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I have 1,000 units of the iShares SP US Dividend Growers Index ETF (CUD). In January I received a distribution of $4,113.56, which was reinvested by the fund right away. Despite this I have not seen an increase in my share number or market value. What is going on here? My broker could not explain this to me satisfactorily.

When even your broker can’t explain it, you know you’ve stepped into … the phantom distribution zone.

Phantom distributions – also known as reinvested distributions – continue to baffle and bemuse investors, despite my previous attempts to explain them. With the April 30 tax deadline approaching – and the number of phantom distributions rising – now is a good time to revisit the topic.

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“Even some accountants don’t get it,” said Lea Hill, president of ACB Tracking and an authority on this arcane corner of investing.

Let’s start with the basics. Exchange-traded funds (and mutual funds) distribute interest, dividends and other income to unitholders, who are responsible for paying tax (assuming the units are held in a non-registered account.) Distributions are typically paid in cash at regular intervals, unless the unitholder chooses to reinvest them.

You get money. You pay tax. Pretty straightforward.

Capital gains are treated differently. Funds sell securities throughout the year and redeploy the cash internally to buy other securities, giving rise to both capital gains and losses. Instead of distributing capital gains immediately, however, funds typically wait until the end of the year when they add up all of their gains, subtract their losses, and determine their net capital gains. (You can see how it would create a problem if a fund distributed a capital gain one month, only to have it cancelled by a capital loss the next month, which is why they wait until the end of the year when the dust has settled).

This is where phantom distributions come in. To transfer that year-end net capital gain to investors for tax purposes, the fund performs what is essentially an accounting move and “distributes” the gain, but only on paper. No cash changes hands – hence the word “phantom” – because the money was already reinvested by the fund during the year. But the investor still has to pay the tax.

(The actual mechanics are a bit more complex. As iShares explains on its website, the fund issues additional units, but then immediately consolidates the number of units. The end result is that the investor has the same number of units, trading at the same price, as before. With mutual funds, new units are issued, but the price of each unit drops, so the investment’s value doesn’t change.)

Driven by surging stock markets – which generate more capital gains for funds – the number of phantom distributions has soared. For 2017, a record of more than 300 phantom payments were declared by ETFs, up from 190 in 2016, Mr. Hill said.

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“Many investors will be in for a nasty surprise when they file their 2017 tax returns this April” and have to pay tax on these non-cash distributions, he said.

If you hold your ETF units in a registered account, there’s nothing to worry about because distributions – phantom or otherwise – aren’t taxable. But in a non-registered account, tracking phantom distributions is essential. Otherwise, you could end up paying tax, not just on the distribution itself, but again when you sell your ETF units.

When a fund makes a reinvested distribution, it is effectively taking your money – which is already subject to tax – and plowing it back into the fund. From a tax perspective, it’s as if you are investing new cash. To recognize this – and to avoid getting taxed twice – you must increase the adjusted cost base of your investment by the amount of the reinvested distribution. This will reduce the capital gain that you will ultimately face when you dispose of your units.

“Many investors pay tax twice … because they do not understand phantom distributions,” said Mr. Hill, whose web-based service (acbtracking.ca) calculates, for a fee, the ACB for ETFs, closed-end funds, split shares and other investments.

To illustrate the importance of tracking phantom distributions, he cites the currency-hedged iShares Core S&P 500 Index ETF (XSP). An investor who bought 1,000 units in October, 2006, and sold them in January, 2018, would have had an apparent capital gain of $15,000. But the actual capital gain, taking into account phantom distributions, would have been $10,137. The difference in tax for someone at Ontario’s top marginal rate: about $1,300.

ACB Tracking includes phantom distributions in its calculations, but you can look them up yourself on the ETF company’s website. For iShares funds, look under Tools and Resources, Tax Information Centre and 2017 Distribution Characteristics. To find the phantom distribution, if any, for a particular ETF, look under the column with the heading Reinvested Distribution Per Unit.

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Having to pay tax on phantom distributions is bad enough. Don’t make the mistake of paying tax a second time.

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