While your primary focus as an investor should be on the yield from your investment as well as the capital appreciation, the tax treatment of distributions on the investment is also important. From a tax perspective, distributions from ETFs are composed of the following types of income:
The individual stocks or shares held by an ETF pay dividends that are received by the ETF. Distributions by an ETF to investors out of the ETF’s dividend income are generally treated as ordinary income to the investors. However, where the ETF pays a distribution out of dividends received by the ETF from Canadian companies, an investor can treat that distribution as if it were a dividend from a Canadian company. For investors who are Canadian resident individuals, this means that such a distribution qualifies for the lower effective tax rate applicable to dividends from Canadian companies.
Interest and Other Income
Fixed income ETFs receive interest on their investments in bonds and other debt obligations. Distributions by an ETF to investors out of the ETF’s interest and other income are generally treated as ordinary income to the investors.
An ETF may also realize capital gains on the sale of investments in the ETF’s portfolio. If the ETF pays a distribution to investors out of its net realized capital gains, an investor can usually treat this distribution as if it were a capital gain realized by the investor. As is the case for realized capital gains, only one-half of such a capital gains distribution has to be included in the investors’ income.
Foreign Income and Foreign Tax Paid
An ETF may earn dividends or interest on foreign investments and therefore be required to pay foreign withholding tax. When the ETF pays distributions out of this foreign income, an investor that pays Canadian tax may be able to claim a foreign tax credit for some of the foreign tax paid by the ETF, depending on the investor’s particular situation.
Return of Capital
In some cases, an ETF may distribute an amount to investors as a return of capital that is generally not taxable to investors. However, such a distribution will decrease the ACB of the investor’s units. When the investor sells the ETF units, the lower ACB will increase the capital gain (or decrease the capital loss) that would otherwise be realized on the sale.