Imagine you’re part of a group of 10 friends at a restaurant to celebrate the holidays. Everyone else arrives on time and enjoys cocktails, appetizers and a main course, while you get stuck in traffic and barely make it in time for dessert. At the end of the meal, the server brings 10 separate bills, each for the same amount. “But I only had a slice of pie!” you complain. “Why am I paying for a full meal?”
If you’re an ETF or mutual fund investor who makes a large purchase in December, you may end up feeling the same way. That’s because some funds distribute capital gains at the end of the year, and you’re on the hook for the taxes whether you’ve held the fund for a couple of weeks or the full 12 months. (Note this only applies to non-registered accounts: you don’t need to worry if you’re using only RRSPs and TFSAs.)
Giving them the slip
Let’s back up and review why this happens. Mutual funds and ETFs occasionally sell investments that have increased in value, resulting in capital gains. Over the course of the year, a fund may also do some tax-loss harvesting to realize losses that can offset some or all of those gains. Then, at the end of the year, the fund declares any net capital gains and, if you hold the fund in a taxable account, you’ll receive a T3 slip with this amount indicated in Box 21.
So here’s the issue: funds make a single capital gains distribution in December, regardless of when the gains happened to have been realized. That’s not the case with dividends or interest. If a fund pays a quarterly dividend of $0.25 cents per share and you buy 1,000 shares in December, your T3 slip will only include the $250 you received for the fourth quarter, not the amounts paid in March, June and September. But if the fund realized a large taxable gain any time during the year, your tax slip will include it if you held units of the fund on the date of the distribution. It doesn’t matter whether you were around to benefit: you’re like a restaurant patron who gets handed the same bill as everyone else, even though you missed the drinks, appetizers and main course.
What big gains you have
That’s why it’s not a good idea to make a large purchase of an ETF or mutual fund in a taxable account in December—unless you can be reasonably sure the fund won’t be distributing any gains for the year. The good news is traditional broad-market index funds distribute little or nothing in capital gains, especially if they have been around a while. However, there are exceptions, so always check: fund providers typically send out a press release with an estimate late in the year.
To give you an idea of how large capital gains distributions can occasionally be, consider the estimates recently announced by BlackRock. The iShares US Fundamental Index ETF (CLU) leads the pack with an estimated distribution of $3.47 per share, equal to roughly 10% of the ETF’s current price. The iShares US Dividend Growers (CUD) and iShares U.S. High Dividend Equity (XHD) also estimated distributions of $2.12 and $1 per share, respectively.
The press release from iShares explains these gains are largely the result of stocks being sold after being deleted from the funds’ benchmark index following an increase in price. This highlights a potential problem with alternative indexes that screen for value stocks and dividend growers. If stock enjoys a run-up in price, it may no longer qualify as “cheap,” so it gets assigned less weight in the index, or even gets booted out altogether, resulting in a taxable gain. For all their faults, one of the many benefits of broad-market index funds is they never remove companies for this reason: indeed, they typically have extremely low turnover and many have not distributed gains for many years.
What you need to know
Even if you’re not planning to make new purchases this late in the year, you should still understand the implications of capital gains distributions if you hold ETFs in a taxable account.
First, you should be aware that the term “capital gains distribution” is confusing, because it implies you received a payout of some kind. After all, most distributions consist of dividends, interest or return of capital, all of which are paid in cash. Or, if you have a dividend reinvestment plan (DRIP) in place, you’ll receive new units of the fund. But neither is the case with capital gains distributions: when a fund sells a holding you don’t usually receive any income or new shares. The manager just reinvests the proceeds, which won’t affect the fund’s market price or the number of units you own.
Finally, if your ETF issues a reinvested capital gains distribution, you need adjust the book value of your holding to reflect it. For example, if your ETF has a book value of $25 per share and it distributes a reinvested capital gain of $0.10 per share, you should adjust the book value to $25.10. Otherwise you’ll pay tax on this gain twice: once when it appears on your T-slip and again when you eventually sell the shares. For more information, see our white paper, As Easy As ACB.
Thanks again for another good post. I have a tangential question: I noticed this year that, in the estimates you describe, many ETF providers are reporting that CAD-hedged versions of certain funds seem to be reporting much higher CG distributions than their unhedged equivalents. See some examples below. What’s that about?
BMO MSCI EAFE Index ETF (ZEA) – $0.0619270
BMO MSCI EAFE Hedged to CAD Index ETF (ZDM) – $1.3461700
BMO International Dividend ETF (ZDI) – $0.0000000
BMO International Dividend Hedged to CAD ETF (ZDH) – $1.1512760
I don’t use these myself, but curious.
@Willy: This is a great point: currency hedging can also lead to significant capital gains, because the forward contracts are sold and reset every month. Interestingly, however, the iShares MSCI EAFE Index ETF (CAD-Hedged) should be almost identical to ZDM, yet it distributed no gains for 2016. So the actual execution of the hedging strategy clearly varies from fund to fund, even if the both track the same index.
I like your reminder about reinvested dividends – I have been banging away for years at the brokerage firms that they should include this info with their T3s. They show ROC in box 42 yet completely ignore the more important reinvested dividends – so why is Roc important to the tax department – yet not an increase to ACB – oh yeh – less tax! I actually finally moved my complete portfolio from BMO Investorline to RBC-Direct Investing since they at least record a notational adjustment to book value (done in April of the next year). I know the info is on the ETF issuer sites (ie ishares) yet I find it so strange that the financial community is so backward and slack.
Thanks for another great article Dan. A subscription to Money Sense is on my Christmas wishlist this year!
Most of my stock ETFs (all of which come from your model portfolios – past or present) are in a non-sheltered account. Although I have never sold an ETF, I get a T3 every year, presumably for capital gains distributions. I confess that I am probably not very good at doing my tax returns, but I am always surprised at how much tax I have to pay on such relatively small distributions.
My question is this: is the calculation of my ACB in any way relevant to the taxes I pay annually for capital gains distributions? In other words, is it possible I am paying too much in tax because I haven’t accounted for ACB? Or is ACB only relevant when you sell the ETF?
Thanks again for all of your great posts.
@David: I fully agree that most brokerages don’t do a very good job of ACB tracking, though RBC is one of the better ones. As for dividends, I’m not sure any brokerage makes a distinction between dividends paid in cash and those that are reinvested. Certainly that is not evident on any T-slip, and I don’t think one can blame the brokerages for that. That’s why we recommend avoiding reinvested dividends in taxable accounts, as it can make bookkeeping much more difficult.
@Mike: Unfortunately MoneySense is ceasing publication after its next issue. :(
Regarding your question, your T3s include not only capital gains, but also dividends and interest, so that is probably why the tax bill is higher than you expect. Indeed, capital gains are likely to be the smallest component among these three. The correct calculation of your ACB isn’t really relevant to the amount of annual tax you pay: it will only be an issue when you ultimately sell the shares. If you have not properly accounted for the reinvested gains, you could end up paying the tax twice.
Dan, you agree that brokerages don’t do a good job at ACB tracking. But *they* are the ones that send this information to CRA and this is what CRA will have as reference in the end. In this case what’s the point of me computing the (probably) correct value and giving the CRA a different number than they received from the brokerage? I believe the CRA is going to trust the one received from the brokerage anyway, right?
So, is there a reason *why* capital gains are only distributed at the end of the year? Why not on the same schedule as other distributions?
@Andrei: When it comes to capital gains, remember that a brokerage cannot be ultimately responsible for making the calculations. Consider an investor who has accounts with two different brokerages and holds the same security in both. His ACB on that security will include all of the purchases, sales and adjustments made at both brokerages. But of course, each brokerage cannot know the details of the other. We have also frequently seen book values getting lost or corrupted when securities are transferred from one brokerage to another. That’s why both CRA and the brokerages will always say that the investor is ultimately responsible for calculating ACB and reporting capital gains properly.
@Tyler: The reason is that only net capital gains are taxable, and this can’t be known until the end of the tax year. For example, if the fund realizes a gain of $10,000 in March and then realizes a loss of $10,000 in October, the net gain for the tax year is $0 and there will be no capital gain distribution for the year.
Excellent explanation. I now understand Capital Gains Distribution.
How do I find out when and if there will be CGD in the ETFs I hold? Is it possible to take tax advantage of capital losses on ETFs by purchasing them before the distribution? Assuming one could find out ahead of time of the distribution.
Dan,
I was reading through your comments above and noted that you recommend to not hold DRIP in a taxable account. Correct?
So would it be better/easier to have the dividend paid out in cash and reinvest myself (buying new shares) or doesn’t that make any sense?
Thanks
@Jerome: The ETF providers usually announce the estimated gains in November. Here are the announcements for the big three providers:
Vanguard: http://www.newswire.ca/news-releases/vanguard-announces-estimated-2016-annual-capital-gains-distributions-for-the-vanguard-etfs-602855666.html
iShares: https://www.blackrock.com/ca/individual/en/literature/press-release/pr-2016-11-17-en1.pdf
BMO: https://newsroom.bmo.com/press-releases/bmo-asset-management-inc-announces-estimated-annu-tsx-bmo-201611181077097001
There is no way to profit from this information: ETFs and mutual funds cannot distribute capital losses.
@Koen: Using DRIPs in taxable accounts can complicate recordkeeping. So, yes, I generally recommend taking the distributions in cash and reinvesting them when rebalancing.
https://canadiancouchpotato.com/2013/04/08/why-you-should-avoid-drips-in-taxable-accounts/
Hi, I’m a bit confused regarding the terminology. If I understood correctly, the main topic of the post is Capital Gains Distributions, whereas the press release from iShares linked-to in the post seems to instead show Reinvested Capital Gains Distributions. In my understanding these are not the same thing. The 3,47$ cited for CLU, which is in the press release in question, would thus not actually be a Capital Gains Distribution per se (for which tax would be paid in the year it appears in box 21 of the T3), it would instead be a Reinvested Capital Gains Distribution, which affects the ACB, as stated in the last paragraph of the post, and has nothing to do with box 21 of the T3. Did I get that right? :-) Thank you very much for the ACB white paper and the blog!
@Marc Broule: In the majority of cases, capital gains distributions are reinvested: funds can pay them out in cash, but they rarely do. The point is that even if the gain is reinvested, it still appears on your T-slip and you still need to pay tax on it, although you received no actual income. If it was paid in cash, then you would not have to adjust the book value.
Unfortunately, your T-slip does not specify whether the gain was paid in cash or reinvested. This information should be reported on the ETF provider’s website, but in our experience it’s not always accurate. The only way to be sure is to look it up on the CDS Innovations site, which Justin and I explain in our white paper:
https://canadiancouchpotato.com/2013/04/04/calculating-your-adjusted-cost-base-with-etfs/
While I agree that the taxpayer is ultimately responsible for the ACB – yet brokerages issue the T3s to CRA – and Box 42 is very clear “Amount resulting in costbase adjustment – This amount represents a distribution or return of capital from the trust….” The form used to only say “return on capital” – so I maintain brokerages are delinquent by not providing this info at T3 time. Since the investor gets a T3 for each account, the argument that multiple accounts with the same investment just doesn’t apply.
Furthermore, in discussions with financial planners and tax accountants they all say the same thing – “We just use the T3 info – our clients don’t want to pay extra for us to do the bookkeeping on maintaining an ACB. I thought this extra step was not worth the effort until I realized that in my case it represented a potential of more than $1000 of tax (25% of the reinvested dividends).
For those who maybe following your lead in moving from the UberTuber to a more slim potato, is the flipside of this logic correct? ie: that December is a good time to be selling a large amount of an ETF that will be distributing capital gains in a taxable account (assuming you were planning letting go off the allocation to start with)? If so, when is the “cut-off” date to do this?
@sleepydoc: If you were planning on selling an ETF anyway then doing so before the distribution may be a good idea. As with any distribution, these would be paid to all unitholders of record on a specified date: to avoid them you would need to sell the shares at least three business days before that to allow for settlement. The record date is specified in the press releases about the distributions (linked in a comment above).
Is a capital gains distribution also referred to as a “phantom distribution”?
@skube: Yes, this term is sometimes used because a reinvested distribution often goes unnoticed by the investor.
@Dan: I’m new to a lot of this, so help me if I’m missing something. Above you said you recommend, “avoiding reinvested dividends in taxable accounts, as it can make bookkeeping much more difficult.”
But I read this written by you a few years ago talking about the benefits of certain Horizons funds which reinvest dividends from what I can gather and are beneficial in non-registered accounts:
http://www.moneysense.ca/etfs/tax-efficient-etf/
Am I indeed missing something?
So I’ve realized the Horizons funds function differently than DRIPs, which I’m guessing is critical difference, right? Thanks for you help, Dan.
@A.V.: Yes, sounds like you’ve got it. The Horizons ETFs don’t actually pay dividends, so new new shares are purchased, which means no need to adjust the cost base.
This is what i’m trying to understand. I own XIC, ishares core S&P/TSX capped composite index etf, and I also own ZCN, BMO S&P/TSX capped composite index etf. Now while they both follow the same index, XIC’s 2015 capital gains distribution was 2.35% of NAV, while ZCN’s 2015 capital gains distribution was zero. BlackRock said XIC’s capital gains distribution was primarily due to Catamaran Corp and Tim Hortons being ejected from the index. But ZCN would also have had to sell the same companies. Only thing I can think of to account for the difference in capital gains distributions, is that XIC may have bought these two companies much earlier than ZCN bought them, and thus the larger gains for XIC. Which if that’s the case, it’s like the dirty little rub of mutual funds, more recent purchasers paying taxes on income they’ve never received. Any insight into this. Could there be something else at play here which could account for a 2.35% vs a zero capital gains distribution for two etf’s that follow the same index. Thanks for any comments.
@Kildare: It’s impossible to know exactly what happened here unless the fund providers are willing to share. Your suggestion is probably part of the story: XIC has been around longer and may have had a larger accrued gain on the companies that needed to be sold. Another possibility is that ZCN had some carried-forward capital losses that it was able to use to offset the gains it realized in 2015.
I am 4 years away from planned retirement and was recently counseled to start mitigating risk by allocating more money to fixed income. Bond ETFs were mentioned as a possibility. I understand the notion of risk mitigation at this point in my life.
What I don;t understand is “Why a Bond ETF”? If I am reading things right, Bond ETFs currently have very low returns. Why not simply buy a GIC that protects the principal 100% and also gives me similar return to what the Bond ETFs seem to be paying. Am I missing something?
Thanks!
@Mark: Great questions. This should help you weigh the pros and cons of each:
https://canadiancouchpotato.com/2015/03/27/ask-the-spud-gics-vs-bond-funds/
Hello CCP,
Thanks for putting together this great blog.
My question: from what I understand, you will only need to pay the capital gains distribution if you own the security at the time of distribution – is that true?
For example, let’s say I bought VCN earlier in the year (say, May), but sold it in September, before the capital gains distribution in December. I would not need to pay any capital gains distribution for that security, since I did not own it on the distribution date, correct?
If that is the case, would a “capital gains distribution avoidance” strategy work in which you would sell off your security before the distribution date, and re-purchase it afterwards, or alternatively sell it and purchase a similar security with a lower capital gains distribution (in this example, XIC or ZCN, provided that they have lower distributions)? Of course, for this strategy to be beneficial (assuming that it would work as I’ve described it), your capital gains realized from selling the security has to be less than what you would save from avoiding the capital gains distribution.
Thanks again.
@Jonathan: Yes, you would only be responsible for paying taxes on the distribution if you held the security on the record date. If you do not, then it would not appear on your T-slip.
I would have to work through specific numbers to see whether your strategy might work, but I would guess that in most cases realizing a capital gain in order to avoid a distribution is not likely to be worth it. It might be reasonable if you could harvest a loss and then buy back a similar security that did not have a capital gains distribution.
If you hold an ETF listed on the NYSE inside your RRSP will the capital gains distribution be taxed or will it be tax free just like a regular US dividend?
As for in a TFSA I believe it won’t be tax free as normal US dividends are taxed.
Specific ticker is ARKW just announced capital gains distribution.
@Rory: Since there is no T-slip issued in registered accounts, the distribution will not be taxable in an RRSP or a TFSA. However, if the distribution is paid in cash in the TFSA, it would likely be subject to a 15% withholding tax, just as a regular US dividend would be.
Thanks for the article, makes sense to me.
Is there any way or can you offer tips that will help avoid paying (or lessen paying) taxes on capital gains distribution in a taxable account?
And if this is true
“Now here’s the good news. When you sell your shares in the fund, the tax you will be required to pay at that time will be lower than it otherwise would have been because you have, in essence, prepaid your tax. And if you sell your fund for a loss, you’ll actually get a refund for the tax you already paid.”
1. I’m confused by the following: “… if the fund realized a large taxable gain any time during the year, your tax slip will include it if you held units of the fund on the date of the distribution. It doesn’t matter whether you were around to benefit.” My confusion lies in the fact that it sounds to me that if I bought the ETF in December I would benefit from the reinvested cap gains (proceeds of the sales) because they were distributed/applied in December. I’m not only getting a “bill” but I also received the cap gains/proceeds of the sales. Am I missing something?
2. Another point of confusion – with “cap gains distributions” the investor does not receive cash or new units of the fund. However, “the manager just reinvests the proceeds, which won’t affect the fund’s market price or the number of units you own.” So how is this different from a “reinvested cap gains distribution” where there is a distribution of the reinvested capital gain? It seems there was a reinvestment in both cases. How do those reinvestments differ?
3. Finally, how do capital gains dividends differ from reinvested cap gains? Are cap gains dividends distributed as cash or as new units of the fund? I ask because I have read that cap gains dividends must be tracked for ACB but regular dividends and interest do not (non-DRIP) and I don’t understand why they are treated differently.
Thx
@LP:
1. A capital gains distribution is not paid in cash, and it does not increase the value of the fund. It really is just a tax bill for gains that were already accrued in the fund earlier in the year.
2. “With ‘cap gains distributions’ the investor does not receive cash or new units of the fund.” Most of the time this is true, but it is possible for a capital gain to be distributed to the unitholder in cash. With ETFs, however, most capital gains are reinvested in the fund and the “distribution” is simply a number on your T-slip.
3. You’re correct that dividends and interest don’t require adjustments to a fund’s book value, while capital gains distributions do. This is because you will also need to report a capital gain or loss on your holding when you eventually sell the units. If you do not adjust for the capital gains distribution (which is taxable in the current year even if you don’t sell your units) then you will pay tax twice on the same gain.
At what % threshold does it make sense selling to avoid? Looking at ZDB for example, an estimated 1% isn’t high. That said, the way I see it, would only make sense if in a break-even or a loss situation where tax loss harvesting now comes into the picture. Speaking of ZDB and tax loss harvesting, is there even a reasonable alternative out there for a non-reg account? If not, does it make sense taking the gamble of keeping in cash for 30 days instead (considering superficial loss rule) or just leave invested and pay the 1%?
@Scott: I don’t think there are many situations where it makes sense to sell an ETF to avoid an expected capital gains distribution. We can agree that this is foolish if it would realize a larger capital gain, and as you point out, if there is a loss you would need to wait 30 days to repurchase unless you can switch to an almost identical fund. I suppose it could make sense if the expected capital gain was large (say, 3% or more) and your holding was in a significant loss position, and you could easily switch to a good alternative. But this seems like a rare convergence. It’s certainly not the case with ZDB this year.