Apart from their low fees, exchange-traded funds (ETFs) have attracted widespread interest because of their supposed tax efficiency.

As passive investment products, ETFs have a reputation for low portfolio turnover, which means distributions of capital gains should be at a minimum.

For non-registered portfolios, capital gains taxes can be minimized by taking a long-term buy and hold approach. As with stocks held directly or regular equity mutual funds, capital gains taxes bite hard only when a profit is realized.

However, this does not mean zero capital gains taxes outside registered retirement savings plans. Even without taking a profit, ETFs will generate a certain amount of taxable activity, just as any mutual fund trusts do (not just equity funds). There is a distinction between capital gains realized by the investor and gains realized internally by the fund and passed on annually to unitholders in the form of capital gains distributions.

Certain types of foreign ETFs are generating higher than expected taxable events for Canadian clients, according to a Toronto-based investment counsellor that uses ETFs to build client portfolios.

Milestone Investment Counsel Inc. has been using ETFs for five years to gain access to global equity markets in a cost- and tax-effective manner, says partner Paul Mitchell. But some of the firm's clients have been getting tax slips for 2000 with unexpectedly high distributions, he says.

"Although we think many benefits continue to exist with these products, we have recently become less impressed with their tax efficiencies, particularly non-North American ETFs trading on foreign exchanges," Mitchell says.

So while the U.S.-based Standard & Poor's depositary receipts (Spiders) have annual distributions of 1%, some European ETFs are passing on distributions that exceed 10% of the share price.

Barclays Global Investors' annual report for the year ended Aug. 31, 2000, states the average turnover rate for its iShares (formerly WEBS) was more than 40%. The reasons: merger and acquisition activity (particularly in Europe), corporate spinoffs (similar to BCE's disposition of Nortel Networks) and the fact these products are restricted from owning more than 25% in any given security. The spectacular appreciation of companies like Sweden's Ericsson last year forced Barclays to pare back these positions, resulting in higher turnover.

Distributions of U.S. ETFs are usually lower than their global counterparts and present less of a tax problem to the non-registered portfolios of Canadian investors. Mitchell attributes this to the greater diversification within their portfolios.

Even here, though, U.S. ETFs that focus on small-caps or mid-cap stocks may incur extra trading when a stock moves categories.

The bigger problem for Canadian investors is that capital gains distributions from foreign ETFs are taxed as foreign income, Mitchell says. Relative to Canadian equity investments (including mutual funds) the tax penalty is therefore high, since income is more punitively taxed than capital gains.

Steve Rive, Barclays Global Investors Canada general manager for iUnits, concedes this but says it applies to any foreign trust, not just ETFs.

ETFs trading on Canadian exchanges (such as the Barclays XIUs or Dow Jones 40s) do not have the same tax problems as they are considered Canadian trusts for the purposes of capital gains, interest and dividends, Rive says.

However, the Nortel situation could crop up in the five Canadian equity ETFs that now exist in the market (two from Barclays, one from State Street and, as of last week, two from TD). Two of those funds are "capped" products that may necessitate trading in order to stay within the 10% maximum exposure to any one security. However, Rive says, because they are Canadian trusts, any gains will retain their character as capital gains for unitholders, whereas gains in U.S. trusts would be treated as income.

Some people think Barclays Canada may d