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Mutual Funds' December Tax Bite
Year-end distributions could leave you in the cold

December is typically the season for gift-giving and hearty holiday meals. However, mutual fund investors know this month for another regular occurrence that's not so jolly - fund distributions. Investment funds that have realized gains throughout the year pay out income distributions to fund unitholders. The problem: the distribution is paid out regardless of how long you've been invested or how much money you've made. Based on the recent weakness in many pockets of the market, some investors may have "paper losses" just as some funds are poised to pay out fat taxable distributions. That kind of "gift" is hard to swallow for most investors.

Distributions explained

Depending on the securities held in a particular fund, it likely has some interest income, some dividends, and probably some capital gains as a result of the fund's activities. A capital gain is basically the profit made when selling a holding for more than its cost. Such gains, along with interest and dividends make up the total of the fund's taxable income for the year. Mutual funds generally pay out all of this income (net of expenses) to its unitholders on record as of a specified date (i.e. record date). Unitholders then must claim this income (according to the T3 slip) on their annual tax return. If this income is not paid out, it would become taxable to the fund - where a heavier tax rate would likely apply. (There are some complex tax laws that sometimes allow a fund to pay out less than its net income, keeping the remainder in the fund without attracting taxes.)

Tax inefficiency

All pooled investment products (like mutual funds, segregated funds, exchange traded funds, etc.) have a built-in tax inefficiency. Essentially, you could end up paying the tax bill on gains in which you didn't participate during the time invested. While it's not double taxation per se, distributions often result in a prepayment of taxes. To illustrate this point, let's consider a hypothetical fund that holds $1 million in assets at the end of 2000. Also suppose:

  • the fund rises in price over the past five years from $5 to $10 per unit, thanks to the rise in price of its stock holdings; and
  • you made a $1,000 investment - 100 units or 0.1% of the fund - before year's end.

    During 2000, let's say the fund had sold all of its stocks - realizing a gain of $5 per unit. The fund must then pay out that gain of $5 per unit, which equates to $500 for your account ($5 x 100 units) or an additional 100 units if reinvested.

    The bottom line here is that you invest 100 units at $10 each ($1,000). Also recall that upon paying a distribution of income, the fund's assets decrease by that same amount since the fund is actually paying out cash. At the end of the year, you're left with 200 units at $5 each ($1,000) and additional taxable income of $500. In other words, you've prepaid a good chunk in taxes and your total value is still anchored at $1,000. While that's not a great position to be in, imagine if you were actually down on your investment and the fund still paid out a big fat taxable distribution. Talk about a kick in the pants.

    Some of this year's tax-unfriendly funds

    The year 2000 has presented an ideal environment for big distributions, regardless of returns. For the past two years, technology has been leading movements in the markets all over the world - both up and down. From late 1998 to March of 2000, technology stocks (and the NASDAQ) ascended at full speed with few interruptions. Since March, tech stocks have been on a roller coaster ride that would cause even the most adventurous to get a little dizzy. Many portfolio managers whose funds had benefitted from the tech run began trimming exposure to the volatile sector in the second quarter (between March and June). That meant taking big profits on some stocks while the sector saw steep losses during the remainder of the year - at least so far. Here are a few funds that you should either not buy until after its distributions or that might be good selling candidates in your year-end tax planning.

    Dynamic Quibec

    This fund, run by Jon Goodman and Ed Ho of Goodman and Company, aims to capitalize on underpriced securities that are likely to benefit from Quibec's economic growth. However, this month there won't be anything pretty about this fund. On a year-to-date basis (to November 30), the fund is down nearly 6 per cent - well below most Canadian stock funds. The kicker, however, is the expected distribution of $3.47 per unit - more than 35 per cent of the fund's unit price.

    AGF Canadian Aggressive Equity

    This aggressive small-to-mid cap fund is down more than 10 per cent on so far this year but investors who remain in the fund for its rich $1.75 per unit distribution might make the Grinch look like a jolly fellow. That estimated distribution is equivalent to nearly 30 per cent of the current unit price.

    AGF Aggressive Growth

    One of the few actively managed US stock funds I recommend, this one focusses on medium sized stocks. Richard Driehaus runs this gem and typically looks for stocks of companies that are growing profits faster than most; whose profit projections are continually revised upward; who report growth above expectations; and who have strong upward price momentum. The unique part of Driehaus' approach is that the four momentum factors are his initial screen. He then digs deeper into each potential name, carefully studying companies' underlying fundamentals to determine if that momentum can be sustained.

    While I love this fund for the aggressive portion of some portfolios, Driehaus trades pretty frequently and almost always generates big capital gains to be distributed to his unitholders. At the peak of the tech euphoria, Driehaus had nearly three quarters of this fund's assets in technology. During the spring of this year, he trimmed that down to below half. That's still substantial but he obviously sold off a lot of winners. On December 22, 2000 this fund is expected to pay out a capital gains distribution of $8.95 per unit. Based on the funds November 30 unit price of $35.49, that's more than 25 per cent of the unit price (or more than 21 per cent of the unit price at the beginning of the year). The fund has lost more than 16 per cent so far this year (to November 30) so those who bought based on his success last year, face an ugly tax bill if they remain invested.

    The three funds highlighted above are those that are projected to pay the highest distributions, as a percentage of November 30 unit prices. Four additional funds are expected to pay distributions in excess of 20 per cent of the current unit price: Fidelity Small Cap America (24 per cent), Dynamic Small Cap (23 per cent), Fidelity Canadian Large Cap (22 per cent), and Clarington Global Small Cap (21 per cent).

    Twenty-nine other funds are expected to pay distributions between 10 and 20 per cent. They're too numerous to name but the affected fund families are AGF, AIM/Trimark, Bissett, Clarington, Dynamic, Fidelity, Franklin/Templeton, Global Strategy, Mackenzie, Spectrum, Talvest. To find out if your fund is expecting a big distribution, call the fund company directly or check their web sites. All of the companies mentioned in this article have released estimates. As for other companies, the respective client services people should have the information at their fingertips, if the estimates have been prepared at all - not always the case. Alternatively, check out the web site of Rob Barfuss (http://204.83.206.32/keystone/news/2000dist.htm), a financial planner with TWC Financial Corp. in Lethbridge Alberta, who generously posts distribution estimates for his clients and the general public.

    Tax avoidance strategies

    If you want to try to avoid the pending taxable distributions on some of your holdings, you must proceed with caution to ensure you make tax-smart decisions and implement properly. Things like superficial losses can throw your tax strategies for a loop if you're not careful. Check back here next week to find out if you should try to sidestep expected distributions, and how to go about it.

    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 dha@danhallett.com
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