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Are distributions from exchange-traded funds (ETFs) treated as interest or dividends for tax purposes?

Several readers have asked that question. The answer is that the tax treatment depends on the ETF.

If an ETF invests in Canadian dividend stocks, for example, the distributions will consist largely of eligible dividend income. If it's a bond ETF, the distributions will be primarily interest. In both cases, there may also be a component of capital gains or return of capital.

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There are many other possibilities.

If the ETF invests in foreign stocks or bonds, distributions will usually consist largely of foreign income. If the ETF holds real estate investment trusts, the distributions might include eligible dividends, non-eligible dividends, capital gains, return of capital, foreign income and other income.

Complicated, isn't it? The good news is that you don't have to calculate these amounts yourself. They will be included on your T3 tax slip (the Statement of Trust Income Allocations and Designations). ETF providers also post detailed tax information on their websites.

For ETFs from Bank of Montreal (etfs.bmo.com) or iShares (ca.ishares.com), after you select a particular ETF, click on "distributions" and scroll down the page to see the tax breakdown. (With BMO ETFs, you need to select the year from a drop-down menu.) Note that, as of Feb. 22, information for the 2012 tax year had not yet been posted on the sites, but you can see data for previous years.

For Horizons ETFs, you can access tax information from the home page at horizonsetfs.com. On the left side you'll see a link labelled "2011 Distribution Summary," which takes you to a spreadsheet with the tax treatment for all of Horizons ETFs.

Howard Atkinson, CEO of Horizons ETFs Management, said 2012 tax information will be posted on the website and made available to financial institutions by the end of February. Financial institutions then use the information to prepare T3 slips for clients. Typically, T3s are mailed out by the end of March.

Why does it take so long?

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"We get these things checked and rechecked," Mr. Atkinson says. "The last thing you want to do is send out an erroneous tax slip, so we get many sets of eyes on it, both internal and external, to make sure the numbers are right."

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What happens in a synthetic DRIP if the dividend isn't enough to buy a share – for example, if the share costs $100 and the dividend is only $90?

You're out of luck, unfortunately. In most cases, the $90 will just sit in your account as cash. With synthetic dividend-reinvestment plans (DRIPs) operated by discount brokers, the dividend must be large enough to purchase at least one whole share. Even then, you'll still end up accumulating cash. For example, if the dividend is $50 and the share costs $40, you'll purchase one share and get the remaining $10 in cash. This is one of the main drawbacks of synthetic DRIPs.

If you want your entire dividend reinvested, you'll need to set up a "true" DRIP that allows fractional share purchases. These DRIPs are operated by the company's transfer agent. To qualify you'll need to have the share certificates registered in your name, which costs about $50 (in addition to the commission for purchasing the shares). You can also buy your first share privately to avoid these fees. More information is available at www.dripprimer.ca.

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