Mutual fund
tax refresher
Each year I
provide some guidance on how to handle your funds at tax time. I won’t repeat
my tax tutorial from a year ago. Rather, I’ll refer you back to my previous
installment on proper
tax reporting for funds. This week, however, I’ll focus on tax issues that
are more timely – how to determine and treat return of capital (RoC) distributions.
Recall that
in order for investment funds to avoid a tax bill at the fund level,
distributions of income are paid out annually such that any liability for tax
is flowed through to fund unitholders.
The most
common sources of RoC distributions are income trusts and high income mutual
funds.
Income
trusts – i.e. mainly royalty trusts and real estate investment trusts – pay out
a RoC distribution if they benefit from special tax credits and deductions associated
with the underlying business. For instance, investment tax credits and special
depreciation deductions are available to energy businesses.
High income
mutual funds have a RoC source of a different kind. Since they were created to
spit out fat amounts of cash while attracting minimal tax, they simply pay out
an amount that far exceeds the fund’s income.
The first
step to dealing with RoC distributions is knowing how much of your fund’s
distribution is made up of RoC. Easier said than done.
With one
exception that I know of, it’s not reported on your T3. Only Dynamic Mutual
Funds actually breaks out the RoC portion of the distribution for investors –
thereby making tax reporting easier.
For the
rest, it’s a little more effort. From your annual statement, add up all
distributions you received from your trust or fund for the calendar year. Once
you receive your T3 information slip, compare the two side by side.
If the
total of the distributions from your statement exceeds the actual income shown
on your T3; the excess is considered RoC.
In short,
RoC distributions are not taxable when received because tax laws consider them
to be a return of your original capital, rather than some form of income.
Refer to
last year’s article (linked above) on how to calculate a fund’s adjusted cost
base (ACB). Generally, when taxable income is paid out of a fund and taken in
cash, the investors is taxed on the income and the ACB of the fund units
remains unchanged.
If, like
most investors, the taxable distribution is reinvested, the ACB of the fund
units is bumped up by the amount of the distribution that is reinvested. It’s
treated no differently than if the distribution had been paid out in cash, and
the investor turned around and wrote a cheque to invest the same amount back
into the fund. The reasoning is that tax has already been paid on the
distribution so it should bump up the ACB – which is really nothing more than
your cost for tax purposes.
RoC
distributions, recall, are not taxable when paid out. If received in cash, the
ACB of the investor’s fund units will fall exactly by the amount of that part
of the distribution. If, on the other hand, the RoC distribution is reinvested,
the bottom line impact is “nil”.
Properly tracking
and reporting this stuff can be a daunting task even for knowledgeable
investors. So, don’t be shy about recognizing when you need help and paying for
quality advice. Alternately, I hope this article, along with last year’s
tutorial help make the foggy world of taxes a little clearer.
Dan Hallett, B.Comm., CFP, CFA is the 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, Alberta, and Manitoba.