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.

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.)

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:

0. 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

0. 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.

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 benefited 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.

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 Québec’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.

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.

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), Guardian Centurion Canadian Value (23 per cent), and Clarington Global Small Cap (21 per cent).

Thirty 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, Guardian, 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 excel file attached, which list distribution estimates for several funds.

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.

Investors whose paper or unrealized gain on a fund is less than the expected distribution would save themselves a few tax dollars by trying to avoid the distribution. If you’re in a gain position it’s pretty straightforward. Let’s look at an example.

Gary invested $10,000 in the Global Strategy Canadian Companies fund on December 31, 1999 – acquiring about 793 units. Unfortunately, Gary is sitting on a paltry year-to-date gain of about 1 per cent (about $100). The worst part: this fund is expected to pay a distribution of $1.41 per unit – that’s about $1,118 or more than 11 per cent of his original investment. In this case, it’s a no-brainer. Assuming Gary still wants to hold this fund, he can sell it before the December 21 record date - triggering his $100 capital gain – then buy back after the December 22 distribution. This strategy would produce a tax savings of about $200 this year – deferring that eventual tax bill to later years when he eventually sells at a likely lower tax rate.

Those in a loss position might be tempted to implement this same strategy but caution must be exercised for those investors. The Canada Customs and Revenue Agency (CCRA) doesn’t take kindly to the tax-loss selling that often takes place this time of year. In fact, they view such transactions as very superficial since many are selling for tax reasons, not because they really want to get rid of their investment. So strong are their feelings that they created tax laws to cover just this scenario.

Superficial losses result when a holding is sold at a loss, then bought back shortly thereafter. This transaction is viewed as "superficial" and, as such, the loss triggered on the sale can’t be used in the current year. Sure, it's a good idea to sell before a distribution is paid but you must proceed carefully to make sure you’re not prohibited from using the capital loss this year. If a superficial loss is triggered, the loss cannot be used in the year realized. Instead the loss is added to the holding’s adjusted cost base (ACB) to reduce any future gain or increase a loss. How is this avoided?

It is often said that you must sell and wait 30 days before buying back in to avoid a superficial loss. However, there’s more to it than that. There actually is a 61-day period, of which to be aware - 30 days on either side of the date of sale which triggers the loss. During that 61-day period, neither you nor any person affiliated with you (i.e. your spouse or a corporation controlled by you or your spouse) can purchase the security-to-be-sold, or an option to buy this security. Let’s look at another example.

On the heels of its stellar year of performance, Sandy invested $20,000 into the AGF Aggressive Growth fund (a US mid-cap stock fund) on December 31, 1999, acquiring about 472 units. Sandy is down by more than 14 per cent – roughly $2,858. We saw last week that the expected distribution on this fund is $8.95 per unit – $4,788 for Sandy. How can she avoid the distribution without triggering a superficial loss? Can she avoid the superficial loss and stay exposed to US mid-cap growth stocks? As in Gary’s situation above, I’m assuming that Sandy wants to keep this fund because she has confidence in its long-term potential. There are two strategies that Sandy can use to keep exposure to this area.

The first involves using tax-deferred accounts like RRSP and RRIF plans. Sandy can sell the fund at a $2,858 loss and put it in cash. In a separate transaction, Sandy can direct an equivalent amount of money in her RRSP to buy the same fund immediately. That allows her to use the capital loss that year while effectively keeping the position in her portfolio. Had Sandy tried to transfer her AGF Aggressive Growth directly to her RRSP, the $2,858 capital loss would have been denied and its benefit lost altogether. However, this strategy involves two separate and distinct transactions that are perfectly legal and avoid the superficial loss trap.

If you don’t have a RRSP or if that first strategy just isn’t possible, there is another alternative. Sandy can sell her fund at a loss before December 21, but instead of putting the proceeds in cash, she can invest it in a similar fund. If she is tied in by a deferred sales charge schedule, Sandy can sell her AGF Aggressive Growth and buy the AGF Special US Class – a small-to-mid cap US stock fund managed by Cameron Scrivens and Steve Rogers. (Universal US Emerging Growth is a similar fund also, but it’s expected to pay a distribution of about 6 per cent.) While they’re not identical funds, they offer very similar exposure and the AGF Special US Class fund is not expected to distribute any income for 2000. Since Sandy still wants to hold the AGF Aggressive Growth fund, she can buy back in on January 22, 2001. Either of the two strategies allows her to trigger the loss, use it for the 2000 tax year, maintain exposure to US mid-cap stocks, and resume ownership of her desired fund.

While triggering a superficial loss doesn’t result in permanently losing use of the capital loss, having its use in the year incurred can provide added flexibility. If you have capital gains from other sources this year, having the use of the loss may have a significant benefit. Even if you have no gains this year, being able to trigger and use the capital loss this year will enable you carry the net capital loss for the year back three years or forward indefinitely to offset capital gains of other years, if any. (In order to carry capital losses backward or forward, the net amount of gains minus losses must be negative for the current year. If a negative figure - i.e. net capital loss - results, that net amount is available for use in other years.) Capital gains prior to February 28, 2000 were taxed at the 75 per cent inclusion rate, making the loss carry-back more valuable than using it in 2000 or in subsequent years.

The distribution figures mentioned here are only estimates. Market movements and portfolio activity between now and year-end can result in a significant difference between the estimated and actual payout. Income tax is inevitable, but any steps you can take to minimize and/or defer them equals money in your pocket. The distribution information mentioned and the strategies detailed above should help you in your planning. Before taking any action, consult with a professional advisor who knows a thing or two about income tax – specifically the superficial loss rules, the definition of identical property, and the fine details capital gains/losses.