
Tax & Estate planning Tax savvy: Navigating 2024 filing changes
Learn what you need to know about 2024 tax filing and what’s coming in 2025.
Normally, an exchange-traded fund (ETF) will pay most of its income distributions in cash. In some instances, the ETF will choose to reinvest all or a component of its distributions within the ETF. These reinvested distributions are commonly referred to as “phantom distributions” because the investor doesn’t actually receive the cash, nor do they see a change in the number of units invested or a change in the Net Asset Value (NAV).
Whether distributions are paid in cash or automatically reinvested, they are taxable in the year they are received if the ETF units are held within a non-registered account.
All distributions received are reported on the annual tax slip for the year. For units of an ETF that are legally structured as mutual fund trusts, distributions are reported on the T3 tax slip. However, it is important to note that there is no distinction between cash distributions and reinvested distributions from an ETF reported on the T3.
The phantom distribution is reported on the tax slip, ensuring proper reporting of that income for tax purposes. However, the investor does not receive a tangible cash payment or see an increase in number of units held inside their investment account. As phantom distributions are automatically reinvested in the fund as opposed to being paid out in cash, the NAV of the ETF units does not drop by the amount of phantom distributions as it does after cash distributions. If the investor does not account for these reinvested distributions (that they already paid tax on) properly by adjusting their adjusted cost base (ACB) upwards, they will realize a greater capital gain or a lesser capital loss (by the amount of reinvested distributions) when they subsequently dispose of their ETF units. Here lies the double tax issue related to phantom distributions. Read on to understand how to avoid double taxation.
Generally, a reinvested distribution occurs because ETFs do not keep excess cash on hand to pay distributions. Since the cash isn’t readily available, many ETFs reinvest that income back into the fund and this could happen throughout the year. If these distributions were not reinvested in the ETF, it could cause a tracking error if the ETF follows an index.
Initially, the investor receives a notional distribution of more units of the ETF. The outstanding units are then immediately consolidated so the net asset value per unit and number of units held by the investor are the same as they were before the reinvested distribution.
As with a reinvestment of distribution proceeds (i.e., cash) in any security, the allocation and automatic reinvestment of a phantom distribution has the effect of increasing the investor’s ACB. For distributions that have been automatically reinvested on the investor’s behalf, it is the investor’s responsibility to understand what part of the total distribution has been received and reinvested to be in a position to adjust their ACB accordingly.
A proper adjustment of the ACB ensures that a future disposition of the ETF units accounts for distributions for which tax was already paid (for both distributions of cash and reinvested units). It will ensure the investor’s ACB reflects amounts that have already been subject to tax and avoids the double tax issue.
Importantly, phantom distributions most frequently consist of capital gains and return of capital (ROC) but can consist of any form of investment income (e.g., Canadian eligible dividends, interest income, foreign non-business income). The ACB should be adjusted upward to account for the component of the phantom distributions that reflects the reinvestment of that income.
Investors should check the website of the ETF provider for information about distributions of reinvested units (“phantom distributions”) and adjust their ACB accordingly.
As an example, here is historical information on some distributions for Invesco S&P International Developed ESG Index ETF - CAD (IICE) for the 2024 tax year.
Ex-date | Record date | Pay date | Cash | Reinvestment NAV | Total distributions |
---|---|---|---|---|---|
Dec. 30, 2024 | Dec. 30, 2024 | Jan. 8, 2025 | $0.13591 | $1.68564 | $1.82155 |
Sep. 27, 2024 | Sep. 27, 2024 | Oct. 7, 2024 | $0.12995 | $0.00000 | $0.12995 |
Jun. 27, 2024 | Jun. 27, 2024 | Jul. 8, 2024 | $0.12483 | $0.00000 | $0.12483 |
Mar. 26, 2024 | Mar. 27, 2024 | Apr. 5, 2024 | $0.12550 | $0.00000 | $0.12550 |
Annual summary | 2024 |
---|---|
Eligible dividends | $0.00000 |
Non-eligible dividends | $0.00000 |
Other income | $0.00000 |
Capital gain | $6.29717 |
Return of capital | $0.50877 |
Foreign income | $3.01535 |
Foreign tax paid | -$0.44562 |
Total | $9.37567 |
For the distribution declared in December 2024 and paid on January 8, 2025, a unit factor of $1.68564 was automatically reinvested in additional units of the ETF on behalf of investors. The investor will need to ensure they first reduce their fund’s ACB by the total amount of the ROC received and then increase the fund’s ACB by the total phantom distribution.
Example
Let’s assume an investor originally purchases 1,000 units of IICE at $30/unit. The investor has a total ACB of $30,000 on 1,000 units, which equates to an average cost per unit (ACB/unit) of $30. An investor can check our website to confirm the fund’s income distribution factors for the calendar year. For instance, based on the website distribution factors for fund IICE, our hypothetical investor would have had the following taxable income amounts reported on their T3 Trust income tax slip for 2024.
Fund |
Ticker |
Capital gains (T3 Box 21) |
Return of capital (T3 Box 42) |
Eligible Canadian dividends (T3 Box 49) |
Net foreign non-business income (T3 Box 25 – Box 34) |
Other income (T3 Box 26) |
Total distribution |
---|---|---|---|---|---|---|---|
Invesco S&P International Developed ESG Index ETF - CAD |
IICE |
$6,297.17 |
$508.77 |
$0 |
$2,569.73 |
$0 |
$9,375.67 |
First, the investor will need to check their account statements to ensure their ACB was reduced by the total amount of ROC that was issued throughout the year. Since the total ROC component was equal to $508.77, the client’s ACB should have been reduced to $29,491.23.
Second, per the information found on our website, the phantom distribution (“Reinvestment”) of $1.68564/unit requires the investor to ensure that the total ACB has increased by $1,685.64. The ACB then increases to $31,176.871.
Assuming the investor later sells all the units at $40/unit, the proceeds from the sale would be $40,000. The total ACB on the ETF would be $31,176.87. This creates a capital gain of $8,823.13, of which 50% is a taxable capital gain.
If the investor did not account for the phantom distribution of $1,685.64, the capital gain would instead be $10,508.77. At a 50% marginal tax rate (MTR), this could cause him or her to pay $421.41 more in taxes than is actually required. This results in double taxation because the phantom capital gain distribution already appears on the annual T3 tax slip for which taxes will be payable on that amount.
The following chart demonstrates the double tax phenomenon when an investor does not sufficiently adjust their ACB after a reinvested distribution.
Transactions |
Tax implications with adjustment for reinvested distribution |
Tax implications without adjustment for reinvested distribution |
---|---|---|
Purchase 1,000 IICE units @ $30/unit |
Total ACB of $30,000 or $30/unit |
Total ACB of $30,000 or $30/unit |
Reduction in ACB due to ROC distribution ($508.77) |
Total ACB reduced to $29,491.23 $29.49/unit |
Total ACB reduced to $29,491.23 $29.49/unit |
Reinvested phantom distribution of $1.68564/unit($1,685.64) | Total ACB of $31,176.87 or $31.18/unit |
Total ACB of $29,491.23 or $29.49/unit |
Proceeds from sale of 1,000 Units @ $40/unit |
$40,000 |
$40,000 |
ACB of 1,000 units sold |
$31,176.87 |
$29,491.23 |
Realized capital gain |
$8,823.13 |
$10,508.77 |
Taxable capital gain (50% inclusion rate) |
$4,411.57 |
$5,254.39 |
Marginal tax rate |
50% |
50% |
Taxes payable |
$2,205.78 |
$2,627.19 |
Double tax paid |
$0 |
$421.41 |
The bottom line is that investors should be cognizant of phantom distributions from ETF investments and make the necessary adjustments to their ACB to avoid double taxation.
We have assumed that all other cash distributions (i.e., non-phantom distributions) were paid to the investor and not reinvested into additional units of the fund.
Learn what you need to know about 2024 tax filing and what’s coming in 2025.
The Tax and Estate team discusses the PFIC rules as they apply to U.S. residents holding foreign securities, including Canadian-domiciled mutual funds and exchange-traded funds.
The uncertain destiny of capital gains tax
Get the latest information and insights from our market strategists, investment experts, and tax and estate specialists.
You may unsubscribe from these communications at any time by emailing us at inquiriescanada@invesco.com or by calling us at 1.800.874.6275
NA4443562
Important information
Header image: FreshSplash / Getty
For more information about this topic, call us at 1.800.874.6275.
Commissions, management fees and expenses may all be associated with investments in mutual funds and exchange-traded funds (ETFs). Trailing commissions may be associated with investments in mutual funds. Mutual funds and ETFs are not guaranteed, their values change frequently and past performance may not be repeated. There are risks involved with investing in ETFs and mutual funds. Please read the prospectus before investing. Copies are available from Invesco Canada Ltd. At www.invesco.com/ca
Ordinary brokerage commissions apply to purchases and sales of ETF units.
The information provided is general in nature and may not be relied upon nor considered to be the rendering of tax, legal, accounting or professional advice. Readers should consult with their own accountants, lawyers and/or other professionals for advice on their specific circumstances before taking any action. The information contained herein is from sources believed to be reliable, but accuracy cannot be guaranteed.
This link takes you to a site not affiliated with Invesco. The site is for informational purposes only. Invesco does not guarantee nor take any responsibility for any of the content.