Few tax surprises this year
December's arrival conjures up images of a jolly, bearded man dispensing gifts to children around the world. This season also brings to mind gifts handed out to many adults that make them a little less jolly - fat mutual fund distributions. At the end of each year, investors have their ears and eyes peeled for estimates of big mutual fund distributions. Most every year, mutual funds flow out taxable income to unitholders, regardless of how long they've been invested or how much money unitholders have actually been made. In a tough year like 2001, there are many examples of funds expecting distributions that are significantly higher than the returns they've handed investors.
Why mutual funds distribute income
Most mutual funds are legally set up as trusts. Think of a mutual fund trust as a regular taxpayer, just like you and me. When we sell stocks at a profit, get interest from bonds, or receive dividends from our Canadian stocks, we must pay tax on that income. So is the case with mutual funds.
Unlike the progressive scale of tax rates that applies to regular taxpayers, mutual funds are always taxed at the highest marginal tax rate. If a mutual fund realizes income, it must flow all of it through to unitholders to avoid paying tax at the trust level.
In other words, unitholders pay the tax personally so that the trust doesn't have to. And since no individual will ever have a tax rate that exceeds the trust, it's more beneficial to pay it out.
Distributions can exceed returns
One of the most common questions I hear is: How can a fund pay out a distribution that is larger than my return? I know it sounds counterintuitive, but it's a fact. Let's say a fund buys a stock, its sole holding, at $20. After three years, the stock rises to $35, taking the fund' s unit price along for the ride - at which point you buy some units of the fund. The stock subsequently drops to $30, causing the fund manager to sell and take profits.
The fund realizes a gain since it bought the stock at $20 and sold at $30. Since you bought in at a higher point, the fund went down in value - resulting in a paper loss for you. However, since the fund realized a gain, it must distribute it to you and other unitholders.
That simplistic example doesn't get into the factors that can influence the actual distribution that must be paid out to unitholders. For instance, a set of tax provisions knows as the Capital Gains Refund Mechanism (CGRM) benefits many mutual funds by helping to minimize taxable distributions. Hence, while there are some tax inefficiencies with any type of pooled investment, it's not as bad as my brief illustration above.
Knowing when and if to take action
Very basically, investors who expect their share of the income distribution to be larger than the dollar amount of their untaxed, or paper, gain may want to think seriously about taking action to avoid the expected income distribution.
Those sitting on a paper gain that is less than the expected distribution can save taxes this year by simply selling prior to the distribution record date and buying back in immediately after the payout. Suppose Joe is sitting on a paper gain of 2 per cent but expects a distribution of 7 per cent. If he does nothing, he'll have a gain equal to 7 per cent of his holding to report on his tax return next April. Rather, if he sells his fund early enough to avoid the distribution and buys back in afterwards, he'll only have to report a gain of 2 per cent.
While the decision of whether or not to take action will be much easier for those sitting on paper losses, these investors will have to be a bit more careful in the steps they take. Revisit my recent articles on capital loss planning and avoiding superficial losses to give you an idea of how to proceed.
If your paper gain is larger than the expected distribution, it's probably best to simply sit tight and pay the taxes on gains that come with accumulating wealth. A nice problem to have, some would say.
I currently have distribution estimates for well over a hundred different funds. While I have yet to receive estimates from some of the larger companies, like CI, estimates on some of Canada's most popular funds may surprise you.
One of the larger surprises this year may be the Maxxum Natural Resources fund. It has a return of under 2 per cent year-to-date (YTD) to November 28, 2001 but is expecting a distribution equal to more than 11 per cent of its recent net asset value (i.e. unit price).
AGF Latin America is shaping up to be the worst offender of 2001. It has dropped in value by 19 per cent YTD, yet AGF estimates that unitholders will get a kick in the pants, a distribution that is, equal to nearly 7 per cent of its net asset value. This can be largely explained by the recent change of managers. Patricia Perez-Coutts (formerly of Trimark Americas fund) replaced Peter Gruber of Globeinvest, long considered the father of Latin investing. However, Gruber's inconsistent relative performance and long-time bias toward Brazil lead AGF to make a change. While I view the change as a positive one, there may be some short-term tax pain for those who get hit with the upcoming distribution.
Royal Premium U.S. Index fund has lost close to 8 per cent of investors' money this year, but is expecting a distribution equal to about 4 per cent of its net asset value.
AGF World Opportunities has lost nearly 2 per cent YTD, but is expecting a distribution close to 7 per cent of its recent net asset value.
The very popular AGF International Value has fallen by about 2 per cent YTD, but is expecting a distribution equal to about 6 per cent of its net asset value.
Cundill Recovery C has returned 3.5 per cent year-to-date (YTD) to November 28, but is expecting a distribution of about 12 per cent of its unit price.
Bissett Microcap A and F class shares have given investors a YTD total rate of return of about 9 and 10 per cent. However, both funds are expecting distributions amounting to just over 11 per cent of net assets. In this case, it may not be worth moving, unless your personal experience is much different than the YTD figures.
Trimark Canadian Endeavour (formerly RSP Equity) has had rather flat performance so far this year. While that's quite an accomplishment in this sagging market, it pales by comparison to the distribution that is expected on this fund - nearly 7 per cent of its recent unit price.
About three dozen funds are expecting distributions of 4 per cent or higher. Less than five of those mutual funds are expecting distributions equal to more than 10 per cent of net assets. This is in sharp contrast to most of the past several years, when there is usually a long line of funds ready to greet investors with a fat taxable gain.
Make personalized decisions
Most investors probably prefer to find a lump of coal under the tree this time of year than an extra tax bill in a money-losing year, but that doesn't mean it's inevitable. While you can't stop a fund from paying a distribution, you may be able to take steps to avoid, or lessen, the tax hit you take personally. A little heightened awareness on upcoming distributions (which will start being paid in less than two weeks) and savvy tax planning can save you a bundle. And, as always, get advice from a qualified advisor prior to taking any action.
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 email@example.com
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