ETF Year-End Distributions - A primer on how ETFs differ from mutual fund distributions

Ahmed Farooq, CIMA®, CFP

Ahmed Farooq, CIMA®, CFP
Vice President - ETF Business Development at Franklin Templeton Canada

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In the investment world, there are certain things that are standard. Like the changing of the leaves, or the first frost of winter, asset management firms announcing their year-end tax estimates is something you come to expect. Most firms provide this information in the middle or end of November and their final estimate by mid-December. It’s an important announcement for investors of both mutual funds and ETFs, as it helps them to calculate how much tax they could potentially be paying at year end.

In the past, ETFs were known as being tax efficient as most products were passive and index tracking. Nowadays ETFs have evolved to include strategic beta and active mandates, so tax efficiency depends largely on the ETF type and how it is managed.

I therefore wanted to answer some questions that I often hear on this topic, but first this quick primer.

ETF Distributions

ETFs, like mutual funds, make cash distributions that can include Canadian dividends, interest income, foreign income, return of capital, capital gains, and at year-end specifically, notional (non-cash) capital gains distributions.  

Like mutual funds, investors should also be fully aware of year-end tax distributions, as they will have to include notional capital gains distributions in their tax filings. It is very important to do your due diligence when purchasing an ETF or mutual fund near a year end.

With mutual funds and ETFs, there is a difference in how tax slips are issued. For most mutual funds, the fund provider sends tax slips to end investors as the provider maintains investor records. An ETF is different, as an ETF issuer provides the ETF’s tax information that is required to prepare an investor’s T3 through the fund’s transfer agent and Clearing and Depository Services Inc. (CDS), which is then used by a brokerage firm to populate investor tax slips. This information is normally made available by early February, so tax slips can be sent to investors by the brokerage firms’ back office in advance of investor tax-filing deadlines.

For a duplicate tax slip or in the case of a lost tax slip, any request must be made directly with the brokerage firm, or alternatively by speaking to an advisor and requesting this information from their back office.

How do ETF distributions work?

Notional Capital Gains—not paid in cash, increase your adjusted cost base

Return of Capital—normally paid in cash, decrease your adjusted cost base

Foreign Income and Interest Income—normally paid in cash

Canadian Dividend Income—normally paid in cash

Cash Distributions Versus Re-Invested Distributions—ETFs, like mutual funds, may pay distributions to unitholders in cash or, alternatively, reinvest into the fund. ETFs regularly pay capital gains at year end as notional distributions, which can cause confusion. People may ask: “where did my capital gains go?”  Or “why didn’t I receive additional units for my capital gains like I did with my mutual fund holdings?” Allow me to explain what happens.

With mutual funds, any reinvested distributions received are reinvested on the unitholder's behalf in additional units of the fund. This results in an increase in the number of units held by each unitholder and a corresponding drop occurs in the net asset value (NAV) per unit of the fund you own.  If you look at the total value of the investment you own prior to or after the change, there is no change in value from the distribution.

With ETFs, since partial units cannot be issued on the stock exchange, the mechanism for issuing capital gains is different than with mutual funds. Immediately following a notional distribution at year end, the number of units outstanding for the capital gain distribution is consolidated so that the number of units held by the investor is the same as before the distribution. It’s as if nothing happened, so this notional distribution is sometimes referred to as a “phantom distribution”. ETF unitholders will not receive cash, will not see an increase in the number of units held and will NOT see a change in the NAV per unit.

Where are my additional units?

This is a question I tend to hear most often from investors when they do not see any additional units after a notional capital gains distribution. A notional distribution for an ETF results in no change to the total value of the holdings as a result of the distribution.

With notional distributions, an investor increases the adjusted cost base (ACB) of their holding by the amount of the notional distribution. This adjustment is made so the investor does not pay tax twice on the distribution, as the notional distribution is included in investor tax slips in the year of its ex-date. In many instances, brokerage firms will adjust investor ACBs to reflect reinvested distributions on ETFs.

Tax is another one of life’s formalities and is a complex subject, so I hope I have been able to answer some of the questions you may have about ETF distributions.

ETF Year-End Distributions

A primer on how ETFs differ from mutual fund distributions

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What Are the Risks?

Commissions, management fees and expenses may all be associated with investments in ETFs. Investors should carefully consider an ETF’s investment objectives and strategies, risks, fees and expenses before investing. The prospectus and ETF facts contain this and other information. Please read the prospectus and ETF facts carefully before investing. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. Performance of an ETF may vary significantly from the performance of an index, as a result of transaction costs, expenses and other factors. The indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any security holder that would have reduced returns. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

Author’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.