We hold Canoe EIT Income Fund (EIT-UN-T) and have been pleased with the income stream and recent gains of the fund. But I am perplexed by something. In December, the fund announced an estimated “special distribution” of 44 cents per unit that was confirmed in early January. I reached out to Canoe Financial and asked how the special distribution would be paid. I was told that I would not receive any cash or units but that my broker would increase the average cost of my units. My question is: If there is no increase in units or cash, how is it a benefit to unitholders? Am I the only one that does not understand this?
No, you’re definitely not the only one. Such non-cash distributions have been bedevilling investors for years. But with Canadian and U.S. stock markets surging in 2021, the number of reinvested, or “phantom,” distributions has risen dramatically. When even Canoe EIT Income Fund – a closed-end fund that had never paid such a distribution in its 25-year history – gets in on the action, you know phantom payouts have become too ubiquitous for investors to ignore.
Understanding how these non-cash distributions work, and the tax consequences they entail in a non-registered account, is critical for investors. If you ignore them, it could end up costing you money.
Let’s start by answering the first question that many investors have: If a reinvested distribution doesn’t give you any additional cash or units, what exactly is being distributed?
Answer: a capital-gains tax liability. That’s all.
During the year, investment funds are constantly buying and selling securities. For example, a fund might take some profits on a stock that’s jumped in price or, in the case of an exchange-traded fund, it might need to rebalance its holdings in line with the index it tracks.
These transactions trigger capital gains and losses, which funds typically tally up at the end of the year. Generally, if the net result is a capital gain, the fund “distributes” it to unitholders in December – but on paper only. No cash actually changes hands, because the fund in most cases has already reinvested the money. The reinvested distribution is just a year-end bookkeeping exercise that transfers the net capital gain to unitholders, who are then responsible for paying the tax.
Canoe EIT is a slightly unusual case because, unlike many funds, it does distribute some capital gains in cash to unitholders during the year. This helps to fund its above-average distribution yield, which is also typically supported by return of capital and a small contribution from dividends.
But 2021 was such a good year for markets – the S&P/TSX Composite Index and S&P 500 gained 21.7 per cent and 26.9 per cent, respectively – that the fund still had a chunk of capital gains left over even after paying its regular monthly cash distributions.
“Strong performance in many of the Fund’s underlying holdings resulted in net capital gains that exceeded its $0.10/unit monthly distribution,” Canoe Financial explained in an FAQ on its website. “Capital gains that were realized by the Fund must be distributed in the calendar (tax) year they are earned.”
More than the usual number of mutual funds and ETFs also declared phantom distributions in December. For example, a press release on the BlackRock Canada website revealed that 74 of its 157 iShares ETFs had a reinvested distribution in 2021, up from just 30 the year before.
“That is a huge number,” said Lea Hill, president of ACB Tracking Inc. “You’re seeing it because we had very strong equity markets last year.”
Everyone loves rising markets. But the downside of reinvested distributions is that investors have to pay tax on capital gains they didn’t receive in cash. What’s more, if investors don’t pay attention to these phantom payouts, they could end up paying tax a second time when they eventually sell their units.
That’s why investors need to increase the adjusted cost base (ACB) of their units by the amount of the reinvested distribution. This will reduce the eventual capital gain (or increase the capital loss) when the units are sold.
Failing to increase the ACB would result in capital-gains tax that is higher than it should be because the gain would include the reinvested distribution that has already been taxed on a T3 slip.
Many brokers take into account reinvested distributions when they calculate the “average cost” or “book value” figures on client statements. But these adjusted cost base numbers aren’t always accurate, and brokers “don’t make the adjustment until about May,” said Mr. Hill, whose company provides ACB calculations for a fee. If you sell your ETF units in February or March, before the ACB is updated, you could fall into the double taxation trap, he said.
It’s therefore imperative to be aware of any reinvested distributions and to adjust your ACB accordingly. You can use a service such as ACB Tracking or AdjustedCostBase.ca, or look up phantom distributions yourself on the fund company’s website. But if you use your broker’s ACB numbers, it’s a good idea to check them against another source to be sure they’re accurate.
It’s tedious work, but it could save you money in the long run.
E-mail your questions to firstname.lastname@example.org. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.
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