Taxes and mutual funds
A guide to ensure proper tax reporting
Financial institutions are busy issuing what many investors dread this time of year - T3 and T5 slips. While reporting income from these T-slips is pretty straightforward, it's easy to miss things all taxpayers are required to report. Also, there are ways to reduce taxes resulting from your investment activities that some may forget about. Reporting your activities right the first time will save lots of headaches later.
Many people assume that all they need to report on their tax returns for their investments is reflected on their T-slips. However, that's a bad assumption. In the context of mutual funds, T3 and T5 slips report only taxable income that was distributed to investors, even if the distributions were reinvested. If you own stocks, you'll get a T5 slip only if you received a dividend of some kind.
If you sold any of your stocks or mutual fund units, you will have to report this activity separately because it won't be reflected anywhere on the T-slips. You'll need the following information for proper reporting: how many shares or units sold; the total proceeds received from the sale; any costs incurred to sell them (i.e. brokerage fees); and your adjusted cost base (ACB). The calculation of that latter term is what causes many people to report erroneous information.
However, if the ACB is incorrectly calculated, more taxes may be paid than necessary.
The ABCs of ACB
Generally speaking, the ACB of an investment is calculated as:
(1) total of all purchases + total of all transaction costs + reinvested distributions
If you sold only a portion of your investment holdings, you'll need to calculate the ACB on a per unit basis. Hence, take the ACB calculation, in formula (1) above, and divide it by:
(2) total units purchased + total units acquired by reinvesting distributions
Hence, ACB per unit = (1) / (2)
Since ACB is the average "acquisition" cost, only purchases are included in the calculation - i.e. only include dollar and unit amounts for purchase transactions. The only time you use "sell" transactions is when you are calculating a capital gain or loss.
To determine the total ACB of the units sold, you simply take ACB per unit and multiply it by the number of units sold.
To calculate your capital gain or loss:
(3) total proceeds from the sale - transaction costs - total ACB
Let's take a look at an example.
A numerical example
Sandra had activity in two investments - shares of Acme Corp. and units in XYZ Aggressive Equity fund.
Sandra first purchased 500 shares of Acme Corp. in 1996 for $15 per share ($7,500). In 1998, she bough another 200 shares at $20 per share ($4,000); and another 300 shares in 2000 at $18 per share ($5,400). In 2001, Sandra sold 400 shares at $28 per share. Each buy and sell cost Sandra $30.
First, let's calculate the ACB of Acme Corp. shares. Sandra purchased a total of 1,000 shares of Acme Corp. for a total cost of $16,900. Since they were acquired with three purchases, transaction costs came to $90. Hence, the ACB of Sandra's stock comes to $16,990 ($16,900 + $90). Since 1,000 shares were acquired in the process, her ACB per unit on the shares is $16.99 ($16,990 / 1,000 shares).
Sandra's 2001 sale of 400 shares resulted in proceeds of $11,200 (400 x $18). Hence Sandra's capital gain on this sale was:
$11,200 - $30 - ($16.99 x 400) = $4,374
Recall that the taxable portion of capital gains has changed often over the years. Currently, only half of net capital gains are taxable.
Sandra first invested $4,000 into units of XYZ Aggressive Equity in early 1999 at a price of $11 (363.636 units) . Nine months later the fund took off and Sandra decided to keep pouring the money in - so she invested another $10,000 at a unit price of $24 (416.667 units). At the end of 1999, the fund paid out a taxable distribution of $2,000, which was reinvested into more units at the year-end price of $30 (66.667 units). At mid-2000, Sandra sold $3,000 of this fund at $32 (93.75 units) since the fund had lots of tech stocks and things were looking rocky. She didn't sell any more units of the fund until October 2001, when the fund had tumbled all the way down to $8 per unit, at which point Sandra sold $7,000 (875 units). She never paid any sales charges or other transaction costs.
Let's look at Sandra's ACB, step by step. Before she sold some shares in 2000, her ACB per unit would have been:
($4,000 + $10,000 + $2,000) / (363.636 + 416.667 + 66.667)
= $16,000 / 846.97 units
= $18.89 per unit
When Sandra sold some units in 2000, her gain would have been:
$3,000 - ($18.89 x 66.667 units) = $1,740.66
Remember that even though units were sold, the "per unit" ACB figure doesn't change - that's only affected by additional purchases or reinvested distributions. So, her ACB per unit remained at $18.89 going into 2001.
Sandra's sale of $7,000 was done at a loss, calculated as:
$7,000 - ($18.89 x 875 units) = a capital loss of $9,528.75
In summary, Sandra's stock gains totalled $4,374, while her losses totalled $9,528.75. Assuming this represents all of her capital gains and losses for 2001, she will report a net capital loss of $5,154.75 for the year.
This loss can be carried back to offset gains in any of the previous three taxation years; or kept for indefinite carryforward to use against future gains.
In this November article I discussed some issues surrounding capital loss planning.
February 22, 1994
Until 1994, Canadians could realize capital gains (just like Sandra did with her Acme stock) and not pay tax on the first $100,000 of gains over each person's lifetime (i.e. the general capital gains exemption). However, on February 22, 1994 (the budget date on which Paul Martin announced the rule change), that tax benefit became part of history. The change in rules did allow people to lock in capital gains up to that date (even if it was just on paper) so that they could take advantage of the rule before if was officially phased out.
Investors holding stocks before that date could effectively have their ACBs "bumped up", which would reduce the capital gain, or increase the loss, when the shares were ultimately sold.
Holders of investment funds were treated a bit differently. When gains were crystallized for mutual, segregated, or any type of pooled investment fund (known as flow-through entities), the ACB of these units didn't get bumped up like they did for stocks. Rather, a "pool" of exempt capital gains was created for each fund for which gains were crystallized. You could use a fund's exempt gains balance to offset only capital gains (either from distributions or from selling units) of that same fund. But investors were given only ten years during which to use up that pool, which means you must "use it or lose it" by the year 2004.
Taxes can be a real headache, but I hope these tips will better help you prepare your taxes - or at least help you get more organized when you deliver your pile of papers to your tax preparer. It's also worth noting that although I've tried to highlight the important points on mutual fund taxation (and ensure their accuracy), there may be things I've overlooked that apply to some of you. Hence, it's always a good idea to seek the advice of a real pro when it comes to taxation.
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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