Why phantom distributions can be scary at tax time
It doesn’t seem to matter whether taxpayers do it themselves or use the services of a professional, tax time is stressful. It’s particularly so for those with multiple sources of income and with multiple investments held in a variety of accounts.
And with the rise of exchange-traded funds (ETFs) — at the end of February there were 583 different funds with about $150 billion under management — what’s known colloquially as phantom distributions have increased taxpayers’ stress.
Those distributions differ from normal distributions in two ways. For one, while the holder receives no cash, the amount is reinvested into more units. But that constitutes a taxable event, provided the investment is held in a non-registered account. Second, those distributions increase the adjusted tax base.
“Many investors are paying tax twice on the same income receipt because they do not understand the implication of phantom distributions,” said Lea Hill, one of the founders of ACB Tracking, a company set up to allow investors to calculate the accurate adjusted cost base for income trusts, closed end funds, split shares and ETFs. ACB is important for non-registered investments.
“You have to catch the distributions,” said Hill, a former closed-end analyst with CIBC World Markets, who along with his wife Kathy and former colleague Michael Wooding, set up ACB a dozen years back.
Such distributions are more than noise. Hill, whose database contains 80,000 lines of data, said since inception there have been more than 1,400 phantom distributions — of which more than 1,100 were from ETFs. In 2017, 294 phantom payments were made with 20 per cent of them for more than $1. In 2016, there were 190 such distributions. On all those phantom distributions, the taxpayer receives a T3.
By way of example, he pointed to the iShares Core S&P 500 Index ETF, a fund that Hill owns. Since October 2006, the fund (XSP/TSX) has made 22 regular distributions and six phantom distributions.
The phantom distributions are large: In 2007, $2.089 (or eight times the normal distribution) per unit was paid out; in 2017 $1.594 per unit, or six times the normal distribution, was received.
If Hill, who bought XSP in October 2006 for $16,730, had sold his 1,000-unit holding at the end of 2017, he would have generated a capital gain of $15,070.
But when Hill uses his own website to determine the actual capital gain after adjusting for the phantom distributions, he gets a different result — a capital gain of $10,206.88. The difference between the two capital gains is $4,863.12.
“Here,” said Hill, the investor would be paying tax on gross capital gains of $4,863.12 “twice if the phantoms are not detected.”
When Hill set up ACB Tracking in 2006, income trusts were in full swing and investors had to learn, tax-wise, how to deal with distributions that included a return of capital, a tax-deferred payment that reduces the adjusted cost base.
“Investors were finding it difficult to find the information to reduce the adjusted cost base. And investors needed a way to accurately to calculate their adjusted cost base,” said Hill, whose clients then and now include investment advisers, accountants and individual investors.
To use the service, taxpayers sign up for a minimum of 10 calculations, which costs $85.
In 2006, the federal government decided to reduce the tax effectiveness of income trusts and phase in those changes over four years.
So Hill looked around for other products that were suitable for tracking the adjusted cost base. “The ETF is making our business these days,” he said.
Financial Post