What Are ETF Distributions?

By Erin Allen, VP, Online Distribution, BMO ETFs

(Sponsor Content)

ETF distributions are payments made by an ETF [Exchange Traded Fund] to its shareholders. In non-registered accounts, these distributions are taxable to the investor in the year they are received and may include dividends, interest income, capital gains, and return of capital (which is non-taxable).

ETF distributions are typically paid out in cash; however, year-end distributions may be received “in-kind” and reinvested. Whether a distribution is received in cash or reinvested, it has the same tax impact for a non-registered investor. The tax impact will depend on the type of distribution received (interest, dividends, or capital gains) and will be reflected on an investor’s year-end tax slip.

Types of ETF Distributions

• Canadian Dividends: Dividend distributions occur when an ETF invests in Canadian equity securities that pay dividends. Canadian residents qualify for a dividend tax credit, if the ETF invests in Canadian securities that pays dividends.
• Interest and Other Income: Fixed Income ETFs earn interest on their investments in bonds and other debt obligations. When an ETF pays our distributions as interest and other income, distributions are taxed as ordinary income.
• Capital Gains: An ETF may incur capital gains if an underlying security in the ETF is sold for more that its purchase price. Only 50% of the capital gain is included in the investor’s taxable income.
• Foreign Income & Foreign Tax Paid: When an ETF earns dividends or interest on foreign investments the ETF may have to pay foreign withholding tax. When an ETF distributes this foreign income, a Canadian investor may be able to claim a foreign tax credit in respect of the associated foreign tax paid by the ETF.
• Return of Capital: An ETF may distribute a portion of your initial investment. This is considered return of capital and is not taxable to investors. However, such a distribution will decrease the ACB (adjusted cost base) 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.
• Reinvested “Phantom” Distributions: Phantom distributions are the reinvestment of unpaid capital gains that an ETF may realize if an underlying security in the ETF’s portfolios sold for more than its purchase price. Learn More here

What triggers a Capital Gain?

An ETF could incur a capital gain if one of the following events occur:

• Performance – If the ETF experiences positive returns since purchase and the underlying investment is sold, the ETF could realize a capital gain.
• Corporate Action – When a merger or acquisition occurs resulting in a disposition of one of the underlying holdings, the ETF may realize a capital gain.
• Portfolio Rebalancing – When this occurs, the ETF will trade the underlying securities, which could result in a capital gain.

More on Return of Capital (ROC)

Any distribution that is paid out in excess of taxable income is classified as ROC. For cash distributions paid throughout the year, BMO ETFs generally distributes based on the underlying portfolio yield less expenses. This benefits investors by providing greater certainty on the payout. As the ETF grows, the income earned is allocated across unitholders.

The important consideration for ROC, is whether it impacts the sustainability of the distribution. We define good ROC as sustainable, where the invested capital is not depleted over time. We define bad ROC as dipping into the invested capital to support the distribution, which leaves less investment for future years.

Timing of Distributions

Distributions are paid to investors based on the number of units they hold of an ETF on its “record date”. The record date is generally the business day prior to the distribution date. The frequency and amount of distributions can vary between different ETFs.  Investors should review an ETFs prospectus or website to understand the distribution policy and schedule before investing.

If you are purchasing an ETF and would like to receive that month’s distribution you must do so before the ETF’s “ex-date,” this will ensure you are on record for the payment. Continue Reading…