Top 5 Tax Considerations When Investing in ETFs
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Exchange-Traded Funds (ETFs) continue to gain in popularity for a variety of reasons which can include their low cost and convenience. The way in which they are taxed is also an important consideration for investors. While investors shouldn't prioritize tax efficiency when investing in ETFs, taxes can have a profound effect on overall return.
With this in mind, we decided to dedicate a blog to outline what we feel are the top 5 tax considerations investors should consider when investing in ETFs.
- 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.
- Structure matters - Generally speaking, ETFs are usually more tax efficient than actively managed mutual funds, largely because there is less turnover within the portfolio since units are bought and sold on the exchange which may not impact the cash flows in the ETF portfolio. This lower turnover can help minimize capital gains distributions resulting in improved long-term after-tax efficiency and performance. Moreover, there is typically a reduced potential for tax distributions to investors because the selling activity by investors on the exchange doesn’t always result in fund redemptions like with mutual funds.
- Canadian vs U.S. ETFs – When it comes to Canadian's investing in either Canadian or U.S. listed ETFs there are two key words investors need to consider – 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. And that’s not all. There are often times multiple levels of withholding taxes charged, depending on the assets held in the ETFs. A first 15% withholding tax may first be applied by the countries where the stocks in the portfolios are listed, and then depending on where the ETF is actually listed, there could be an additional 15% withholding tax. 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.
- Tax loss selling – Tax-loss selling is the act of selling a security at a loss (capital loss) and using the loss to help offset realized gains (capital gains) incurred from selling other securities in a non-registered account. The losses can be used to help offset capital gains realized elsewhere in a portfolio. There’s a challenge with this strategy, however, since-realizing a capital loss could mean selling a security that plays an important role in your portfolio. ETFs can be used to maintain exposure to a particular asset class while allowing for claimable capital losses.
- Phantom distributions - ETF distributions are often paid in cash but may also be reinvested within the fund. Reinvested distributions are provided to ETF investors in the form of additional units of the fund, however, the investor will still be taxed, and an adjustment will be made to the adjusted cost base (ACB). Investors would receive a T3 or T5 tax slip which would include phantom distributions but there are various nuances from a reporting standpoint (beyond the scope of this blog) which can impact taxes upon the sale of the investment. This is why investors should be diligent in tracking ACB values when their ETF distributions are reinvested.
Where can information about tax considerations for a specific ETF be found?
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 and download our TD ETF Product Guide.
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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