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investor clinic

Some investors are under the mistaken impression that holding ETFs in a registered account is a bad idea because they get no benefit from the change in their adjusted cost base. But, registered accounts are a perfectly acceptable place to hold ETFs, because all distributions are tax-free.Lim Yong Hian/Getty Images/iStockphoto

After last week's column on the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ), I received the following reader e-mail (which I've paraphrased).

Because this is a topic many investors find confusing, today I'll respond to the question in detail.

I own some CDZ units, and recently noticed that my adjusted cost base per unit (as per my brokerage statement) was increased to $27.20 from $25.92, a difference of $1.28 per unit.

My adviser was initially just as puzzled as I was by this, but later explained that this change reflected a distribution of capital gains.

Can you explain what's going on here?

Your adviser is only partly right. It wasn't the capital gains distribution, per se, that caused your adjusted cost base to rise; it was the fact that iShares reinvested the distribution.

Let's back up for a moment. Late in 2014, CDZ declared a monthly distribution of $1.34509. However, only 6.469 cents of that amount was actually paid in cash; the other $1.28040 was classified as a reinvested distribution. (You can see this information for yourself by searching "CDZ" on the iShares website and clicking on "distributions," then choosing the "recent" and "table" views. The distribution in question has an "ex-date" of Dec. 29.)

Reinvested distributions typically arise when a fund earns capital gains from selling securities during the year. At the end of the year, it "distributes" its net capital gains to unitholders, who are responsible for paying the tax. Unitholders never actually see the money, however, because it was already plowed back into the fund. It's really just an accounting move done for tax purposes, which is why reinvested distributions are also known as "phantom" distributions.

Why not just distribute all capital gains in cash periodically, as is the case with interest and dividends? Well, a fund might have a capital gain one month, a capital loss the next, and another capital gain three months later. It has to wait until the end of the year – after all the gains and losses have been tallied – to know what the final taxable net capital gain, if any, will be. In the meantime, because the fund wants to remain fully invested, it redeploys the sale proceeds internally. The purpose of the year-end reinvested distribution is to push out the capital gains tax liability to unitholders (which is more efficient from a tax perspective than if the fund were to report the gain itself).

Keep in mind that a fund's net capital gain and the amount of the reinvested distribution won't necessarily match up exactly, but they're usually pretty close. If you go back to the iShares website and look under "distributions" and "calendar year," you'll see that CDZ's net capital gain in 2014 was $1.32849 per unit – less than a nickel higher than the reinvested distribution amount of $1.28040

Now that you know where reinvested distributions come from, the next step is to understand how they affect your adjusted cost base (ACB). Before we get into that, it's important to realize that if you own CDZ (or any other security) in a registered plan, you will not pay tax on any distributions, reinvested or otherwise. Nor will you pay tax if you sell your units for a capital gain (notice that there are two types of capital gains – those generated internally by the fund, and those earned by investors who sell the fund's units).

In a registered account, because there are no capital gains taxes when you sell your units, your ACB is basically irrelevant. The ACB only matters for the purposes of calculating the capital gain or loss you incur when selling your units in a taxable account.

So, for the sake of the following explanation, we'll assume you hold CDZ in a non-registered – i.e. taxable – account.

Recall that your broker increased your ACB by $1.28 per unit – which, you'll note, is virtually the same as the reinvested distribution of 1.28040. This is no accident: When a distribution is reinvested, your ACB increases by the same amount. (Not all brokers will do this calculation for you; the onus is often on the investor to look up reinvested distributions on the ETF website and adjust the ACB accordingly.) If you fail to increase your ACB, you'll end up paying more capital gains tax than necessary when you eventually sell your units.

Some investors are under the mistaken impression that holding ETFs such as CDZ in a registered account is a bad idea because they get no benefit from the change in their ACB. But this reasoning is flawed. Registered accounts are a perfectly acceptable – even desirable – place to hold ETFs, because all distributions are tax-free. With non-registered accounts, increasing your ACB merely prevents you from getting taxed twice.

Reinvested distributions can be a difficult concept to grasp, but understanding how they work can make you a better investor. For further reading, check out my previous columns at tgam.ca/EBpH and tgam.ca/ECA8.

There's also a helpful explanation on the iShares website; find it under "Distributions and Tax" in "Frequently Asked Questions."