Call me old-fashioned, but I like to give ETFs to my loved ones at Christmas. Nothing captures the spirit of the holidays quite like a low-cost, passively managed investment project. But before you go shopping for the Couch Potatoes on your wish list, be aware that December can be a terrible time to buy ETFs.
No, it’s not because of all the last-minute shoppers pushing and shoving at the discount brokerage. The reason is that any capital gains that the funds have incurred over the last 12 months are distributed at the end of the year. Although they’re called “distributions,” capital gains are not handed out in cash like dividends or interest. You don’t receive any new shares, and the market price of the ETF won’t change. All you get is a T3 slip showing the amount of the gain, which you’ll need to report on your 2010 tax return. Imagine the look on your child’s face when she opens your thoughtfully wrapped ETF, only to find that it comes with a nasty tax bill. Talk about a lump of coal.
Their gain, your pain
In general, ETFs are extremely tax-efficient, especially if they track broad, cap-weighted indexes. Funds incur capital gains when they sell securities at a profit, and passively managed funds don’t do a lot of selling. (The ETF structure may allow fund managers to avoid taxable gains even when they do sell stocks.) However, a fund may have no choice but to realize capital gains when its benchmark index is changed, forcing the manager to sell some securities and replace them with others. The funds are then required to pass those capital gains on to their investors, usually at the end of the year. (Of course, this is not an issue if you’re investing in an RRSP or a TFSA.)
If you’re a buy-and-hold investor, capital gains are just part of the deal: take comfort in the fact that your fund made some profits during the year and put money in your pocket. However, if you’re thinking about buying into an ETF for the first time, December may not be the time to do it. If you buy shares of the fund now and it pays out a large capital gains distribution at the end of this month, you’ll wind up paying tax on other people’s gains.
When ETFs declare that they will be distributing a capital gain for the year, they name a date of record and an ex-dividend date. (These terms will be familiar to investors who buy individual stocks. This article offers a more complete explanation.) If you buy an ETF before the ex-dividend date and still hold it on the date of record, you’ll pay tax on all of the capital gains accumulated during the year, even though you may have only owned the fund for a week.
Claymore, iShares and BMO all have the same capital gains distribution schedule for 2010:
| Declaration date: | December 17 | |
| Ex-dividend date: | December 24 | |
| Date of record: | December 30 | |
What does this mean for investors looking to buy an ETF in a taxable account now, perhaps as a gift for that special someone? It means that you should consider waiting until December 17 to see if that fund is going to distribute a capital gain. If it is, you should delay your purchase until after December 24. Any shares you purchase after that date will not be hit with the tax.
Big gains in 2010
Although the official declarations won’t be made until December 17, most ETF providers have already made estimates. It looks like 2010 was a particularly bad year for capital gains distributions. Here are the links to each company’s press releases, plus a few highlights that stood out:
- For the first time in four years, Claymore’s flagship Canadian Fundamental Index ETF (CRQ) announced a capital gain of $0.29 per share, or about 2.5%.
- The Claymore US Fundamental Index ETF (CLU) will distribute a gain twice as large as last year’s: $1.33 per share, or more than 8%.
- Both of Claymore’s dividend ETFs (CDZ and CYH) are also passing along capital gains.
- The most popular iShares Canadian equity funds (XIU, XIC and XDV) incurred zero gains again this year.
- The iShares S&P/TSX SmallCap Index Fund (XCS) estimates a capital gain of 4.67% because more than 40 stocks were deleted from the index, and many had to be sold at a profit.
- The iShares S&P 500 Index Fund (XSP) generated a 2% taxable gain because of its currency hedging strategy.
- The iShares S&P Capped REIT Index Fund (XRE) incurred gains when the index was adjusted in September after a 20% run-up in the fund’s value.
- There will be no capital gain distributions on several popular equity ETFs, including the BMO Dow Jones Canada Titans 60 Index ETF (ZCN), the BMO International Equity Index ETF (ZDM), and the BMO Emerging Markets Equity Index ETF (ZEM).
- High-yield bond ETFs (ZHY and ZEF) will see taxable distributions of more than 2.5%.
- Vanguard continues to be extremely good at tax-managing its ETFs. The only fund with a taxable gain that is likely to be held by Canadians is the Vanguard FTSE All-World ex-US Small-Cap ETF (VSS).
{ 15 comments… read them below or add one }
Keep in mind, though, that you will be able to deduct the distribution amount from your adjusted cost base.
@alvanson: This is typically done by the brokerage, so you shouldn’t have to make this calculation. This is from the FAQ on the iShares site:
“For reinvested distributions for an iShares fund, an investor can increase the adjusted cost base (ACB) of the iShares fund by the amount of the reinvested distribution. This adjustment means that any gain realized on a subsequent sale of units will, in effect, be reduced by the amount of the distribution. In this way, you do not pay tax twice on the distribution. In many cases, your brokerage firm will automatically change the ACB to reflect reinvested distributions on iShares funds. However, not all brokerage firms provide this service.”
A note on the re-constitution of CDZ: I called Claymore about a week ago to find out what to expect as CDZ re-constitutes itself in the wake of income trust conversion. Interestingly, all of the effects of this re-constitution will be felt at the end of 2011 as they assess which conversions increased their dividends in 2011 or not.
@Flagen: Claymore just explained to me that the index will be reconstituted in late December.
As much as people seem to love the Aristocrats index, this to me is its biggest weakness. If a company raises its dividend ten years in a row, then keeps it constant one year, it gets removed from the index and stays out for the next five years. That’s why most of the banks got kicked out, even though they are clearly still good dividend stocks.
If you’re currently in the market to buy ETF’s, should you wait until Jan 1?
@Ryan: If the ETFs you want to buy will not be distributing a capital gain (check by clicking the links above) then you don’t have to worry. If they will be distributing a gain, you will likely want to wait until after December 24. Note, too, that if you’re investing inside and RRSP or TFSA you can ignore all of this.
And another thing for others to be aware of: If and when the emerging markets index changes dramatically by the movement of whole countries from emerging to developed, it will produce sizable capital gains issues.
I don’t have any way to assess this: I called Vanguard re. VWO and they basically didn’t give me an answer. Vanguard, as you’ve noted, are very good at managing capital gains because of the structure of their etfs, but I’m not sure even they could cope with the huge turnover created when this comes to pass. My concern was enough to make me move VWO into RRSPs and out of an open account (where it would, as it exists, make the most sense from a tax perspective).
2010 is the first year I started doing the couch potato. I hope to see some tax articles when tax season begins.
@Flagen: It’s true that if a country is promoted to “developed” status it will force emerging markets index funds to sell the stocks from that country. That’s likely to happen with Korea and Taiwan soon, and probably Brazil, too. But keep the “danger” in perspective. It would affect perhaps 10% to 12% of the fund, the capital gains distribution would be a one-off expense, and only half of capital gains are taxable.
That said, if you have room in your RRSP, it would almost certainly be better to keep VWO there. I don’t agree that it makes more sense from a tax perspective to keep VWO in a taxable account, because it’s subject to the 15% withholding tax on dividends, and because there is no tax credit on foreign dividends.
Can you expand on what this means in a TFSA or RRSP? I figure it’s just a wash when you look at payout vs. unit value. Should TFSA investors buy before the capital gains payout?
Can you please also discuss the HST and what it means for investors across Canada in a future posting? Here is a good basic article on Moneyville, but it’s in need of an update for 2011 Couch Potatoes: http://www.moneyville.ca/article/834055–luukko-fund-investors-and-the-hst
@Jon: Capital gains distribution mean nothing for RRSP and TFSA investors. Investors with these accounts pay no tax, period. (Until RRSP funds are withdrawn, of course.)
The HST has already increased the cost of ETFs and mutual funds. These costs will encompass all Canadians, regardless of where they live. As far as I know, no ETF or index fund provider has created special classes of funds for investors outside of Ontario.
Wouldn’t the price of the ETF fall in compensation of the knowledge that the ETF will incur the tax? Kind of like how the price of a stock drops immediately after a dividend has been paid?
Is this called arbitrage?
@Slacker: No, the price will not drop the way it does when a dividend is paid. The capital gains in the fund have already been realized and reinvested during the year, so the price changes occurred then. The “distribution” at the end is really just the waiter handing you the bill at the end of the meal.
Hi – thanks for this article. I have been googling the heck out of this subject and remain uncertain. I thought I understood after reading the article but then one of your comment responses seemed to contradict the article. I’m hoping you can elaborate.
In my case, I first noticed an issue in my 2009 taxes last year and have to deal with it again this year. I had bought a few ETFs mid-year (XCB and XRE) and when my tax bill came, I noticed that the capital gains (line 21 of T3) were higher than the actual total distributions that I had received. In other words, I was being taxed on money I had not received because of my mid-year purchase.
I was uncertain whether I should raise the ACB and chose not to. Your article implies that was correct. But your first comment makes me wonder if I am understanding this all correctly and if I can in fact raise the acb. (my brokerage does not do acb calculations – I do all the math myself).
@Bif: My understanding is that you can indeed raise the ACB to account for the capital gains. But I did not get into the details in the post because this is not my area of expertise. I would suggest you speak to an accountant or tax specialist for a definitive answer.
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