Adjusted Cost Base With US-listed ETFs

Many readers have used our white paper, As Easy as ACB, to learn how to calculate the adjusted cost base of their Canadian ETF holdings. I’ve received several comments and questions from readers who wonder whether the process is the same for US-listed ETFs—and the answer is no.

You already know that dividends and interest from US securities are taxed at your full marginal rate. What you may not realize is that return of capital (ROC) and capital gains are also fully taxable. And although ROC and reinvested capital gains affect your ACB with Canadian securities, they are unlikely to be a factor with US-listed ETFs.

Schmidt happens

First some background: in a 2012 court case, a Calgary investor named Hellmut Schmidt argued that ROC and capital gains distributions from a US-listed security should get the same tax treatment as they do when they come from Canadian funds. He argued the ROC should not be taxable, and that he should be on the hook for only half the capital gain. But the judge disagreed and ruled that all the US fund’s distributions were fully taxable as foreign income.

Let’s consider the implications of that ruling. Recall that ROC from a Canadian fund is not taxable in the year it is received, but it lowers your adjusted cost base, thereby increasing the future capital gains tax liability. The Schmidt case made it clear that if you receive return of capital from a US-listed ETF, it is fully taxable as income, and it does not affect your ACB.

Fortunately, return of capital does not seem to be a common characteristic of US-listed ETFs. You should be able to tell if there were ROC distributions by visiting the ETF’s website. One example is the Vanguard REIT ETF (VNQ), which had four ROC distributions in 2013:

VNQ distributionsThe lesson here is you should probably not hold this ETF in a non-registered account. Indeed, foreign REIT ETFs can be extremely tax-inefficient, because they throw off a lot of fully taxable income. If foreign REITs are part of your portfolio, consider holding them in an RRSP.

At a loss for gains

Capital gains reported by Canadian ETFs will appear on your T3 slip and are taxed at half your marginal rate. But as we’ve seen, any capital gains distributed by a US-listed ETF will be reported as foreign income on your T5 slip, and they are fully taxable.

More good news, however: capital gains distributions from US-listed ETFs are even rarer than ROC. According to a Morningstar article published at the end of last year, “at five large ETF providers—iShares, Vanguard, State Street, PowerShares, and Schwab—just 38 out of 670 funds are facing capital gains distributions of any kind.” Moreover, the Vanguard and iShares ETFs that did have capital gains in 2013 were mostly bond funds, and there can’t be many Canadians who hold US bonds in taxable accounts.

Even when a US-listed ETF does have a capital gains distribution, it is likely to be in cash, which means you don’t have to worry about adjusting your cost base. So this one is a moot point for Canadian ETF investors.

Making the exchange

All of which is to say that calculating your ACB with US-listed ETFs is largely about keeping track of purchases and sales. Lowering your ACB to account for return of capital is not permitted, and increasing it for reinvested distributions is almost never necessary.

Of course, that doesn’t mean it’s straightforward. ACB calculations for US securities need to be done in Canadian dollars, which means you will need to learn the USD-CAD exchange rate for the settlement date of each transaction. For a detailed explanation, see pages 13 and 14 of our white paper, As Easy as ACB.

31 Responses to Adjusted Cost Base With US-listed ETFs

  1. Darren April 10, 2014 at 12:02 pm #

    Just so I’m clear on this: capital gains distributions from US-listed ETFs are taxed at 100% of your marginal tax rate, but capital gains from selling US-listed ETFs are taxed at 50% of your marginal tax rate?

    Darren

  2. Canadian Couch Potato April 10, 2014 at 12:12 pm #

    @Darren: Correct. A capital gain distribution from a US-listed ETF is treated as foreign income. But selling shares of a US-listed ETF at a profit is just like any other kind of capital gain.

  3. Tyler April 10, 2014 at 1:55 pm #

    I realize you’re not a tax lawyer, but do you have any insight into the reasoning behind the tax court’s decision? I read through it and the judge was not convinced that the type of distributions that the fund says they made, actually flowed through to Mr. Schmidt. Why wouldn’t they?

  4. Jake April 10, 2014 at 2:01 pm #

    what are the MER’s of the new BMO mutual fund etc series D funds?

  5. Canadian Couch Potato April 10, 2014 at 2:08 pm #

    @Tyler: Jamie Golombek has written about this, and he quotes the following from Canada Revenue Agency: “It is a question of corporate law, not U.S. tax law, that will determine the nature of the cash distribution for Canadian tax purposes. Under U.S. tax law, certain distributions may be treated as a return of capital when in fact they are a dividend under corporate law [and thus properly taxed as a foreign dividend].”
    http://business.financialpost.com/2012/05/12/not-all-dividends-are-taxed-the-same/

    I’m not going to pretend I understand exactly what that means, but it is reasonable to expect that the two countries are not bound by the other’s laws. My guess is that for US investors, capital gains and ROC from Canadian companies are also treated like foreign income and taxed accordingly.

    @Jake: I’m getting some information on these and will report on them soon.

  6. Chris April 10, 2014 at 4:13 pm #

    I don’t think you’re reading the Schmidt case right. The judge makes no conclusion of law in the decision. The only conclusion the judge reaches (paragraph 10) is that Schmidt failed to establish an evidentiary basis for concluding that DNP’s distributions flowed through to him. Unrepresented litigants like Schmidt often fail to establish an evidentiary basis for their arguments. This is absolutely not the same thing as the judge ruling that US return of capital or long-term capital gains are treated as income.

    Perhaps a tax lawyer or accountant can chime in on whether there is a better decision on this issue.

  7. Canadian Couch Potato April 10, 2014 at 4:48 pm #

    @Chris: I am certainly no legal expert, but the discussions I have read reference the Schmidt case as a precedent and advise against trying to claim that ROC from US investment funds is not taxable, and against trying to claim that distributed capital gains should be taxed at half the rate of foreign income. Investors are welcome to do whatever they want on their own tax returns, but you’re playing with fire if your claim doesn’t match up with your T5s.

    http://www.taxtips.ca/personaltax/investing/taxtreatment/etfs.htm
    http://business.financialpost.com/2012/05/12/not-all-dividends-are-taxed-the-same/

  8. VM April 11, 2014 at 8:54 am #

    Thank you very much for this info! You saved me a lot of money. I sold UBA last year that had decent amount of “Return of Capital” and I recalculated ACB based on that. Now I will ignore Return of Capital and save that money :)

  9. Canadian Couch Potato April 11, 2014 at 10:38 am #

    @VM: I’m sure you know this, but just to clarify for others, it is indeed a benefit if you don’t have to lower your ACB to account for return of capital from a US security. But the flip side of that coin is that the ROC is fully taxable as foreign income (it would appear on your T5) which is not a benefit at all. So holding US securities that generate a lot of return of capital is probably not a great idea to begin with.

  10. Zaphod April 11, 2014 at 11:41 am #

    @CCP – You say that holding US ETFs that generate a lot of ROC is not a great idea – I assume that is the same for US ETFs that generate a lot of capital gain distribution. Any idea how to know in advance what ETFs are likely to do this? Any difference on taxable vs non-taxable accounts?

  11. James April 11, 2014 at 1:17 pm #

    Dan, my accountant advised using average annual exchange rates in calculating the ACB. I find this simplifies the bookkeeping considerably, compared to looking up daily exchange rates for each transaction.

    From http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/rprtng-ncm/lns101-170/127/clc-rprt/menu-eng.html: “Report your gains or losses in Canadian dollars. Use the exchange rate that was in effect on the day of the transaction or, if there were transactions at various times throughout the year, you can use the average annual exchange rate.”

  12. Canadian Couch Potato April 11, 2014 at 1:40 pm #

    @Zaphod: This is only an issue in taxable accounts. I would just suggest looking at whether an ETF had made return of capital or capital gains distribution in the past: if they have never none so (which is usually the case) there’s little reason to suspect they will suddenly start. I’d be most wary of REITs for return of capital.

    @James: I never argue with accountants. :)

  13. Robert April 11, 2014 at 4:12 pm #

    @James: My discount broker (BMO Investorline) included the following line on my annual investment summary:
    THE US$ EXCHANGE RATE FOR 2013, ISSUED BY THE BANK OF CANADA IS: 1.0299
    I was told to either use this or the noon rate on the transaction (settlement) date as long as I am consistent. I’m hoping this was the right advice.

  14. James April 12, 2014 at 8:01 am #

    @Robert: You’ll see that rate is the same as the Bank of Canada’s annual average rate. :)
    http://www.bankofcanada.ca/stats/assets/pdf/nraa-2013.pdf

  15. Cristian April 12, 2014 at 7:48 pm #

    Excellent post.
    What about reinvested dividends of US ETFs? Do we omit those as well from the calculation of the ACB?

  16. Canadian Couch Potato April 13, 2014 at 12:37 am #

    @Cristian: Do you have an ETF with reinvested dividends? I’m not aware of any ETF that does this.

  17. Jas June 4, 2014 at 11:57 am #

    @CCP:

    How about ROC for Canadian-listed ETFs which invest in US etfs (like Vanguard VUN) ?
    Does it appear as foreign income or ROC on the T5 ?

  18. Jas June 4, 2014 at 12:00 pm #

    @CCP:
    And how about ROC for Canadian-listed ETFs investing directly in US equities (like BMO ZSP) ? Do you have the ACB for the ROC distributions?

  19. Canadian Couch Potato June 4, 2014 at 2:12 pm #

    @Jas: If the return of capital was generated by the Canadian-listed ETF itself (as opposed to the underlying US holdings) then it should show up as ROC on your T3 (not T5, because it’s a Canadian-listed ETF). If the underlying holdings generated the ROC directly, then it would lose its character and become foreign income. But this is really a moot point: VUN’s underlying holding is VTI, which has never distributed ROC. And the companies in ZSP are equally unlikely to distribute it.

  20. Jas June 15, 2014 at 12:01 pm #

    @CCP:
    So tracking re-invested ETF distributions and ROC if only a problem with Canadian equities ETF and not for international/US ETFs (US listed or Canadian listed)?

    If thats the case, one could consider using TD e series for canadian equities and ETFs for US/International equities to simplify the tracking of the ACB?

  21. IlyaK June 21, 2014 at 1:57 am #

    @JAS

    Like Jas, I too am very conscious about avoiding complex ACB calculations.

    My current solution for my non-registered account is to use Horizon swap ETFs, HXT and HXS, which only require me to track purchase and sale to calculate ACB.
    I also like GICs for the ease of calculating taxable income.
    I’ve also considered buying Berkshire Hathaway stock as AFAIK it never has distributions.

    So Jas, when holding TD e-funds, are there no “phantom distributions”, or ROC or dividends?

  22. Jas June 22, 2014 at 9:38 am #

    @IlyaK:
    That’s right, with TD e-series funds there are no “phantom” re-invested distributions. I’ve never seen any ROC distribution either. Dividends are distributed once a year in december, unless you decide to have automatic re-investment of distributions, in which case the Adjusted Cost Base is automatically adjusted by TD waterhouse. In that case, you would see one transaction every year in december with the number of shares bought with the re-invested dividends. Also, every year you receive a T3 report from TD asset management inc. with the breakdown of the income you’ve received from your mutual funds (re-invested or not).

    https://www.tdassetmanagement.com/Fund-Document/pdf/Distributions/TD-Mutual-Funds/2012_TDMF_TDCT_e_ENG.pdf

  23. Jas June 22, 2014 at 4:13 pm #

    @CCP:
    Ok, so ROC distributions isn’t a problem with US-listed ETF in your recommended model portfolios because they never distributed ROC in the past?

    How about “phantom” re-invested distributions (dividend and/or capital gains)? Do we have to keep track of these? Is there a website similar to cdsinnovations.ca but for US-listed ETFs?

    Thanks!

  24. Jas June 22, 2014 at 4:54 pm #

    @CCP:

    According to this article, “phantom” re-invested distributions is only a problem with Canadian ETFs (and Canadian listed ETFs investing in US-listed ETFs).

    It appears that US-listed ETFs do no have re-invested distributions… It would be interesting to know if there a is reason for this difference ? It makes ACB tracking for Canadian ETFs much more complicated….

    “While our neighbours stateside will typically receive actual cash distributions, which they are then liable to pay tax on, in Canada the process is handled a bit differently. Rather than making a payout, ETFs in Canada will usually automatically reinvest the “distributions.” Investors then can increase their adjusted cost base by the amount of that reinvested distribution”

    http://cawidgets.morningstar.ca/ArticleTemplate/ArticleGL.aspx?id=533682

  25. Jas June 22, 2014 at 5:12 pm #

    Many articles have been written lately concerning phantom distributions and ROC distributions affecting the ACB for Canadian ETFs…. this is good because I think many DIY investors in Canada are unaware of this, I agree with the following comment from a globeandmail reader:

    “There is such a wide gap between the perception that ETFs are a simple way to invest, and the reality that confounds the retail investor when, for example, tax time rolls around.”

    http://www.theglobeandmail.com/globe-investor/funds-and-etfs/etfs/how-to-keep-more-of-your-etf-nest-egg/article10207129/#dashboard/follows/

    http://www.theglobeandmail.com/globe-investor/investor-education/haunted-by-phantom-etf-distributions/article18225076/#dashboard/follows/

    http://www.theglobeandmail.com/globe-investor/investor-education/more-fun-with-phantom-distributions/article18409698/#dashboard/follows/

  26. IlyaK June 25, 2014 at 1:13 am #

    @JAS
    Thank you for the explanation. What to do however with the foreign income distributions listed in the annual reports? Is that paid out or a phantom re-investment by the fund?

  27. Jas June 25, 2014 at 7:39 am #

    @IlyaK:
    All distributions (Canadian dividends, foreign income, capital gain distributions) are distributed once a year in december. If you activate the DRIP option, instead of receiving the amount in cash, you will get an automatic transaction to buy new mutual fund shares with the amount received. You will then need to adjust your ACB just like for any transaction when you buy new shares ( if you track it yourself, otherwise TDWaterhouse does a good job of tracking it’s mutual funds ACB). There are no phantom/hiddend re-investment distributions (like for ETFs) with TD e series mutual funds. The re-invested distribution is optional, and is not hidden, it will show up as a new transaction to buy new mutual fund shares.

  28. Jas June 25, 2014 at 7:52 am #

    @IlyaK

    For what it’s worth, I’m considering using a mix of TD e series fund and Horizon’s tax-friendly swap ETFs (HXT/HXS) for my business investment account.

  29. ilyak June 30, 2014 at 12:43 pm #

    @Jas
    Thank you. I have TD eseries in my registered accounts. I understand your approach, but for my goals, I will personally not use TD efunds in my non-registered account as I don’t want to have to pay taxes yearly on distributions before re-investing them (less gets compounded every year) – though of course I am keeping my eye on diversification considering the relatives sizes of my non-registered and registered accounts.

    My next worry is the 15% withholding tax on US dividends inside the HXS account – I’m thinking of simply investing in US-based investments directly in my RRSP account to avoid the withholding.

  30. Canadian Couch Potato June 30, 2014 at 2:51 pm #

    @ilyak: There is no withholding tax on HXS because there are no dividends. However, there is a 0.30% “swap fee” charged on top of the fund’s MER, so the effect is similar (a 15% withholding tax on a 2% yield = 0.30%). The one important difference is that the swap fee is not recoverable on your tax return.

  31. IlyaK July 4, 2014 at 8:53 pm #

    Thank you CCP – great explanation!

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