Q. I have never seen an article written on the problem of phantom dividends from

exchange traded funds (ETFs) in Canada. I have run into this problem and stopped investing in ETFs as a result. It is causing tax issues for me and I don’t like the non-transparency of these shares and dividends, which makes the dividends harder to keep track of. I’m also receiving

Old Age Security (OAS) and wasn’t sure what effect, if any, it was having on the OAS clawback. Was this the right thing to do?

—Jim FP Answers: By phantom dividends, I believe you are referring to phantom distributions, Jim. Phantom distributions occur when a managed product, such as an exchange traded fund (ETF) or mutual fund sells one of its underlying securities for more than its purchase price. Essentially, it is when a fund you own has a capital gain on an investment it owns.

The proceeds of that sale are reinvested in the fund, and no cash payment is made in most cases. As a result of this reinvestment, your adjusted cost base (ACB) would increase due to the reinvestment of the capital gain proceeds.

Phantom distributions can also happen because of corporate actions such as mergers and acquisitions that may result in the amalgamation or delisting of securities that result in capital gains. Although the investment returns are surely welcome, there will be taxable income that results from these capital gains distributions if these securities are held in taxable investment accounts.

In Canada, the taxation of ETFs and mutual funds should result in similar after-tax returns as if the securities they hold were owned individually. For example, if a Canadian bank ETF has an effective yield of four per cent, and investors hold the same proportion of the bank stocks underlying the ETF, they should also have a comparable yield with the same tax payable. The fund may sell a stock it owns and generate a taxable capital gain for the investor if it is held in a taxable account and this unexpected aspect of an ETF or mutual fund can surprise an investor. The taxable income is not exactly phantom income though because it is an actual capital gain the investor would have had if they owned and sold the same stock themselves.

Most ETFs are designed to distribute income back to the unitholders in cash or as reinvested units. Common sources of income from ETFs are interest from bonds or dividends from stocks. This income may also be reinvested within the fund, but again, it is income nonetheless, despite investors not receiving it in their hands.

For broad-based market ETFs, it’s unlikely that you will have a huge amount of capital gains from year to year. There are rarely large capital gains from year to year, but rather, rebalancing that triggers modest gains. On the other hand, if you purchase a factor-based ETF that employs active strategies these may result in more trading in the fund and higher capital gains from year to year. I recommend reviewing the trading exchange ratio (TER) or turnover rate of funds that you are purchasing in a taxable account, as this may be indicative of what you can expect.

Mutual funds, active and passive, will have similar attributes to ETFs, with more sporadic capital gains typically associated with active funds compared with passive funds. In situations like these I would always evaluate the materiality of the issue versus the alternative. For example, are you content with your portfolio’s risk/return profile, and is there a suitable alternative to avoid the phantom income?

You could consider corporate class ETFs and mutual funds if you are worried about annual tax considerations, Jim. The trade-off is that fees tend to be higher than for other investments.

Corporate class funds use a structure that pools all investor income and expenses for a number of different funds to write off the highest rate income generated by the funds in the corporate class structure. For many funds the goal is to write off as much interest and foreign income that is available to offset first, as they are taxed at higher rates. Instead, they aim to distribute taxable capital gains and eligible dividends, which have preferred tax treatment.

Corporate class funds commonly offer a return of capital series that pays a fixed percentage back to the investor on a regular basis. Usually, the payment percentage would exceed the typical yield of that portfolio, so the difference is made up of a tax-free return of capital. The downside of the return of capital is that it will increase your long-term tax liability by reducing your cost base based on the returned amount of capital. Then, you can have your cake and eat it too, with cash in hand and a lower tax bill.

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The alternative is to hold a portfolio of individual stocks in your taxable account. That way you would have control of the timing of the sale of any securities to manage your capital gains and losses more precisely than when holding a fund so that you can better manage the effect on your OAS recovery tax, Jim.

Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.