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Q. I have never seen an article written on the problem of phantom dividends from exchange traded funds (ETFs) in Canada. I have run into this problem and stopped investing in ETFs as a result. It is causing tax issues for me and I don’t like the non-transparency of these shares and dividends, which makes the dividends harder to keep track of. I’m also receiving Old Age Security (OAS) and wasn’t sure what effect, if any, it was having on the OAS clawback. Was this the right thing to do? —Jim

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FP Answers: By phantom dividends, I believe you are referring to phantom distributions, Jim. Phantom distributions occur when a managed product, such as an exchange traded fund (ETF) or mutual fund sells one of its underlying securities for more than its purchase price. Essentially, it is when a fund you own has a capital gain on an investment it owns.

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The proceeds of that sale are reinvested in the fund, and no cash payment is made in most cases. As a result of this reinvestment, your adjusted cost base (ACB) would increase due to the reinvestment of the capital gain proceeds.

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Phantom distributions can also happen because of corporate actions such as mergers and acquisitions that may result in the amalgamation or delisting of securities that result in capital gains. Although the investment returns are surely welcome, there will be taxable income that results from these capital gains distributions if these securities are held in taxable investment accounts.

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In Canada, the taxation of ETFs and mutual funds should result in similar after-tax returns as if the securities they hold were owned individually. For example, if a Canadian bank ETF has an effective yield of four per cent, and investors hold the same proportion of the bank stocks underlying the ETF, they should also have a comparable yield with the same tax payable. The fund may sell a stock it owns and generate a taxable capital gain for the investor if it is held in a taxable account and this unexpected aspect of an ETF or mutual fund can surprise an investor. The taxable income is not exactly phantom income though because it is an actual capital gain the investor would have had if they owned and sold the same stock themselves.

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Most ETFs are designed to distribute income back to the unitholders in cash or as reinvested units. Common sources of income from ETFs are interest from bonds or dividends from stocks. This income may also be reinvested within the fund, but again, it is income nonetheless, despite investors not receiving it in their hands.

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For broad-based market ETFs, it’s unlikely that you will have a huge amount of capital gains from year to year. There are rarely large capital gains from year to year, but rather, rebalancing that triggers modest gains. On the other hand, if you purchase a factor-based ETF that employs active strategies these may result in more trading in the fund and higher capital gains from year to year. I recommend reviewing the trading exchange ratio (TER) or turnover rate of funds that you are purchasing in a taxable account, as this may be indicative of what you can expect.

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Mutual funds, active and passive, will have similar attributes to ETFs, with more sporadic capital gains typically associated with active funds compared with passive funds. In situations like these I would always evaluate the materiality of the issue versus the alternative. For example, are you content with your portfolio’s risk/return profile, and is there a suitable alternative to avoid the phantom income?