Tax implications of index funds

Q – If I buy into an equity index fund that has unrealized capital gains, am I correct in assuming that the unrealized capital gains tax implication is not worrisome because when and/or if a stock is dropped from the index it typically would have to have depreciated from the original purchase price?

What about the concern if there are lots of redemptions; wouldn’t the fund manager than have to sell some potentially appreciated stocks to re-balance? – D.A.

A – First, there are no “unrealized capital gains tax implications” in any equity fund, of any type. No taxes are payable on unrealized gains. Only when a stock is sold at a profit within the portfolio does this apply.

Second, a stock being dropped from an index doesn’t necessarily mean it has declined in value. Take-overs and mergers are another reason. Many companies have vanished from the TSE 300 in recent years because they were bought out by another firm, usually at a premium price. A company could also be dropped from an index because of a listing change. For example, there have been cases of Canadian firms moving head offices to the U.S. and switcng their listing to the NYSE or Nasdaq.

In the case of large-scale redemptions, yes an index fund manager might have to sell stocks at a profit to meet cash requirements and that could trigger a taxable event. However, the stocks would be sold across the board, in line with their index weighting, to maintain the proper portfolio balance. So there would be losers as well as winners involved. Capital losses are subtracted from capital gains, and only net capital gains after expenses are distributed to unitholders and subject to tax. – G.P.