How Exchange Traded Funds are TaxedExchange Traded Funds (ETFs) continue to gain in popularity for a number of reasons. These can include their low cost and convenience. The manner in which they are taxed may also become an important consideration for investors in the future. This article outlines some common questions you may have about the taxation of Canadian listed ETFs1. First, let’s review some tax basics as they pertain to ETFs:

How Exchange Traded Funds are Taxed PAGE 2

Tax basics

Capital GainsCapital gains tax is a tax which applies to the profits earned on the sale of an investment. The profit is the amount the investment has increased in value compared to the adjusted cost base (see Book Value), and is determined at the time of sale, not while it is held by the investor. In Canada, generally, tax payers only pay tax on 50% of any capital gains calculated while capital losses can be carried forward to future years to offset capital gains earned in the future.

DividendsDividends are a periodic payment to a shareholder from corporate earnings that have already been taxed. To avoid double taxation, dividend tax credits are intended to compensate individual shareholders for income tax paid by Canadian companies in which they have invested. An enhanced gross-up and dividend tax credit is available for “eligible dividends” designated as such by a taxable Canadian corporation in accordance with the Tax Act. The end result to the taxpayer is that eligible dividend income is generally taxed at a lower rate than regular income due to the mechanism of dividend tax credit.

Foreign Income and Foreign TaxIncome earned outside of Canada is classified as foreign income. Many countries have withholding taxes that get deducted before a Canadian investor would receive a payment from a foreign investment.This results in foreign tax paid.

Other IncomeEarnings not classified as capital gains, dividends or foreign income are classified as other income. For example, interest from a bond (or bond ETF) would be classified as other income.

Return of CapitalSometimes an ETF may pay investors distributions that make up more than the taxable income earned by the ETF. In this scenario the amount of the distribution that exceeds the ETF’s taxable income is classified as return of capital. Put another way, the fund is giving the investor their money back. This distribution is not taxed but results in a decrease in the investors book value.

Book ValueMost brokerages will show the book value of an investment online and in their client statements. Book value is also known as an investor’s Adjusted Cost Base. It shows the average cost of the investor’s investment. For example, if you purchased 10 units of an ETF @ $100 (10 x $100 = $1,000) and then a week later purchased an additional 10 units of the same ETF at $90 (10 x $90 = $900) your book value is $1,900 ($1000 + $900) or $95 for each unit ($1900 / 20). Book value is used for calculating your capital gains (or losses) when you sell your investment.

How do ETFs pass taxes on to unitholders?ETFs pass taxes on to investors in the form of distributions of capital gains, dividends and income. While a return of capital is considered a non-taxable event (it is not considered a dividend or capital gain distribution), it will impact the investors book value and therefore will affect the calculation of capital gains or losses of the investor when their units are sold. A return of capital effectively reduces the tax basis of the investment and is the result of a fund returning a portion of the investor’s original investment.

What taxes might you pay (if held in a non-registered, taxable account)?If the ETF investment is held in a taxable account, you will receive a tax slip for distributions received during that tax year. If you sell units of an ETF, you may receive a tax form or report from your broker detailing the

1Should you have any questions regarding potential tax implications relating to ETFs, please consult your tax advisor.The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. Commissions, management fees and expenses all may be associated with mutual fund and/or exchange-traded fund (“ETF”) investments (collectively, “the Funds”). Trailing commissions may be associated with mutual fund investments. ETF units are bought and sold at market price on a stock exchange and brokerage commissions will reduce returns. Please read the fund facts or summary documents and the prospectus, which contain detailed investment information, before investing in the Funds. The Funds are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer and are not guaranteed or insured. Their values change frequently. There can be no assurances that a money market fund will be able to maintain its net asset value per unit at a constant amount or that the full amount of your investment will be returned to you. Past performance may not be repeated. TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank. All trademarks are the property of their respective owners. ® The TD logo and other trade-marks are the property of The Toronto-Dominion Bank.

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proceeds of the sale. Some brokers may provide details of the gains or losses based on the book value they have on record at their firm while others leave this to investors to calculate.

How your capital gains/(losses) are calculated?Capital gains/(losses) in Canada are determined using average cost basis (book value), which is usually provided by your broker on your statements. The difference between your average cost and the price the ETF is sold at is your capital gain/(loss).

Why are ETFs touted as being tax efficient vs. traditional mutual funds?The efficiency of ETFs generally refers to the taxable activity that occurs within the ETF compared to a traditional mutual fund. Buys and sells typically happen between investors on the exchange – no taxable activity occurs within the ETF itself. In contrast to this, investors buying or selling a traditional mutual fund do this directly with the fund which may result in the fund having to either buy or sell underlying investments each day investors transact. This can result in more taxable activity in a traditional mutual fund than an ETF.

Another way ETFs may be more tax efficient than traditional mutual funds is based on their investment objectives. The majority of ETFs in Canada are based on tracking an underlying index while the majority of traditional mutual funds are actively managed. By nature, most index strategies tend to have lower turnover than active strategies which will result in less taxable activity within the fund that would be distributed to unit holders.

Where to find information on the tax situation for a particular ETF?For detailed information on the tax situation of a particular ETF, please refer to the ETF prospectus, your financial statements, or the Management Reports of Fund Performance (MRFP).

There are a number of tax considerations which are not covered above. For further information, please speak with your tax advisor.