Top 5 Tax Considerations When Investing in ETFs

1. Don't take yield at face value – When it comes to ETFs, not all distributions are created equal. ETFs may make distributions consisting of very different types of income including Canadian dividends, interest, foreign income, capital gains as well as returns of capital (ROC) to unitholders. These various forms of income within distributions can be taxed very differently with some being more tax efficient than others, and is a factor that ultimately needs to be considered when evaluating an ETF to invest in.
2. Structure matters - Generally speaking, ETFs are usually more tax efficient than actively managed mutual funds, largely because there is less turnover of securities within the fund. A mutual fund manager needs to frequently sell securities within the fund to accommodate redemptions or re-allocate assets. Because ETFs trade on a stock exchange, trading activity within the fund is limited. A lower turnover can help minimize capital gains distributions resulting in improved long-term after-tax efficiency and performance.
3. Canadian vs U.S. ETFs – For Canadians investing in either Canadian or U.S. listed ETFs there are some key words to consider – U.S. estate tax and withholding tax.  Depending on your situation, you may be subject to U.S. estate taxes upon death since U.S. listed ETFs are considered "U.S. property". These taxes can be significant. Then there is withholding tax. Most countries levy a tax on dividends paid to foreign investors. For example, the U.S. government levies a 15% withholding tax on distributions paid to taxable Canadian investors. Thus, depending on the vehicle in which you hold your U.S. listed ETFs (there are different rules for registered and non-registered accounts which are beyond the scope of this blog), you may be subject to foreign withholding taxes. These withholding taxes tend to increase the cost of the investment and reduces net returns when compared to direct exposure through Canadian-listed ETFs. Ultimately, for a Canadian investor, it is usually better to purchase a Canadian-listed ETF given the considerations above.
4. Tax loss selling – Tax-loss selling is the act of selling a security at a loss (capital loss) and using the loss to offset realized gains (capital gains) incurred from selling other securities in a non-registered account. These current capital losses can not only be used to offset capital gains in the current tax year but can also be carried back three preceding years or forward indefinitely. By applying realized losses from the sale to the current or prior year's capital gains in a non-registered account, investors can reduce their tax bill – which can mean more money in their pockets. However, investors need to be aware of the Superficial Loss Rule. You can read more about it in Is There a Silver Lining in Investment Losses?
5. DRIP units & phantom distributions – ETF distributions are often paid in cash but may also be reinvested within the fund when enrolled in a dividend reinvestment plan (or "DRIP"). With a DRIP the unitholder receives the "income" for tax purposes but doesn't actually receive cash as they are given additional units instead which increases their adjusted cost basis (ACB). Also, often at year-end, an ETF may distribute units and then immediately consolidate the number of units back to what they were before the distribution. These are referred to as "phantom distributions".  They are also known as "notional" or "non-cash" distributions.  Effectively this process transfers tax liabilities (usually capital gains) from the ETF to unitholders and an adjustment will be made to the ACB, usually upwards, offsetting the tax liability transferred. Investors will receive a T3/RL-16 tax slip which would include the DRIP and phantom distributions (if any). There are various nuances (beyond the scope of this blog) which can impact taxes upon the sale of the investment which is why investors need to be diligent in tracking ACB values.

For more information on the taxes and distributions associated with a specific ETF, please refer to the ETF’s prospectus, your financial statements, or the Annual Financial Report for the ETF. It is also recommended that you contact a tax professional for additional information about taxes. You can also visit our Tax Resource Centre for more information. To view our entire ETF line-up, visit us at td.com/etfs.

The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance.

Commissions, management fees and expenses all may be associated with investments in exchange-traded funds (ETFs). Please read the prospectus and ETF Facts before investing. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. ETF units are bought and sold at market price on a stock exchange and brokerage commissions will reduce returns.

Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS.

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