Understanding how your investments are taxed is an important part of developing an effective investment plan.
Generally, tax considerations related to your ETF investments can be grouped into two categories:
- Taxes associated with selling your ETF; and
- Taxes related to the distributions received from an ETF, including withholding tax.
ETFs may earn dividends and interest income from the securities they own, and they may realize capital gains or losses when investments are sold. This income may be reduced by the ETF’s expenses. The ETF distributes any remaining income or capital gains to unitholders by way of distributions, which are taxed at the investor’s applicable tax rate. This is preferable to having the income retained by the ETF, where it would be taxed at the highest marginal tax rate. Income is distributed in the same form as it is earned by the ETF: as interest income, Canadian dividends, foreign income or net capital gains – or a combination of the four.
|Type of ETF distribution||Description||Tax treatment|
|Interest income||Earned on Treasury bills, commercial paper, bonds, debentures and mortgages||Fully taxable at the same marginal tax rate as employment income|
|Eligible Canadian dividends||Occurs when ETFs invest in shares of Canadian publicly traded companies that pay dividends||Preferential tax treatment for individuals through the dividend tax credit|
|Foreign income||Earned when the ETF receives dividends from, or interest on, non-Canadian investments||Fully taxable at the same marginal tax rate as employment income|
|Capital gains||Realized when an investment within the ETF is sold for more than the adjusted cost base||Preferential tax treatment, as only 50% of a capital gain is taxable|
|Return of capital (ROC)||ROC describes distributions in excess of an ETF’s earnings (income, dividends and capital gains). For tax purposes, ROC represents a return of an investor’s own invested capital||Not generally taxable in the year received, but reduces the adjusted cost base in the same amount as the corresponding cash distribution, which generally has the effect of deferring the existing unrealized capital gain or loss until the investment is sold.|
|Selling units||If an ETF experiences strong price appreciation, unitholders could realize a capital gain for the current tax year if they sell units held in a non-registered account.|
|Portfolio changes||Portfolio changes are made from time to time (for example, due to periodic rebalancing). Portfolio changes may result in capital gains that are taxable to investors, even if they do not sell their ETF units.|
|Corporate actions||Corporate actions, such as mergers and acquisitions, can often result in capital gains. Such gains are normally realized by the ETF on the date of the transaction, and they are taxable to unitholders even if no ETF units are sold.|
No. While monthly and quarterly distributions are paid in cash to the unitholder, capital gains distributed annually in December are paid as a reinvested distribution (no cash is distributed to the unitholder).
These capital gain distributions are reinvested in additional units of the ETF, and units are immediately consolidated such that the ETF’s total units outstanding does not change. The capital gain distribution will be immediately taxable and will appear on your T3 tax slip. Your adjusted cost base (ACB) is increased by the amount of the reinvested distribution, which will lower any realized capital gain or increase any realized capital loss when you eventually sell your ETF units.
For investments in a non-registered account, annual taxes apply to capital gain distributions, whether they are paid in cash or as reinvested distributions.
To explain, let’s consider an investor, who invests in 10 units of an ETF for $100. Over a given period, the unit price grows to $12, based on $1.60 of dividends and $0.40 in price appreciation.
So, their total investment value grows to $120.
The ETF distributes the $1.60 of dividends per unit to the investor , so they receive $16 in cash. After the distribution, the unit price falls to $10.40 and their investment value falls to $104 ($10.40 x 10 shares).
However, because the investor also received $16 in cash, their total wealth is unchanged at $120 ($104 + $16).
ROC is a tax term used to describe distributions in excess of an ETF's earnings (income, dividends and capital gains). For tax purposes, ROC represents a return to investors of a portion of their own invested capital.
However, the inclusion of ROC in a distribution does not indicate whether an ETF has gained or lost value, since it may have unrealized capital gains that have not yet been paid out.
ROC distributions typically occur when an ETF declares a regular monthly distribution. If interest, dividends and realized capital gains earned by the ETF are less than declared distributions, an ROC distribution is added to make up the remainder. ROC distributions help stabilize the amount of cash flow you receive on a regular basis from a particular investment.
Annual tax information is submitted to the Canadian Depository for Securities (CDS) by investment firms in February; each investment firm uses this information to prepare and mail tax forms to ETF unitholders towards the end of March.
The answer depends on whether or not your ETFs are held in a registered or a non-registered plan. Income earned on investments held in a registered plan is not immediately taxable and a T3 tax slip is not issued. However, a T3 tax slip will be issued if ETFs are held in a non-registered plan and there’s a taxable distribution. Annual tax applies to any distributions received other than return of capital.
Many countries impose a tax on income paid to foreign investors – whether it’s dividend or interest income. While the tax rate can vary from country to country, Canadian investors are generally subject to a 15% withholding tax for dividend payments from U.S. companies.
The way in which an ETF obtains its exposure to foreign equities affects withholding tax. In addition, the type of account in which an ETF is held is the second important factor in determining the amount of withholding tax a Canadian investor will pay. Different account types are subject to withholding tax in different ways.
Non-registered accountGenerally, an investor can recover foreign withholding tax paid directly via the “Foreign Tax Paid” box on their T3 or T5 slip. Withholding tax paid indirectly is generally not recoverable.
RRSP/RRIFThese accounts are not subject to U.S. withholding tax due to the Canada-U.S. Tax Treaty, but are generally subject to withholding tax collected by other countries that is not recoverable.
TFSA/RESPThese accounts are generally subject to withholding tax, regardless of where it is collected. No U.S. withholding tax exemption exists for these accounts.
Understanding the ETF structure and account type in which the ETF is held are key ingredients that can help an investor minimize withholding tax.
The chart below summarizes the interaction between the two.
ETF structure and account type matter
|Account Type||ETF Structure|
|U.S.-listed ETF holding foreign stocks directly||Canadian-listed ETF holding foreign stocks indirectly via a U.S. ETF||Canadian-listed ETF holding foreign stocks directly|
|Non-registered||U.S. WHT recoverable; foreign WHT not recoverable||U.S. WHT recoverable; foreign WHT not recoverable||Foreign WHT recoverable|
|RSP/RIF*||U.S. WHT recoverable; foreign WHT not recoverable||U.S. and foreign WHT not recoverable||Foreign WHT not recoverable|
|TFSA/RESP||U.S. and foreign WHT not recoverable||U.S. and foreign WHT not recoverable||Foreign WHT not recoverable|
WHT = withholding tax. *U.S. withholding tax does not apply on U.S. dividends earned in an RRSP/RRIF.