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.
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 (http://www2.myto.com/money/tax/)
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.
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.
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 (http://www.sterlingmutuals.com/Telus_TaxLoss_09nov2001.htm)
and avoiding superficial losses (http://www.sterlingmutuals.com/Telus_Superficial_16nov2001.htm)
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.
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, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.