What are phantom distributions from ETF?

06 January 2023 by BMO Global Asset Management
A child disguised as a ghost that wishes to be scary with his hands

Don’t worry, phantom distributions have nothing to do with Halloween! Each year, Exchange traded fund (ETF) investors can expect to receive tax forms from their respective broker. As an investor, your primary focus should be on the total return of your portfolio and the tax efficiency of your return depending on your type of account, taxable (non-registered) or non-taxable (registered).

Investors who received distributions in a taxable account throughout the calendar year will receive information on the tax treatment of the distributions by the end of February of the following calendar year. In this article, discover how ETF capital gains can affect portfolio tax efficiency.  

What are ETF distributions?

During a year, an ETF may earn dividends, interest income, capital gains or losses from the securities they own. The ETF distributes this income or capital gains to unitholders by way of distributions, which are taxed at the investor’s applicable tax rate when held in a non-registered account. If it were retained by the ETF, it would be taxed at the highest marginal tax rate. 

Most ETF investors may be familiar with distributions that are paid in cash or the unitholder can have them reinvested into additional units using a dividend reinvestment plan (DRIP). There is also a second type of distribution where no cash payment is made, yet there are tax consequences for the ETF unitholder. This type of distribution is commonly referred to as a phantom distribution. 

What are Phantom distributions (or Phantom Capital Gains)?

An ETF may incur capital gains if an underlying security in the ETF’s portfolio is sold for more than its purchase price. An ETF’s capital gains are paid out annually as reinvested distributions. In that case, no cash payment is made. Instead, it is automatically reinvested into the ETF, which results in an adjustment of the unit price, but it doesn’t change the number of units held.

As a result, an investor’s adjusted cost base (ACB), which is the average cost of the purchase of the security, is increased by the amount of the reinvested distribution. The reinvested distribution adds to the investor’s adjusted cost base, resulting in a lower capital gain once the ETF is sold and ensuring double taxation is avoided. 

What happens when ETF distributions are paid in cash?

Investors do not adjust their ACB if there are cash distributions of realized capital gains throughout the year. This adjustment may be handled by the broker or dealer where the ETF was purchased.

On a cash distribution of return of capital (ROC), the ACB is reduced by the amount of ROC, since this is a return of the investor’s money. On a reinvested distribution, the adjusted coast base (ACB) is increased, since the investor is paying tax on the distribution. These two events can result in a net cost adjustment.

Picto inspiration

Did you know? Only 50% of capital gains are subject to tax in Canada and must be included in the investor’s taxable income. This is applicable in taxable non-registered accounts only.

What causes phantom distribution?

Phantom distributions can occur when an ETF has realized capital gains during the year. Some of these gains can be paid in cash or paid out annually as reinvested distributions. An ETF could incur a capital gain if one of the following events occur: 

Corporate Action – When a merger or acquisition occurs on one of the underlying holdings, the ETF may realize a capital gain. 

Portfolio Rebalancing – When this occurs, the ETF will trade the underlying securities, which could result in a capital gain.

How to handle “phantom distributions” from ETFs to avoid double taxation

How do I avoid paying taxes on phantom income?

Whether invested in a passive or active ETF, phantom distributions can occur. The easiest option is for investors to hold ETFs within a tax-sheltered account such as RRSP, RRIF, RDSP, and TFSA, which will not be taxed on distributions and therefore will not receive a T3 tax form. If the ETF is held within a taxable account and has a taxable distribution, the investor can expect to receive a T3 tax form that they will need to include in their tax filings.

How to keep track of distributions?

ETFs generally pay distributions in cash on either a monthly, quarterly, or annual basis. Generally, the greater the income generated in the fund, the higher the distribution frequency. If the ETF has any capital gains, they are typically distributed annually in December and investors receive them as reinvested distributions. 

ETF Providers generally post cash and reinvested distributions to their website under the distribution section and in the prospectus, and all distributions are available through the exchanges. Investors will receive T3s from their respective brokerage firms for taxable accounts, this is the simpler way to track it.

How do I report phantom income?

Your online broker will report everything for you and the respective ETF provider generally posts everything to their website in the distributions and tax section. Log in to your account to consult the documents around March of each year and include them in your tax report.

Like all investments held in a taxable account, ETF investors need to be aware of the potential tax issues that can arise. The use of non-taxable accounts when available should be used to avoid phantom distributions. 

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Key takeaways

  • Phantom distributions are the reinvestment of unpaid capital gains that an ETF may realize if an underlying security in the ETF's portfolio is sold for more than its purchase price. Distributions are paid annually and reinvested in the ETF. They result in an upward adjustment to the unit price but the number of units will remain the same. This reduces the capital gain on the sale of the ETF and avoids double taxation on the capital gain.

  • In Canada, capital gains are taxable up to 50% of their amount and must be included in the investor's taxable income, only for taxable non-registered accounts.

  • To avoid the fiscal implications of phantom distributions, investors can hold ETFs in tax-sheltered registered accounts such as RRSPs, RRIFs, RDSPs and TFSAs, which will not be taxed on distributions. 

Author's biography

Erin Allen has been a part of the BMO ETFs team driving growth since the beginning, joining BMO Global Asset Management in 2010 and working her way through a variety of roles gaining experience in both sales and product development. For the past 5+ years, Ms. Allen has been working closely with capital markets desks, index providers, and portfolio managers to bring new ETFs to market. More recently, she is committed to helping empower investors to feel confident in their investment choices through ETF education. Ms. Allen hosts the weekly ETF Market Insights broadcast, delivering ETF education to DIY investors in a clear and concise manner. She has an honors degree from Laurier University and a CIM designation.

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