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In a recent column, you discussed why you added more BCE Inc. BCE-T shares to your model dividend portfolio. Could you comment on the ratio of dividends to net earnings? It looks to me from a quick calculation that their dividends exceed net earnings of late. Am I missing something in the accounting that explains this and maintains the attractiveness of the stock for your dividend portfolio?

True, BCE’s annualized dividend of $3.68 a share exceeds its estimated 2022 earnings of $3.40 a share, according to analysts surveyed by Refinitiv. The payout ratio, based on earnings, is about 108 per cent.

That’s not ideal, but it doesn’t mean the dividend is in any danger, either.

BCE uses a different, less stringent, method to determine its payout ratio. As the company explains in the investor relations section of its website: “We seek to achieve dividend growth while maintaining our dividend payout ratio within the target policy range of 65 per cent to 75 per cent of free cash flow.”

Free cash flow is generally defined as a company’s cash from operations, less capital expenditures to maintain or expand its business. Because free cash flow is not affected by non-cash items such as depreciation that reduce a company’s earnings, it generally provides a more accurate picture of a company’s ability to sustain its dividend.

Jérome Dubreuil, an analyst with Desjardins Securities, projects that BCE will have free cash flow of $3.64 a share in 2022, which is still slightly less than the dividend. He sees BCE’s free cash flow rising to $3.98 a share in 2023, which – even with an expected dividend increase of about 5 per cent early next year – would cover the dividend, although with a higher payout ratio than BCE’s own target.

After that, however, the payout ratio should continue to decline. With BCE’s heavy capital investments in fibre-to-the-home internet now peaking, analysts see BCE’s free cash flow rising over the next few years as spending on the fibre rollout gradually slows. By 2025, analyst Drew McReynolds of RBC Dominion Securities sees BCE’s cash flow rising to $5.19 a share.

Assuming the dividend continues to grow at about 5 per cent annually – consistent with BCE’s recent history – the company would be paying about $4.26 a share in 2025. Dividing that number by projected free cash flow of $5.19 would produce a payout ratio of about 82 per cent – still on the high side but moving in the right direction.

These are just estimates, and a lot can happen between now and then. But BCE’s dividend, which yields about 5.8 per cent, is almost certainly safe and will likely continue to grow. The company has raised its dividend by at least 5 per cent for 14 consecutive years, and I don’t see that streak ending any time soon.

It seems to me that if an investor purchases an exchange-traded fund in a non-registered account and enrolls the units in a dividend reinvestment plan, there would be no need to look out for phantom distributions. That’s because the entire distribution would be reinvested so all of it would contribute to the adjusted cost base. Does that seem correct to you too?

Not quite. You are correct that, if you reinvest a regular cash ETF distribution as part of a dividend reinvestment plan, you (or your broker) would need to increase the adjusted cost base of your units by the amount of the reinvested distribution. It’s the same for a dividend stock enrolled in DRIP: Each time you buy additional shares, you should increase your ACB by the amount of the reinvested dividend.

However, phantom distributions are not the same as cash distributions. So, raising your ACB by the amount of the ETF’s regular cash distributions – as important as that is – will not take into account any phantom (non-cash) distributions the ETF may have declared. You may have to look up these reinvested distributions yourself (more on that later), as not all brokers include them in the “book value” or “average cost” figures for clients.

Here’s a key thing to understand: A phantom distribution is nothing more than a bookkeeping exercise for tax purposes. No cash changes hands. Typically, the only thing being “distributed” is a capital gains tax liability.

How does the tax liability about? Well, during the year, ETFs frequently buy and sell stocks. This triggers capital gains and capital losses. At the end of the year, if the ETF’s capital gains exceed its losses, the fund “distributes” the net capital gain (on paper only) to unitholders, who are responsible for paying the tax at their own marginal rate (Note: only 50 per cent of capital gains are included in income for tax purposes).

However, cash from the ETF’s capital gains doesn’t actually leave the fund. When an ETF sells a stock, it doesn’t leave the proceeds sitting around, because that would affect the ETF’s performance. Instead, it reinvests the cash internally.

This is why phantom distributions are also known as reinvested distributions. Even though the phantom distribution is declared at the end of the year, the money was already reinvested weeks or months earlier. The phantom distribution is just an accounting manoeuvre that makes the unitholder responsible for paying tax on the net capital gain that was already reinvested.

Why does any of this matter? Well, if you fail to raise your ACB by the amount of any phantom, non-cash distributions, your ACB will be lower than it should be. As a result, you will effectively end up paying tax twice – once in the year the capital gain is realized, and a second time when you eventually sell your units.

To see whether one of your ETFs is expected to declare a phantom distribution this year, check out the list of estimated reinvested capital gains distributions that ETF providers published in November. For example, you’ll find estimates for iShares ETFs here and for BMO ETFs here.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.

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