Taxes and funds
Mutual fund tax refresher
Each year I provide some guidance on how to handle your funds at tax time. I won't repeat my tax tutorial from a year ago. Rather, I'll refer you back to my previous installment on proper tax reporting for funds. This week, however, I'll focus on tax issues that are more timely - how to determine and treat return of capital (RoC) distributions.
Source and determination of RoC distributions
Recall that in order for investment funds to avoid a tax bill at the fund level, distributions of income are paid out annually such that any liability for tax is flowed through to fund unitholders.
The most common sources of RoC distributions are income trusts and high income mutual funds.
Income trusts - i.e. mainly royalty trusts and real estate investment trusts - pay out a RoC distribution if they benefit from special tax credits and deductions associated with the underlying business. For instance, investment tax credits and special depreciation deductions are available to energy businesses.
High income mutual funds have a RoC source of a different kind. Since they were created to spit out fat amounts of cash while attracting minimal tax, they simply pay out an amount that far exceeds the fund's income.
The first step to dealing with RoC distributions is knowing how much of your fund's distribution is made up of RoC. Easier said than done.
With one exception that I know of, it's not reported on your T3. Only Dynamic Mutual Funds actually breaks out the RoC portion of the distribution for investors - thereby making tax reporting easier.
For the rest, it's a little more effort. From your annual statement, add up all distributions you received from your trust or fund for the calendar year. Once you receive your T3 information slip, compare the two side by side.
If the total of the distributions from your statement exceeds the actual income shown on your T3; the excess is considered RoC.
Treatment for tax purposes
In short, RoC distributions are not taxable when received because tax laws consider them to be a return of your original capital, rather than some form of income.
Refer to last year's article (linked above) on how to calculate a fund's adjusted cost base (ACB). Generally, when taxable income is paid out of a fund and taken in cash, the investors is taxed on the income and the ACB of the fund units remains unchanged.
If, like most investors, the taxable distribution is reinvested, the ACB of the fund units is bumped up by the amount of the distribution that is reinvested. It's treated no differently than if the distribution had been paid out in cash, and the investor turned around and wrote a cheque to invest the same amount back into the fund. The reasoning is that tax has already been paid on the distribution so it should bump up the ACB - which is really nothing more than your cost for tax purposes.
RoC distributions, recall, are not taxable when paid out. If received in cash, the ACB of the investor's fund units will fall exactly by the amount of that part of the distribution. If, on the other hand, the RoC distribution is reinvested, the bottom line impact is "nil".
Properly tracking and reporting this stuff can be a daunting task even for knowledgeable investors. So, don't be shy about recognizing when you need help and paying for quality advice. Alternately, I hope this article, along with last year's tutorial help make the foggy world of taxes a little clearer.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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