[BELL RINGING]
TREVOR: Tax loss selling or tax loss harvesting is the process by which investors sell an investment that they still like. They leave it for a 30-day period, so that that loss is crystallized, and then they repurchase it in the exact same account.
CHIARA: Hello, and welcome back to the ETF Experience podcast, powered by TDAM Talks. I want to start the show off with a joke about taxes. What do you get when you cross a tax accountant with an airplane? A boring 747.
[Laughter]
CHIARA: No offense to any tax accountants out there, but taxes can be an interesting topic. I have some tips as we wind up 2024.
Today I'm joined by Trevor Cummings, our ETF Specialist here at TD Asset Management. Trevor, I'm so excited to have you on, because if there's one person that can make taxes sound interesting and fun, it's you. So no pressure.
TREVOR: Yeah, thanks, I guess. Happy to be back.
CHIARA: ETF taxation is a topic, although less discussed, I think it's extremely important when considering one's investment plan, especially looking at after-tax returns. So Trevor, let's get the lowdown on ETF taxes. Let's start from the ground up. What triggers an ETF taxation?
TREVOR: Well, there's kind of two levels of tax, if you think about it. There's what the investor does. So if the investor were to buy low and sell high, then there's a gain on that investment, and as a consequence, the investor is going to have to pay some taxes on that gain, presumably if it's in a taxable account.
There's also the layer of the internal workings of the ETF. So if there's turnover within the portfolio or if the investments themselves spin off interest on bonds or dividends, on Canadian stocks, for example, then that gets funneled through to the investor's portfolio and they'll have to pay taxes on that as well-- income that is earned.
Every now and then there is another kind of tax, and that's income that isn't earned. So you might have to pay taxes sometimes on money you don't actually see or receive, but we'll get into that.
CHIARA: Yeah. And I do want to touch upon ACBs. That's often discussed when we're talking about capital gains and capital losses. So what is that?
TREVOR: Yeah. So the adjusted cost base, or the ACB, that's a number that keeps track of the original price you've paid for the investment, plus any capital gains distributions, minus any return of capital that you've received.
CHIARA: So now, let's move on to the top five tax considerations when investing in ETFs. And obviously, we're going to touch upon distribution. So before we get into it, I just want to confirm, these distributions and tax treatments occur when it is in a non-reg account, correct?
TREVOR: That's right. If you have your ETF investments in a TFSA or an RSP, for example, then a lot of these won't apply. It's just, sort of, you're looking at the overall return of the investment and you won't have to worry about taxes until you take out of an RSP or deregister from a RRIF, for instance.
CHIARA: So first tax tip, don't take yield at face value. Talk to us about that.
TREVOR: There's a strong appetite, I think, on the part of the average Canadian investor for yield. We like our dividends. We like interest. With all that's happened over the last few years, you can get a reasonable rate of interest on cash and GICs and fixed income and things like that these days. We love our yield.
I think the market has sort of caught ahold of that and started to manufacture products with extremely high yields-- 10%, 12%, 15% yields. And I would caution investors that oftentimes what that kind of yield comes with is a negative price return.
So I think, as investors, we kind of have to ask ourselves, is it good to have a 15% yield with a minus 10% price return, so that overall I'm up 5%? Or is it better to have an investment with a zero yield and a 5% price return? It's the same overall return. Or maybe it's a 5% dividend yield and a 0% price return. Maybe it's 3% and 2%. It doesn't really matter. But I think ultimately, some blend of gain and income or price return and yield is probably the way to go.
CHIARA: So there's two things-- I want to dive a little deeper. The first one is, you talked about Canadians being yield hungry. So this is often your covered call ETFs. And the second thing, a big distribution that we see in this area is Canadian dividends. Right? So maybe talk to us a little bit about that.
TREVOR: Yeah. So if you're investing in companies that pay dividends-- so let's say I'm buying a Canadian dividend ETF, most often the income that's actually paid and deposited to your investment account would be categorized as eligible dividends. So there's a tax credit for that. If you're buying a global dividend or a US dividend strategy, the dividends that are paid by those foreign companies are not eligible for that tax credit, and they're actually classified as foreign income. So they'd be fully taxed, the same as if you were investing in a GIC or a bond here in Canada.
CHIARA: OK. Let's move on to number two – structure matters.
TREVOR: So I think one of the beauties of exchange traded funds is that a lot of them have very low turnover. So off the top I talked about those two layers. What I do as the investor, I buy and I sell and there could be some capital gains or some tax distributions to worry about. There's also what happens inside of the product. And with a lot of ETFs, they're passive or they're very, very low turn. They're not trading the underlying portfolio that often.
So one of the beauties of ETFs as a structure is that your capital gains distributions are often very, very low. And I just want to be clear here. If I buy something at $10 and I sell it at $18, I have an $8 return that I need to pay taxes on, I need to address with the Canada Revenue Agency and so on.
But, at the same time, what I want to do as an investor is I want to defer all of that $8 to when I choose to sell. I don't want to pay that taxes while I'm invested, because that's a drag on my overall returns. I want to push that out to the end. Because in the end, I might be at a lower tax bracket if I'm retired. In the end, that's inflation adjusted dollars and so on and so forth. There's a bunch of reasons why I'd rather pay later versus pay now, and ETFs are-- generally speaking, they're very good at that.
CHIARA: Canadian versus US ETFs-- I personally know I hold tons of US listed ETFs. So what are some considerations I should be thinking about?
TREVOR: Yeah. I mean, I think what I would say is that the US ETF market is gigantic. It's about 20 times the size of the Canadian ETF market. Let's call it $10 trillion. Any idea you can come up with, you can probably find in an ETF in the United States. And many times there will be a higher asset level in that ETF. Some of the time the management expense ratio, the MER, might actually be lower. And so it's this really interesting notion that a lot of Canadians look south to the ETF market in the United States for exposures.
I want to mention, maybe, a couple of things. One is, you have to think about US estate taxes if you're buying US property. And that's true of US real estate. That's true of US individual stocks and bonds. That's true of US ETFs. So that's something that won't affect every Canadian investor, but it's something to think about.
The big one, though, is every time a dividend crosses a border, generally speaking, there's a tax. So if I'm looking at, say, an international-- let's say I'm looking at a European ETF in particular. When those European companies pay their dividends into that American ETF, there's a tax. That American ETF will not receive the entirety of that European dividend.
And then, as a Canadian, if that American ETF pays a dividend or a distribution itself as it crosses the border into Canada, there's another tax. So it would be better if I as a Canadian investor, looking to maximize my dividend yield, it would be better if I bought the European ETF in Canada, because then that way there's still a tax as that dividend goes from Europe to Canada, but there's only one layer of taxation.
So remember that sort of phrase-- every time a dividend crosses a border, there is a tax. So if you can minimize the number of hops, skips, and jumps that a dividend's taking to ultimately get into your account, generally the less tax you're going to have to pay along the way.
CHIARA: Yeah. So you're essentially saying, if you're looking to gain exposure to foreign markets, look at a Canadian listed focused ETF versus buying a US listed or another ETF on another stock exchange.
TREVOR: Yeah. It might make sense. I mean, there's exceptions to every rule, right, and every investor's needs and desires and objectives are different. But there is a couple of reasons why investors might prefer a Canadian listed ETF over a US listed one, for sure.
CHIARA: OK. Moving on to the next one.
CHIARA: Just a little bit about tax loss selling. That's our number four tip.
TREVOR: Yeah. Tax loss selling or tax loss harvesting is the process by which investors sell an investment that they still like. They leave it for a 30-day period, so that that loss is crystallized, and then they repurchase it in the exact same account. And the reason investors might do something like this is so that they can use that loss to counteract or to net out any capital gains that they've generated in other areas of their portfolio.
So it's not something you can only do at the end of the year, but generally there's an interesting seasonality. People only generally think of it in November and December. And so, 'tis the season for that, I guess you could say. I would say in the context of this year, 2024, there are not a lot of candidates to tax loss harvesting.
But I will say a couple of things. Number one, it sometimes distorts the markets. So if something is down on the year, it may even accelerate that downtrend in November, December, as other investors might be tax loss harvesting. That's good for me. If I'm in cash looking to invest in that product, that might be a really opportune moment for me to invest in that category of that asset class via an exchange traded fund.
I think another thing about it is, you have to sort of pick your spots. So it's not always the case that you can do it every single year. And it's labor intensive as well, right. So you have to decide if the benefit is worth it or not.
Where I think ETFs see a lot of use around this kind of idea is if I'm an investor in a bank stock, for example, or a pipeline stock or an energy stock or an insurance company or something, it doesn't really matter what, one of the things I can think about doing as an investor is I can sell that bank stock, for example.
I can buy a bank ETF for those 30 days while I'm waiting for that tax loss to become official. This way the asset allocation of my portfolio's preserved. I'm still invested in the category of the asset class I'm looking for. And then when the 30 days are up, maybe I sell that ETF and I go back to that bank stock. Maybe I keep the ETF, right. There's some flexibility there. But that's where ETFs get used a lot around tax loss selling and tax laws harvesting.
CHIARA: So, again, this is a great tip or trick to help reduce one's tax bill if there are any capital losses that you can realize in your portfolio, and I believe you can carry it forward indefinitely. Correct?
TREVOR: Yeah. Yeah. I mean, we're in the weeds a bit, but you can take tax losses back three years and you can take them forward indefinitely. Sure.
CHIARA: Last and final one-- this is my favorite one, not only because it has a funny name to it, but it's one that I get the most questions from advisors or family and friends. So talk to us about phantom distributions.
TREVOR: Yeah. Phantom distributions are, again, that second kind of turnover. I might not do anything on my portfolio. I might buy an ETF at the beginning of the year. I might do nothing. I still have it in my account at the end of the year. And yet come Jan, Feb, March, I get a tax slip in the mail, right. And this is due to the-- not me. Obviously, I didn't do anything. It's due to the underlying portfolio turnover.
So you'd see this with active ETFs, for example, right, where the portfolio managers might be writing calls and puts, or they might be turning over their portfolio, harvesting gains and buying new investments elsewhere and being opportunistic in terms of trying to find really interesting investments in the marketplace.
When there's turnover resulting in capital gains generated by the portfolio manager, those have to be distributed to investors. So I'll go back to my example of a hypothetical $10 ETF investment that I'm going to sell a few years from now at $18. Somehow I have a crystal ball. I know it's going to hit $18 in a couple of years.
Well, if there's a phantom distribution of a dollar, for example, because the portfolio manager inside of the ETF has been making transactions, what I'm going to do is I'm going to get a tax slip. I'm going to have to pay taxes on that dollar worth of capital gains. But I'm then going to add that dollar to my ACB, to my adjusted cost base. And so really, the best way to think of a phantom distribution, or capital gains that you don't actually receive in your portfolio, is that you are, in effect, prepaying some of your tax liability.
Down the road, when I sell that ETF at $18, because somehow I knew that it was going to $18, I only have a $7 gain on the investment, because I've already paid the dollar via the tax slip. So I don't pay the dollar and then I pay taxes on the $8 profit. I'm prepaying some of that $8 profit.
If the capital gains distribution was $2, I don't like it. I don't want to have to pay taxes when I get that tax slip. I want to wait till the end when I choose to sell it. So ETF manufacturers are still going to try to minimize these phantom distributions, these capital gains distributions. But I would add that $2 to my cost. So now my cost is $12. If I sell early at $15, I have a $3 gain when I dispose of that ETF, when I sell that ETF, because I've already paid taxes on the $2 via my tax slip.
So it's a little complicated. But hopefully, think of it as prepaying some of your tax liability. We all want to push that tax out as far as we can to the future, but sometimes you will get some capital gains distributions in the meantime. And the good news, if any, is that you add that to your cost base. So you'll have less of a capital gain down the road.
CHIARA: And, like you mentioned, this last type of tip or distribution to look out for is a little bit confusing. So how do investors know when a phantom distribution has occurred? Like, where did they see it? Is it on a tax slip?
TREVOR: Yeah. So you will see capital gains distributions on your T3 that's issued by your brokerage. So it's your brokerage that will issue your tax slips on exchange traded funds. And if you see that capital gains distribution, it's most likely what it is that's going to happen to your portfolio.
Now I would say that 10 or 15 years ago, investors were kind of in the dark and on their own, cold and shuddering and responsible for keeping track of their own ACBs, their adjusted cost bases. Now most all brokerages will take that information and adjust the ACBs for an investor inside of her account or his account.
And so ultimately, it's a little bit easier than it used to be. But it's probably a wise idea to double-check that the capital gains that's on your slip has been reflected in a higher cost base, or a higher book value in your account once the dust settles, perhaps the summer later once there's been some time to make that adjustment.
CHIARA: Well, I've learned a ton. That's a wrap, everyone. Thank you for sharing your expertise with us, Trevor. I know I really enjoyed this conversation.
For more information on this topic, please visit our website, where we have several publications on tax considerations. The first one is, how ETFs are taxed, and a blog post titled "Top Five Tax Considerations."
As a disclaimer, we are not tax advisors, nor are we providing tax advice. We are simply providing a summary of taxation information for Canadian ETF investors. Thank you so much.
TREVOR: Thanks, Chiara.
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