Some funds may surprise
It's time again to keep your eyes peeled for expected distributions. While it's often noted that paying tax on gains in which an investor did not participate is not ideal, it isn't double taxation. Rather, it's a prepayment of tax - i.e. a timing issue. That said, there is no reason to sit there and take a distribution that you know is coming when a bit of tax planning and careful manoeuvres can save a few loonies at tax time.
Canadian small caps
As it did last year, Bissett Microcap (both A and F classes) expects to distribute capital gains in proportion equal to its total return for the year. Its expected 10.2 percent distribution is about the same as the year-to-date (through October 30) return of the F class, and a full percentage point higher than the YTD return for A class units. However, these funds are closed to new investors to selling to avoid a distribution will preclude a repurchase.
Relatively few companies release estimates of year-end distributions so a quick quant screen may be able to filter out potential tax-offenders. For Canadian small cap funds, I searched for funds with strong YTD performance in addition to annualized returns of 10 percent or more over the past few years. Further searching the resulting short list for funds with typically high turnover reveals a list of 18 funds with potential to pay out substantial capital gains over the next few weeks.
The biggest funds and best performers of that list include: Acuity Pooled Small Cap, Norrep Fund (I and II), National Bank Small Capitalization, Maritime Life Canadian Growth, and ING Canadian Small Cap.
Many hard asset funds have posted awesome performance - particularly fund with heavy weightings in basic materials and precious metals stocks. Hence, despite the potential for big distributions, investors' paper gains may be larger making the taxable distribution less painful than actually crystallizing paper gains. Plus, many precious metals funds may still have losses to carry forward to 2003 to offset at least part of realized gains in the year - which is exactly how many avoided big payouts over the last couple of years.
While I'm not aware of any such funds planning fat distributions, investors in funds from the following firms may want to inquire further: Dynamic, Sprott, Altamira, RBC, AGF, and CIBC.
BPI Global Opportunities funds expect to distribute capital gains equal to 2 to 3 percent of recent unit prices. While not a large percentage, many investors bought one of the various versions of this fund at much higher levels and have experienced significant losses. Hence, investors still sitting on paper losses for this fund may want to consider steps to sidestep even the smallest taxable distribution.
Avoiding distributions and superficial losses
For many investors, the most sensible course of action will be to just sit tight, and take the distributions. Investors should only consider taking action if the cost of selling is less than the tax avoided by skirting the distribution. Costs of selling come in two forms - direct and indirect.
Direct costs are more obvious: realized gains and potential sales charges or other transaction costs. Indirect costs refer to opportunity costs. That' s the cost of sitting out of a fund for any length of time - potentially missing out on any rise in price while on the sidelines.
Investors sitting on paper gains that are smaller than the expected distribution can simply sell out of the fund prior to the payout; then immediately buy back in after the distribution has been paid. You're out of a fund for the better part of a week but avoid the distribution.
For those in a loss position looking to avoid a distribution, more care must be taken. There is a 61-day period of which to be aware - 30 days before the sale date and 30 days after the sale date. During that period, neither the investor, the investor's spouse, nor a corporation controlled by either:
- can make purchases in the security in question at any time during the period; or
- own the security (or a right to buy such security) at the end of the period.
While you also can't buy what tax laws consider "identical property", there are ways to avoid distributions while maintaining portfolio exposure. Switching to other similar funds within a family can achieve the twofold objective of covering the opportunity cost of being out of a fund and avoiding the tax hit resulting from a distribution.
For instance, those wanting to avoid the distribution on BPI Global Opportunities may consider simply investing in BPI Global Equity (which is managed by the same team and not expecting a distribution). Much of the same (though not identical) exposure is maintained, with a nearly identical style - all while allowing the investor to make a tax-friendly move.
Recall that a disposition occurs on a trade's settlement date (not trade date) because that's the day that investors are entitled to receive the proceeds. Hence, switching within the same family is ideal since the switch settles on the same day - so you're never completely out of the market and less time is required to implement the strategy.
To demonstrate the identical property rule, Trimark Fund SC and Trimark Fund DSC would be considered "identical" for tax purposes because they are technically the same fund. Even though the same team manages Trimark Select Growth with the same objectives, it is technically a different fund - and that should make it different enough to avoid getting caught by the superficial loss rules.
The above examples should work whether the investor faces a gain or loss - but it's most important for making sure the superficial losses don't kick in when implementing such manoeuvres.
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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