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Can you explain why my broker raised the adjusted cost base of my iShares Core S&P 500 Index ETF (XSP) units recently? I know it relates to a distribution from the ETF, but I’m concerned because I did not receive any cash, and the higher ACB caused the unrealized gain I had to evaporate. As a small retail investor, I am baffled.

What we have here is a case of a reinvested or “phantom” distribution, and I can assure the reader that many investors are just as baffled as he is by these non-cash payouts.

If you invest in exchange-traded funds, chances are you have already encountered a phantom distribution – or soon will. In 2020, more than 200 Canadian ETFs declared these under-the-radar distributions.

“It really has become a big issue over the past couple of years,” said Lea Hill, president of ACB Tracking Inc., a company that provides adjusted cost-base calculations for a fee. “Experience tells us that most investors, and/or their accountants, do not fully grasp the tax implications of phantom distributions received over the time they have held their positions.”

Let’s try to demystify the topic, using XSP as an example.

According to the iShares website, on Dec. 22 XSP declared a total distribution of $1.92382 per unit, of which 26.792 cents was paid in cash. The rest – $1.65590 – was classified as a reinvested distribution. (ETF providers typically publish estimates of reinvested distributions for each of their ETFs in the fall, with final numbers at the end of the year.)

So if that $1.65590 wasn’t paid in cash, what did the investor get exactly?

Answer: a tax liability.

Throughout the year, ETFs buy and sell securities. This triggers capital gains and capital losses, which the ETF tallies up at the end of the year. If the net result is a capital gain, the ETF distributes it to unitholders for tax purposes – but on paper only.

The mechanics of how the ETF does this are a bit complicated, but the key thing to understand is that the unitholder, in effect, receives a distribution that is immediately reinvested in the fund. After this paper transaction the investor still has the same number of ETF units, trading at the same price, as before the reinvested distribution.

In the case of XSP, if you refer to the “2020 Distribution Characteristics” for iShares ETFs published on the BlackRock Canada website (look under “Resources” and “Tax Information Centre”), you’ll notice that XSP’s reinvested distribution of $1.65590 exactly matches the ETF’s total capital gains distribution for the year.

For the unitholder, the reinvested capital gain will be reported on a T3 slip and taxed in his or her hands. To recognize that tax has been paid, the unitholder must then increase the ACB of the units by the amount of the reinvested distribution. Failing to do so could result in the investor paying more tax than necessary when the units are eventually sold.

Some brokers adjust “book value” or “average cost” figures to account for reinvested distributions. But my advice is to double check the broker’s numbers.

Keep in mind, too, that brokers who adjust book values may not get around to doing so until several months after the year-end distribution was declared. An investor who sells during that window might make the mistake of using the unadjusted ACB, Mr. Hill said.

“Thus, the investor would pay tax on the amount of the phantom distribution twice – once … through the T3 received, and again by failure to increase the adjusted cost base, upon [the ETF’s] sale,” he said.

As for the reader’s concern that the increase in his ACB eliminated the unrealized gain that was previously shown on his statement, that is true – but only for tax purposes. Bumping up the ACB didn’t actually change the original price he paid for his units; all it did was increase his cost on paper, which will reduce the capital gain (or increase the capital loss) he will have to report when he eventually sells his units.

I have been holding a high-yielding mutual fund in my non-registered account for more than 10 years. Approximately 80 per cent of the monthly distribution is return of capital. I have been reducing my adjusted cost base every year when I receive my T3. Eventually the ACB will reach zero. What will happen then? How will I report this on my tax return?

Unlike a reinvested distribution, which increases the investor’s ACB, a return of capital reduces the ACB. When the ACB reaches zero, any amount of ROC beyond that is treated as a capital gain for tax purposes.

For example, say your total ACB is $100 and you receive a ROC distribution of $150. To report this on your tax return, you would enter negative $50 for the “adjusted cost base” and zero for “proceeds of disposition.” The difference – zero minus negative $50 (which is the same as zero plus $50 because you’re subtracting a negative number) – equals your capital gain of $50. The ACB then resets to zero.

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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