Portfolio Checkup

There’s nothing you can do about these distributions – they’re an annoying fact of life with investment funds of all types. But you can address the taxes payable when you sell an ETF.

Here’s how: Find the amount of reinvested distributions you received from an ETF over the years you owned it and then combine that amount with your purchase price plus brokerage commission. This is an important part of calculating your adjusted cost base, which you’ll use to determine your ultimate capital gain or loss when selling your ETF.

The net effect of adding reinvested distributions to your purchase price is to lower the amount of your capital gain (or increase the loss, if your ETF fell in value) when you sell. Imagine you take an ETF investment that cost you $50 per share (including commission) many years ago and adjust the cost base to $52.50 after considering your reinvested distributions and another variable called return of capital that we’ll look at shortly. If you sell for $60, the amount of capital gain per share is $7.50.

You’ll need a record of what you paid to buy an ETF for this calculation (including commission), and the cumulative amount of reinvested distributions, if any, for the years you owned it. This latter information should be available under the “distributions” tab on the fund profiles provided online by ETF companies. Look under the column heading that says “reinvested distribution per unit.”

In the case of BMO ETFs, you’ll find a footnote to the information on reinvested distributions that states: “Distributions by the BMO ETF that are not paid in cash should be accounted for by investors for tax purposes by adding the distribution amount to the adjusted cost base of the units held.” The website for BlackRock’s iShares family has the same message, and it’s in the same tiny type, way down at the bottom of the page.

“This information is all publicly available, but you have to mine for it,” said Kathy Hill, co-owner of a website that offers an adjusted cost base calculation service called ACB Tracking Inc. For a modest fee, ACB will produce a personalized adjusted cost base for any TSX-listed closed-end fund, exchange-traded fund or income trust. You just need the buy and sell details for the security you own.

ACB started out as a way to help investors keep track of return of capital payments from income trusts and other investments. Return of capital is another major component of the adjust cost base calculation, and it has the opposite effect of a reinvested distribution. Return of capital payments should be subtracted from your cost base, which means they will either increase your ultimate capital gain or reduce your loss.

The income-focused ETFs that have been especially popular in recent years almost always have a return of capital component to their regular monthly distributions. As a result, investors should have at least a passing acquaintance with this particular tax issue (read more: Reading between the lines: The nitty-gritty on ETF payouts ).

Reinvested distributions are less well understood, in part because ETFs don’t expose investors to them on a regular basis. A reinvested distribution generally occurs when a fund sells securities in its portfolio and locks in a capital gain that isn’t offset by capital losses. Unitholders must pay tax on the gain, even as the money is reinvested back in the fund in a way that leaves the value of your investment unchanged. Now you understand why ACB Tracking uses the term “phantom” to describe those reinvested distributions.

Phantom distributions used to be a sideline to ACB’s main job of tracking return of capital. But the proliferation of ETFs in recent years has made these distributions more of an issue.

Let’s not overstate the matter, though. As an index-tracking investment, an ETF typically offers less risk of reinvested distributions than a conventional mutual fund. A fund manager may, for any number of reasons, sell stocks and thereby lock in a capital gain. A traditional ETF tracks a stock index and thus makes changes in its holdings only when the index is rebalanced. Often, there will be no reinvested capital gains distributions at all.

There are roughly 320 ETFs listed on the Toronto Stock Exchange. ACB says 74 of them made phantom distributions last year, and they ranged from a few cents to almost $1 per unit. In 2011, 45 funds made this kind of distribution.

Phantom distributions shouldn’t have a massive impact on your adjusted cost base, but they may still add up to a significant amount if you’re a long-term investor. ACB says the largest ETF in the country, the iShares S&P/TSX 60 Index Fund (XIU), has made a total of 11 phantom distributions totalling $1.66 per unit since 1999 (adjusted for a 4:1 stock split in 2008).

ACB charges as much as $8.50 and as little as $3 per calculation, depending on which data package you buy. Each calculation allows you to input multiple purchases and sales of a particular ETF to get an adjusted cost base that reflects both return of capital and phantom distributions over the period you owned the fund.

ACB’s database is loaded with return of capital and non-cash distribution data, which saves you the trouble of gathering this information yourself. Note: If you use a dividend reinvestment plan, you’ll have to enter reinvested dividends manually.

Investors who don’t mind keeping their own records should take a look at a free website called AdjustedCostBase.ca. Input all your buy and sell transactions, your return of capital payments, your capital gains distributions and any reinvested dividends and it will keep a running tally of your adjusted cost base.

Ms. Hill said 40 per cent of the people using her website are accountants, 40 per cent are investment advisers and 20 per cent are individual investors who understand how to calculate their adjusted cost base. “We’re seeing the savvy investors. There are lots out there who don’t know.”

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick ) and Facebook (robcarrickfinance ).

For more personal finance coverage, follow me on Twitter (rcarrick) and Facebook (robcarrickfinance).