinvested capital gains distribution per unit as published by the ETF providers, and then manually calculate the amount that should be added to the ACB. There is another alternative to calculating manually, but it depends on your broker. Certain brokers report reinvested capital gains distributions in January or February of the following year on your monthly statement; others do not. It should show as both a debit and credit for the same amount, thereby having no effect on your cash balance.
Here is a sample of proper tracking:
|Year||Transaction Type||Number of Shares||Cost||Adjustment||Adjusted Cost||ACB Per Share|
|2013||Return of Capital||–||–||(36.68)||19,823.30||24.78|
|2014||Return of Capital||–||–||(24.33)||19,893.59||24.87|
The inexperienced tax preparer can make several different mistakes:
|Type of distribution||Proper treatment||Error treatment||Implication||Who wins?|
|Return of capital||Reduce cost base||Ignore||Cost overstated||Taxpayer|
|Non cash capital gain||Increase cost base||Ignore||Cost understated||CRA|
|Cash capital gain||Ignore||Ignore||Correct result||N/A|
|Cash capital gain||Ignore||Increase cost base||Cost overstated||Taxpayer|
The system extant requires a combination of too much knowledge and too much tax preparer intervention. As a result of this mix of both cash and non-cash capital gains distributions being combined into the same box 21, we believe the CRA should implement a new box for reporting year end non-cash capital gains distributions separately. This will allow both tax practitioners and do-it-yourselfers to track properly the ACB of Canadian-based ETFs. Also, all brokerage firms should report this separately on their statements, so the industry can be on a level playing field. Return of capital is already being reported so taxpayers can correctly track their ACB, to the benefit of the CRA with larger capital gains: it’s time that reinvested capital gains distributions are reported properly too, so taxpayers can benefit with lower capital gains from the correct ACB of their investments. Don serves on the National Taxation Committee of the Portfolio Managers Association of Canada, who hopefully will make representation to CRA on this matter.