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

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.

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 dispose of their ETF units. Here lies the double tax issue related to phantom distributions. Read on to understand how to avoid double taxation.

Why do phantom distributions happen?

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.

Effect on ACB and avoidance of double tax

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 be 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. 

Annual due diligence for investors

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 NASDAQ 100 Index ETF – CAD Hedged for the 2022 tax year (QQC.F). 

For the highlighted distribution paid on January 9, 2023, a unit factor of $1.36356 was automatically reinvested within the ETF. 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 QQC.F at $100/unit. The investor has a total ACB of $100,000 on 1,000 units, which equates to an average cost per unit (ACB/unit) of $100. 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 QQC.F, our hypothetical investor would have had the following taxable income amounts reported on their T3 Trust income tax slip for 2022.

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 $209.95, the client’s ACB should have been reduced to $99,790.05.

Second, per the information found on our website, the phantom distribution (“Reinvestment”) of $1.36356/unit requires the investor to ensure that the total ACB has increased by $1,363.56. The ACB then increases to $101,153.61¹.

Assuming the investor later sells all the units at $135/unit, the proceeds from the sale would be $135,000. The total ACB on the ETF would be $101,153.61. This creates a capital gain of $33,846.39, of which 50% is a taxable capital gain.

If the investor did not account for the phantom distribution of $1,363.56, the capital gain would instead be $35,209.95. At a 50% marginal tax rate (MTR), this could cause him or her to pay $340.89 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.

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.