Canadian taxation of Vanguard ETF conversions

Someone recently asked me about the Canadian tax consequences of converting Vanguard’s US mutual fund shares into ETF shares — for example, VTSAX to VTI. It appears, subject to certain assumptions, that a Canadian resident may perform this type of conversion on a tax-deferred basis, relying on section 51 of the Income Tax Act.^[1]RSC 1985, c. 1 (5th Supp.), as amended (herein “ITA”). Analysis in support of this conclusion follows below.

VTSAX and VTI are the Admiral Share Class and ETF Share Class, respectively, of a single fund, namely the Vanguard Total Stock Market Index Fund.^[2]See Prospectus, Vanguard U.S. Stock Index Large-Capitalization Funds, Admiral Shares (Apr 29, 2025) (herein “Admiral Shares Prospectus”) and Prospectus, Vanguard U.S. Stock ETFs (Apr 29, 2025) (herein “ETF Shares Prospectus”). VTI trades on the NYSE Arca exchange. The legal structure of the fund is essentially as follows:^[3]See Vanguard Index Funds, Statement of Additional Information (Apr 29, 2025) (herein “SAI”), pp. B-1 (funds and share classes), B-2 (trust organization), B-3 (tax status), and B-25 (fund management).

• This fund is one of a series offered by Vanguard Index Funds, which is a Delaware statutory trust^[4]Delaware Code, Ch. 38. that is registered with the SEC as an open-end management investment company.
• The funds are managed and administered by The Vanguard Group, Inc., a Pennsylvania corporation that is a jointly owned subsidiary of the investment trusts.
• Each fund expects to qualify as a regulated investment company (RIC) under Subchapter M of the Internal Revenue Code.^[5]Internal Revenue Code of 1986, as amended (herein “IRC”). This implies that the trust is a domestic corporation for US tax purposes. IRC § 851(a), (g); see also Reg. § 301.7701-4(c) (investment trust with power to vary not classified as trust under IRC).

The Admiral and ETF shares afford differing rights and privileges to the shareholder. Notably, Admiral shares may be redeemed at any time by any shareholder, whereas ETF shares may be redeemed only by authorized broker-dealers.^[6]Compare Admiral Shares Prospectus, p. 66 (Redeeming Shares), and ETF Shares Prospectus, p. 20 (“ETF Shares of the Fund cannot be directly purchased from or redeemed with the Fund, except by certain authorized broker-dealers.”) This restriction on redemption enables greater tax efficiency for the fund, which can use strategic in-kind redemptions with market makers to avoid capital gain distributions.^[7]See Jeffrey M. Colon, “Unplugging Heartbeat Trades and Reforming the Taxation of ETFs”, 2 U. Chi. Bus. L. Rev. 53 (2023). Vanguard’s statement also contemplates varying dividend rights between share classes.^[8]SAI, p. B-2: “The amount of dividends per share may vary between separate share classes of the Fund based upon differences in the net asset values of the different classes and differences in the way that expenses are allocated between share classes pursuant to a multiple class plan approved by the Fund’s board of trustees.”

However, Admiral shares include a one-way right of conversion to ETF shares. Notably, this conversion is not an exchange with a third party, but is implemented by Vanguard itself:

“Converting conventional shares to ETF Shares is generally accomplished as follows. First, after the broker notifies Vanguard of an investor‘s request to convert, Vanguard will transfer conventional shares from the investor‘s account with Vanguard to the broker‘s omnibus account with Vanguard (an account maintained by the broker on behalf of all its customers who hold conventional Vanguard fund shares through the broker). After the transfer, Vanguard’s records will reflect the broker, not the investor, as the owner of the shares. Next, the broker will instruct Vanguard to convert the appropriate number or dollar amount of conventional shares in its omnibus account to ETF Shares of equivalent value, based on the respective [net asset values] of the two share classes. The ETF Fund’s transfer agent will reflect ownership of all ETF Shares in the name of the [Depository Trust Company]. The DTC will keep track of which ETF Shares belong to the broker, and the broker, in turn, will keep track of which ETF Shares belong to its customers.”^[9]SAI, p. B-59.

This conversion is not a taxable event in the US.^[10]IRC § 1036 (nonrecognition of gain/loss upon exchange of stock for stock of the same corporation). How about Canada?

Canadian residents are subject to Canadian tax on capital gain from the disposition of property.^[11]ITA ss. 2, 3, 38, and 39. “Disposition” has a non-exhaustive definition which includes any transaction or event where a share is “redeemed, acquired, or cancelled”.^[12]ITA s. 248(1) “disposition” (b)(i).

In examining whether a disposition has occurred, the CRA considers whether there has been a change in the number of shares held by any shareholder or to the interest, rights, or privileges attached to any share.^[13]See CRA Document 2022-0933661E5 (no disposition upon replacement of share certificates to electronic records) and CRA Document 2004-0092561E5 (no disposition on exchange of shares for another class with same rights and conditions). In Document 2004-0092561E5, the CRA explains:

“The CRA’s long-standing position regarding disposition… is to emphasize the nature of the changes made to the shares of a given corporation rather than the method used to effect those changes. Our approach is based on the understanding that a shareholder’s interest in a corporation is an intangible asset, consisting of a bundle of rights and privileges attached to the shares granted by the articles of incorporation and relevant corporate laws. Therefore, a given transaction involving a given share of a given corporation held by a taxpayer might not constitute a disposition if, after the transaction, the taxpayer is left with another share of the same corporation carrying the same privileges, rights, conditions, and restrictions attached to the given share.”^[14]CRA Document 2004-0092561E5 (translated from French by Google Translate).

These principles are reinforced by IT-448 “Dispositions – Changes in Terms of Securities”, which gives examples at paragraphs 14 and 15 of changes in share terms which would or would not cause a disposition.

It appears likely that VTSAX and VTI differ sufficiently in rights and conditions for the conversion to be a “disposition” under the broad definition in s. 248(1). However, this result may be overridden by ITA section 51.

Section 51 is in Subdivision C, which governs capital gains and losses. It provides that certain exchanges of convertible property are automatically deemed not to be dispositions for most purposes. The CCH Canadian Tax Reporter Commentary introduces this provision as follows:

“Section 51 permits certain convertible securities to be exchanged for shares without creating a disposition for capital gains purposes. Property that is a share, bond, debenture or note may be exchanged, provided that the instrument contains a term which confers upon its holder the right to make the exchange for shares of the same corporation.”

Corporations can use section 51 in tax planning for changes in share rights. In particular, it has been observed that “it may be prudent… to effect material changes in share rights with an exchange of shares”, as opposed to an amendment to share terms that is not an exchange but is substantial enough to risk constituting a disposition.^[15]Will House and Katherine McDonnell, “Avoiding a Disposition on the Amendment of Share Rights and Restrictions”, 13:3 Canadian Tax Focus (Aug 2023).

A Canadian resident investor’s exercise of the conversion right in VTSAX to convert those shares to VTI appears to satisfy the statutory conditions for a section 51 rollover:

• VTSAX and VTI are shares of capital stock of the same corporation. Note that Vanguard Index Funds, which is organized in state law as a Delaware statutory trust, should be treated as a corporation for Canadian tax purposes based on the CRA’s two-step approach to foreign entity classification.^[16]CRA Document 2022-0926431C6. Unlike a common law trust, a Delaware statutory trust provides legal personhood and corporation-like liability protections.^[17]12 Del.C. § 3801(i) and § 3803. Therefore, the Canadian tax classification would proceed along similar lines to that of a Delaware LLC, LLP, or LLLP.^[18]See CRA Document 2016-0642051C6 (“We see little substantive difference between LLPs, LLLPs and LLCs governed by the laws of the states of Florida and Delaware.”)
• The investor has acquired VTI shares from the fund itself, in exchange for VTSAX shares which were capital property of the investor.^[19]It is assumed that they are not carrying on a business as a trader or dealer in securities or otherwise in circumstances such that the transaction would occur on income as opposed to capital account. See IT-479R, “Transactions in securities”, noting factors of conduct at para. 11.
• The investor received no consideration for the convertible shares, other than the new share.

Having satisfied the above conditions, a share conversion that would be a “disposition” under s. 248(1) is given rollover treatment by section 51 because it is deemed not to be a disposition for (most notably) s. 39(1)(a), which taxes gain from the “disposition of any property of the taxpayer”.^[20]See ITA s. 51(1)(c) (exchange deemed not to be a disposition of the convertible property). It continues to be a disposition in certain limited contexts, namely s. 20(21) (relating to accrued interest on prescribed debt obligations), s. 44.1(6) and (7) (relating to reinvested small business corporation shares), and s. 94(2)(m) (relating to deemed resident trusts).

Alternatively, if the conversion is not a disposition under s. 248(1) because the rights and privileges of the old and new shares are sufficiently similar, then section 51 does not apply, but the result is the same — no recognized capital gain or loss.^[21]Accord CRA Document 2023-0982781C6.

Note that fractional shares may be redeemed as cash.^[22]See SAI, p. B-59 (describing broker’s options for fractional shares given that the DTC can only handle whole shares). In this case, the section 51 rollover would apply only to the converted portion of the holding, and the redeemed portion would constitute a disposition with taxable capital gain or loss.

The CRA helpfully reassures us that this fractional residue will not cause the converted portion to fail the no-consideration test.^[23]IT-115R2, “Fractional Interest in Shares”, para. 3. In addition, if the cash payout is $200 or less, it may be handled as a reduction to the adjusted cost base of the new shares, instead of a gain or loss at the time of the exchange.^[24]Ibid.

People who move from the US to Canada may do these conversions in anticipation of an in-kind transfer to a Canadian investing account. US mutual funds are usually restricted from issuing to investors outside the US,^[25]See Jeffrey M. Colon, “Foreign Investors in U.S. Mutual Funds: The Trouble with Treaties”, 35 Va. Tax Rev. 483 (2016), note 155 (RICs “almost never registered for sale outside of the United States”). whereas US ETFs can be actively traded in Canadian brokerage accounts. If the conversion occurs subsequent to the investor’s establishing Canadian residence, the application of section 51 will be important to them.

Of course, the investor would also have a deemed acquisition or basis step-up for their investments upon becoming resident in Canada.^[26]ITA s. 128.1(1). If they’ve only recently moved, it’s unlikely that they are facing a large unrealized gain, so the impact of section 51 would be small. On the other hand, the US broker may permit holding the existing mutual fund position for an indefinite period of time after moving to Canada, so it is conceivable that a conversion to ETF will occur years later.