How ETFs Are Taxed in Canada: Distributions, Return of Capital and Your ACB

For tax purposes, an ETF is treated the same way as a conventional mutual fund. Held in an RRSP, RRIF, RDSP or TFSA, one fund company notes, its distributions aren’t taxed as they’re paid, and you get no T3 slip for them. In a regular taxable account there are two tax events: you’re taxed each year on the income and capital gains the fund distributes, and on any capital gain when you sell your units. The fund’s year-end slip tells you which kinds of income it paid, and reinvested amounts count as income even though no cash reached you. Two items change your adjusted cost base (ACB) in ways that don’t match the cash you receive: return of capital (cash you aren’t taxed on that year, which lowers your ACB) and “phantom” distributions (tax with no cash, which raise it). Tracking both keeps your ACB right: the phantom distribution raises it so you don’t pay tax twice on the same money, and return of capital lowers it so the gain you report on a sale isn’t understated.

On this page: Accounts · Kinds of distribution · Return of capital · Phantom distributions · Paying twice · Slips · Selling and switching · Swap and corporate class

Does it matter which account holds the ETF?

Interest, dividends and capital gains earned in a TFSA are generally tax-free, even when you withdraw them. Income earned in an RRSP is usually exempt from tax as long as the funds remain in the plan, and you generally pay tax when you receive payments from it. Our guide to how investment income is taxed covers the rule in full. One fund company points out that an ETF held in a tax-sheltered plan such as an RRSP, RRIF, RDSP or TFSA isn’t taxed on its distributions and produces no T3 slip.

Foreign withholding tax is the exception that reaches into registered plans, and it depends on where the fund is listed and what it holds: see US-listed vs Canadian-listed ETFs. Which fund to keep in which account is covered on asset location.

The sections below look at ETFs in a non-registered account.

How is each kind of ETF distribution taxed?

A fund passes on what its holdings earn as distributions. The CRA’s list of what they can be: “capital gains, capital gains dividends, dividends, foreign income, interest, other income, return of capital, or a combination of these amounts”. Not all of these are taxed the same way or at the same rates, and one fund company says it reports the tax character of a year’s distributions only after the fund’s tax year ends. One fund’s report describes a policy of paying out enough net income and net realized capital gains that the fund itself owes no income tax; the tax lands on you instead.

You owe tax on a distribution whether it arrives as cash or is reinvested in more units: the CRA treats you as having received the money before it was reinvested. Setting up and tracking a reinvestment plan is covered on DRIP investing.

• Interest income is typically taxed at your marginal rate, one fund company notes.
• Canadian dividends get lighter treatment through the gross-up and dividend tax credit. Dividends from taxable Canadian corporations are grossed up and then reduced by a dividend tax credit; foreign dividends don't qualify. A dividend is an eligible dividend only when the Canadian corporation paying it to a resident of Canada designates it as one (eligible dividends usually come from Canadian public corporations and other corporations resident in Canada that are subject to the general corporate tax rate); other taxable dividends, usually from Canadian-controlled private corporations subject to the small business tax rate, are other than eligible (non-eligible) dividends. The taxable amount, reported on line 12000, is the dividend plus a gross-up of 38% for an eligible dividend or 15% for a non-eligible one, whose taxable amount also goes on line 12010. The federal dividend tax credit is 15.0198% of the taxable amount of eligible dividends and 9.0301% of the taxable amount of other dividends: the total of the credit amounts on your slips (T5 boxes 12 and 26, T3 boxes 39 and 51), or from the line 40425 chart of the Federal Worksheet without a slip. Outside Quebec, a provincial or territorial dividend tax credit, at the rates of the province or territory where you lived at the end of the year, is claimed on line 61520 of Form 428; Quebec residents claim Quebec's credit on their Revenu Québec return. The dividend tax credit guide explains how it works.
• Capital gains distributions are the fund’s own net gains from selling holdings during the year. You usually have a capital gain or loss when you sell capital property or are considered to have sold it, and you report it for the calendar year of that sale. Examples of being considered to have sold property include exchanging it for another property, giving it (other than cash) as a gift, having your shares or other securities converted or redeemed or cancelled by the corporation, an option you hold expiring, settling or cancelling a debt owed to you, transferring certain property to a trust, the property being expropriated, stolen or destroyed, changing its use, leaving Canada, and the owner's death. How much of a gain is taxed is on the capital gains inclusion rate.
• Foreign income is dividends or interest the fund earns from investments outside Canada. Where the fund paid foreign tax on it, it can report both the gross income and the tax paid to you, so you may be able to claim a foreign tax credit on your own return. Claiming the foreign tax credit covers the forms and limits, and US-listed vs Canadian-listed ETFs covers the withholding layers inside a fund.
• Return of capital isn’t taxed when you receive it. It’s the subject of the next section.

What is return of capital, and why does it lower your cost base?

Return of capital is the part of a distribution that is more than what the fund earned in income, dividends and capital gains; for tax purposes it is your own money coming back to you. One fund company puts it simply: if a fund earns less than it pays out, the difference is a return of capital. Another notes that option premiums are generally taxed as capital gains or treated as return of capital, so a covered-call fund’s distributions can include return of capital.

• A return of capital isn't taxed in the year you receive it.
• It reduces the adjusted cost base (ACB) of your units.
• On the fund's tax slip it is reported in box 42, "Amount resulting in cost base adjustment"; a positive amount reduces your ACB and a negative amount is added to it.
• If it reduces the ACB below zero, the negative amount is treated as a capital gain in that year.

Return of capital is not a bonus on top of your return. When a fund pays out more than its investments return, one fund company warns, your original investment shrinks. The tax isn’t avoided either; it is put off: the lower ACB means a larger gain, or a smaller loss, when you sell. If the payments push your ACB below zero, the amount below zero is taxed as a capital gain and the ACB starts again at zero; the ACB guide works through that case. For shares of a mutual fund corporation, return of capital doesn’t appear on the T5 slip, so the CRA says to keep track of it yourself.

What is a notional (“phantom”) distribution?

Besides distributions paid in cash or reinvested through a plan, there is a second kind: a phantom distribution, where no cash is paid but there are still tax consequences.

It starts inside the fund. When an ETF sells a holding for more than it paid, it has a capital gain. That can happen when the fund rebalances its portfolio or when a company it owns is taken over or merges. One fund company says these gains are usually paid once a year, in December, as reinvested distributions. Another explains that it pays its regular income in cash and reinvests its realized capital gains.

The reinvested gain buys new units for you, and right after that the units are consolidated, so you hold the same number of units as before. Your unit count doesn’t change, yet the amount is taxable that year.

• A reinvested distribution is taxed in the year it is paid, the same as one paid in cash.
• The reinvested amount increases your adjusted cost base (ACB) by the same amount.
• A fund can pay its year-end capital gains by reinvesting them and immediately consolidating the units, so the number of units you hold doesn't change.

How do you avoid paying tax twice?

By keeping your ACB up to date. A phantom distribution is taxed in the year it’s paid and raises your ACB by the same amount, so the gain you report when you sell is that much smaller. As one fund company puts it, that adjustment means you don’t pay tax twice on the distribution. Return of capital pulls the other way and lowers the ACB, so the two can partly offset each other in the same year. The CRA says to recalculate your average cost every time you buy more units or reinvest a distribution.

Where the numbers come from:

• Return of capital is in box 42 of the T3. The CRA’s rule: subtract a positive amount from your ACB, add a negative one. Box 42 is not income on your return.
• Phantom and other reinvested distributions are posted by fund companies on their websites and in the prospectus, and through the exchanges.
• Your ACB isn’t something the fund company keeps for you, one fund company says; your brokerage may provide it. The T5008 slip explains how the cost it shows relates to your ACB.

The ACB guide shows how to keep a running average across several purchases.

Which tax slips will you get, and when?

Units of an ETF set up as a mutual fund trust come with a T3 slip. With an ETF, the T3 comes from your broker: one fund company says it gives brokerage firms the information they need to prepare your T3 slips, and that brokers are normally required to provide them by mid-March. What to do about a late or missing T3, and how to read each box, is on the T3 slip explained.

When you sell units, you get a T5008 slip or an account statement.

What happens when you sell or switch ETFs?

Your capital gain or loss is the sale proceeds minus your ACB and any selling costs.

A capital loss is a superficial loss, and can't be deducted, if you or a person affiliated with you (such as your spouse or common-law partner, or a corporation either of you controls) buys, or has a right to buy, the same or identical property in the period from 30 calendar days before to 30 calendar days after the sale, and still owns it or has a right to buy it 30 calendar days after the sale. If you are the one who acquires the substituted property, you can usually add the denied loss to its adjusted cost base, so it reduces your gain or increases your loss when you sell it. For ETF switches in particular, see the superficial loss rule; tax-loss harvesting covers the wider approach.

Are swap-based or corporate-class ETFs taxed differently?

Swap-based ETFs. A swap is an agreement in which a counterparty, usually a bank, pays the fund the return of its index, so the fund can track the index without owning the stocks in it. One fund company’s fact sheets say its ETFs may use swap agreements to get their index exposure without holding the stocks, and describe them as suited to an investor who is “not looking for regular distributions”. ETF investors in general are taxed on distributions while they hold the fund and on capital gains when they sell, so with few distributions, more of the tax is left for the sale. One fund company says counterparty risk is one of the main risks of swap-based (synthetic) ETFs. More on swap funds beside funds that hold the stocks: how a fund holds the stocks.

Corporate-class ETFs. A mutual fund corporation can run several funds, each one a separate class of its shares, and one swap-based fund company labels its ETFs corporate class. A fund corporation reports to you on a T5 slip rather than a T3, and it can pay capital gains dividends. Switching from one fund of the corporation to another used to be possible without a sale for tax purposes; a federal budget change made such a switch a disposition at fair market value.

What makes an ETF tax-efficient? Index ETFs usually trade their holdings less than actively managed funds, and lower turnover can mean smaller capital gains distributions. An ETF also doesn’t need to sell holdings to raise cash for redemptions; when units are redeemed it can hand over securities “in kind”, which limits the gains it realizes. ETF vs mutual fund compares the two in full.

Where to go next

• The T3 slip explained: reading the slip box by box.
• Adjusted cost base: the running average and negative ACB.
• US-listed vs Canadian-listed ETFs: withholding tax, currency and hedging.
• Covered-call ETFs and dividend ETFs: income-focused funds.
• The ETF hub: what an ETF is and how to buy one.