ETFs vs. Mutual Funds: Can the Choice Affect Your Taxes in Canada?

Passive investment mandates may offer better tax efficiency for Canadian investors.

Matthew Elder 1 April, 2024 | 4:06AM
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Exchange-traded funds, or ETFs, and mutual funds tend to be viewed by retail investors as representing different investment strategies. The former is traded on a stock exchange, while the latter is bought and sold directly from the fund company. As such, they are different in structure. But does this matter when it comes to Canadian taxation?

ETFs generally are regarded as lower-cost alternatives to mutual funds, due to their low management expense ratios (MERs). Although there has been a trend toward active management within ETFs in recent years, many ETFs continue to follow passive investment mandates, which means their portfolios tend to mirror an underlying index and provide superior tax efficiency compared to active funds. This is because they tend to trade less frequently than actively managed funds, which results in minimal capital gains being realized within a portfolio – not to mention fewer transaction costs.

An index mutual fund will offer similar tax efficiency to that of a passively managed ETF, as its portfolio is also based on the content of the index on which it is based.

Active vs. Passive Funds and Taxes

“While there are differences between ETFs and traditional mutual funds, the differences are largely administrative in nature and not tax driven,” says Wilmot George, Vice-President and Head of Tax, Retirement and Estate Planning with CI Global Asset Management. “From a tax perspective, where differences present themselves, they are largely due to passive versus active mandates. For example, an active ETF and an active mutual fund would be largely similar from a tax perspective. Passive and active mandates – whether they be for ETFs or traditional mutual funds –have the potential for greater differences in taxation.”

Because ETFs are traded like stocks, their units often are exchanged among investors on the open market, so a purchase or sale may have no impact on its securities positions. In some cases, an ETF manager may have to create new units to meet purchase demand or to redeem units to cover sales by investors. This is possible because, although they are traded like stocks, they like most mutual funds are open-end trusts. Closed-end funds and individual securities, on the other hand, generally issue a fixed number of units or shares.

The Cash Factor

For both ETFs and mutual funds, should there not be enough cash on hand to cover redemptions, fund-level transactions may occur, which can trigger capital gains or losses and result in a distribution to unitholders, George says.

Overall, the creation and redemption of ETF units is an ongoing process. An ETF provider or sponsor uses authorized participants (APs) to create ETF shares. APs are typically large financial institutions (such as banks) but also can be other market specialists.

The ETF Creation Process

When an ETF is initially set up, an AP will purchase the market securities needed to fulfill the ETF’s investment mandate (which normally is a representative sample of the stocks that allow the fund to mirror, say, the TSX Composite Index). This basket of “creation units” is delivered to the ETF sponsor in exchange for newly created ETF units. The AP then sells these units to investors on a stock exchange.

Should the AP need to redeem ETF units, due to evolving market demand or to cover excessive redemptions, the AP delivers the redeemed units to the ETF issuer in exchange for the unit’s underlying securities. The ETF units are cancelled, thus reducing the total of outstanding units on the market. This process ensures ETF units trade in line with the underlying portfolio’s net asset value.

In-Kind Nature of ETFs Can Minimize Transaction Costs

The exchanges of individual securities and ETF units between the ETF provider and the AP are conducted on an in-kind basis, which means the securities or units are not cash transactions. This can minimize transaction costs.

ETF and Mutual Fund Distributions are Taxable

As is the case for many mutual funds, income earned within an ETF is normally paid out to its investors year-by-year. The amounts of these distributions are reported to the Canada Revenue Agency on a T3 or T5 information slip – or Revenu Québec Relevé 16 or Relevé 3 slip, respectively – a copy of which is sent to you in March each year and must be reported on your income tax return.

These distributions include:

  • Capital gains realized within the fund’s portfolio, net of any realized capital losses and related expenses. One-half of the amount of a capital gain is taxable.
  • Canadian-source dividends paid by Canadian companies held by the fund. This income is taxable at a reduced rate thanks to the dividend tax credit.
  • Interest and other income earned from bonds and other securities or cash within the fund. This income is generally taxable at the investor’s marginal tax rate.
  • Foreign income, such as dividends received from non-Canadian companies held by the fund. This amount is also fully taxable, although reduced by any foreign withholding taxes.

Return of capital (ROC) is a distribution that exceeds the taxable income earned by the fund and is paid to ETF shareholders as ROC, whereby the fund is in effect returning a portion of your investment. While this amount is not a taxable distribution, it does serve to decrease the adjusted cost base (ACB) of your investment in the fund and would increase the amount of your realized capital gain when you eventually sell units. (For more on ACBs, see The ABCs of ACBs.)

Beware of Phantom Distributions with ETFs

With ETFs, reinvested income, which is how most capital-gains distributions are processed, represents amounts that are not actually paid out to the investor but automatically reinvested into the fund. These are often referred to as “phantom” distributions. “They do not create new units, nor is there an adjustment to the fund’s net asset value per unit, as a consolidation takes place,” George says.

These distributions are included on tax slips and must be reported on your tax return, and the amount is taxable as an income or capital gains distribution, as the case may be. On a positive note, a reinvested capital-gains distribution will increase your fund investment’s ACB thereby reducing tax exposure when the time comes to sell the investment.

Avoid Double-Taxation

Be aware that a T3 or other tax slip will not distinguish between distributions paid out in cash and those that are reinvested. To prevent double taxation – on distribution income and again later when you sell units of the fund – you need to keep records and adjust the investment’s ACB whenever distributions are reinvested. After a distribution has taken place, you must add the value of reinvested distributions to the existing ACB (which is the total paid to purchase units, including commissions), then subtract any ROC as well as the ACB of previously sold units. Your financial advisor or broker should provide you with the distribution details needed to keep track of an investment’s evolving ACB.

Tax Efficiency of Funds Depend on the Mandate

ETFs and traditional mutual funds both provide exposure to a basket of securities that offer market diversification and access for a broad range of investors. Their primary difference is in how they are bought and sold, with ETFs offering intraday pricing. From a tax perspective, the type of fund purchased (i.e., active or passive) can influence tax efficiency.

“Many ETFs are passively managed and track an index. Index funds tend to have lower turnover rates than actively managed mutual funds, which reduces the potential for capital gains” George says. “Actively managed ETFs, on the other hand, would be similar to actively managed mutual funds in this regard and may result in greater trading activity from a portfolio manager versus a passively managed fund. Beyond that, mechanisms available in the management and administration of mutual funds and ETFs in Canada make the products similar from a tax perspective.”

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About Author

Matthew Elder

Matthew Elder  is Former Vice President, Content & Editorial of Morningstar Canada. Matthew was previously an editor and columnist at the Financial Post and The Gazette in Montreal.

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