How to Avoid Paying Other People’s Taxes

By Dan Bortolotti and Canadian Couch Potato on December 10, 2010
Estimated reading time: 4 minutes

Call me old-fashioned, but I like to give ETFs to my loved ones at Christmas. Nothing captures the spirit of the holidays quite like a low-cost, passively managed investment project. But before you go shopping for the Couch Potatoes on your wish list, be aware that December can be a terrible time to buy ETFs. [...]

No, it’s not because of all the last-minute shoppers pushing and shoving at the discount brokerage. The reason is that any capital gains that the funds have incurred over the last 12 months are distributed at the end of the year. Although they’re called “distributions,” capital gains are not handed out in cash like dividends or interest. You don’t receive any new shares, and the market price of the ETF won’t change. All you get is a T3 slip showing the amount of the gain, which you’ll need to report on your 2010 tax return. Imagine the look on your child’s face when she opens your thoughtfully wrapped ETF, only to find that it comes with a nasty tax bill. Talk about a lump of coal.

Their gain, your pain

In general, ETFs are extremely tax-efficient, especially if they track broad, cap-weighted indexes. Funds incur capital gains when they sell securities at a profit, and passively managed funds don’t do a lot of selling. (The ETF structure may allow fund managers to avoid taxable gains even when they do sell stocks.) However, a fund may have no choice but to realize capital gains when its benchmark index is changed, forcing the manager to sell some securities and replace them with others. The funds are then required to pass those capital gains on to their investors, usually at the end of the year. (Of course, this is not an issue if you’re investing in an RRSP or a TFSA.)

If you’re a buy-and-hold investor, capital gains are just part of the deal: take comfort in the fact that your fund made some profits during the year and put money in your pocket. However, if you’re thinking about buying into an ETF for the first time, December may not be the time to do it. If you buy shares of the fund now and it pays out a large capital gains distribution at the end of this month, you’ll wind up paying tax on other people’s gains.

When ETFs declare that they will be distributing a capital gain for the year, they name a date of record and an ex-dividend date. (These terms will be familiar to investors who buy individual stocks. This article offers a more complete explanation.) If you buy an ETF before the ex-dividend date and still hold it on the date of record, you’ll pay tax on all of the capital gains accumulated during the year, even though you may have only owned the fund for a week.

Claymore, iShares and BMO all have the same capital gains distribution schedule for 2010:

	Declaration date:	December 17
	Ex-dividend date:	December 24
	Date of record:	December 30

What does this mean for investors looking to buy an ETF in a taxable account now, perhaps as a gift for that special someone? It means that you should consider waiting until December 17 to see if that fund is going to distribute a capital gain. If it is, you should delay your purchase until after December 24. Any shares you purchase after that date will not be hit with the tax.

Big gains in 2010

Although the official declarations won’t be made until December 17, most ETF providers have already made estimates. It looks like 2010 was a particularly bad year for capital gains distributions. Here are the links to each company’s press releases, plus a few highlights that stood out:

Claymore

For the first time in four years, Claymore’s flagship Canadian Fundamental Index ETF (CRQ) announced a capital gain of $0.29 per share, or about 2.5%.
The Claymore US Fundamental Index ETF (CLU) will distribute a gain twice as large as last year’s: $1.33 per share, or more than 8%.
Both of Claymore’s dividend ETFs (CDZ and CYH) are also passing along capital gains.

iShares

The most popular iShares Canadian equity funds (XIU, XIC and XDV) incurred zero gains again this year.
The iShares S&P 500 Index Fund (XCS) estimates a capital gain of 4.67% because more than 40 stocks were deleted from the index, and many had to be sold at a profit.
The iShares S&P 500 Index Fund (XSP) generated a 2% taxable gain because of its currency hedging strategy.
The iShares S&P Capped REIT Index Fund (XRE) incurred gains when the index was adjusted in September after a 20% run-up in the fund’s value.

BMO

There will be no capital gain distributions on several popular equity ETFs, including the BMO Dow Jones Canada Titans 60 Index ETF (ZCN), the BMO International Equity Index ETF (ZDM), and the BMO Emerging Markets Equity Index ETF (ZEM).
High-yielding bond ETFs (ZHY and ZEF) will see taxable distributions of more than 2.5%.

Vanguard

Vanguard continues to be extremely good at tax-managing its ETFs. The only fund with a taxable gain that is likely to be held by Canadians is the Vanguard FTSE All-World ex-US Small-Cap ETF (VSS).