Investor Advisory Alert – Year End Tax Distributions

Today’s entry is from another guest author – Ken Kivenko from CanadianFundWatch.com. Ken is an investor advocate and regularly provides good material to consider and discuss. He recently sent me this article by email I thought it would be worthwhile to share, with Ken’s permission…

It’s that time of year again.

Time to think about mutual fund income and capital gains distributions. Most actively managed funds are structured as open–ended mutual fund trusts. Mutual fund trusts are taxed at the highest tax rate for all forms of income earned. As a result, fund companies typically avoid paying this tax by distributing to investors the interest/dividend income and capital gains earned within the fund since the last distribution date, net of fees and expenses. This makes sense since unitholders may hold the fund in a RRSP or be in a low tax bracket. Unitholders thus pay income tax on these distributions at their marginal tax rate according to the type of income or capital gain earned.

The accumulated taxable capital gains distributions are unfortunately usually made in December sometimes leading to “unitholder shock ” if a large purchase of a fund in a non-registered account was made toward the end of the taxation year but before the distribution. This may not be too serious for low turnover income and dividend funds but check the distribution history before investing. Some funds may be able to provide you an indication of expected distributions near calendar year end. Additionally, if an investor doesn’t have the cash he or she may have to sell some investments thus reducing ongoing income. That can be especially disturbing if he/she paid a sales commission on purchase or must pay a DSC charge for early redemption. If however he/she has net capital losses for the year there is no tax problem.

Several commentators actually suggest avoiding purchasing a mutual fund after October to avoid this effective prepayment of income tax. This might be appropriate but only done after considering the investment merits of deferring the purchase. The inability of individuals to time capital gains/losses is one of the important disadvantages of mutual fund investing.

Here’s how the convoluted system works:

Suppose John D. invests $100,000 in a Dividend and Income fund at $10.00 per unit to purchase 10,000 units for a non-registered account (e.g. not a RRSP). The mutual fund has been, and intends to, continue paying $0.035 per unit per month. i.e. 4.2% annual yield. John will be delighted to receive a monthly cheque for $350 much of it tax advantaged as dividend or capital gain income. But unknown to unsuspecting John, the fund has realized considerable capital gains during the year. On December 31, the fund declares a distribution of $1.00 per unit taxable as a capital gain in the current tax year. John must declare a capital gain of $10,000($1.00 x 1000) and that will result in an income tax liability of about $1800-$2500 depending on his tax bracket and province of residence.

Assuming John reinvests the distribution in units of the fund it will cause no change in his gross monthly income. Each fund unit will now have a NAV of $9.00 as cash has left the fund. Gross monthly distributions remain the same but there being more units, the distribution per unit will decline accordingly. John will now own his original 10,000 units at a cost of $10 each and will have purchased $10,000 worth of new units at the reduced price of $9.00 per unit for a total of 1,111.11 units .The Adjusted Cost Base for income tax purposes will be $9.90/unit ($110,000 spent to purchase 1,111.11 units) so that he or his estate will realize that much smaller a capital gain upon disposition.
The bottom line is that John must pay income taxes now in exchange for reduced capital gain and tax liability downstream. In effect he is providing an interest-free loan to the government for the term from April of the following year until he liquidates the holding.

Be tax Smart.

Ken Kivenko P.Eng.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 14 comments
  • Michael James

    Things should be made as simple as possible, but no simpler. This post has achieved this goal. My takeaway is that mutual funds are far too complicated to seriously consider as an investment. There are too many factors out of the investor’s control.

  • Richard

    I noticed something similar last year with an index fund in an RRSP – if the distribution I got was based on the amount of time I held it, that’s an amazing yield. Does this mean that I received gains from a time before I invested? Could you just go around investing in the funds that have done well in october to get their yearly distributions and then use the capital for something else from january to september? Something must be wrong with this picture…

  • Preet

    @Richard – unfortunately it doesn’t work like that. If you invest near the end of the year and their is a capital gains distribution you will NOT have participated in the gain, yet have a tax bill at the end of the year to pay. Let’s say a mutual fund only held one stock, which it bought for $10/share at the beginning of the year. By November the stock had doubled to $20/share. The NAV of the mutual fund is also $20. In December the share price did not change, but the manager decided to sell the stock in it’s entirety. You bought in at $20 NAV in November, get a $10 capital gains distribution which means you pay tax, and have a leftover NAV of $10. So at the end of the day, you paid $20 and are left with less than $20 even though the fund and stock did not drop in value. This is something you want to avoid.

  • Richard

    That makes a lot more sense :) I’ll be sure to keep in my for any non-registered investments.

  • Patrick

    I’m with Michael on this one. You have now officially scared me away from ever owning a mutual fund.

  • lxf

    Preet,

    Could you further explain these two sentences?
    “The Adjusted Cost Base for income tax purposes will be $111,111.11 so that he or his estate will realize that much smaller a capital gain upon disposition.”

    Why the cost base is not the current price of the unit ($9) multiplied by the total units (11,111). To me it should still be $100,000.

    “The bottom line is that John must pay income taxes now in exchange for reduced capital gain and tax liability downstream.”

    Since you mentioned that he can reinvest the $10,000 he got to purchase 11,111 more units, does he still need to pay tax? Shouldn’t he pay tax once he sell his units? I’m not familiar with how the tax is calculated

  • Pat

    Shouldn’t the ACB be $110,000 (the initial 100,000 plus the 10,000 distribution that was re-invested)? The market value will still be 100,000 (11,111.11 units * $9/unit = 99,999.99 = 100,000.00)

  • Preet

    @lxf: your formula determines market value. Book value is the sum of all the purchase transactions. He initially bought $100,000 worth of units. Then he bought another $10,000 so his total outlay is $110,000 (I think the post is incorrect in that it states a new ACB of $111,111.11, I’ll verify with Ken to make sure we are both on the same page). The total number of units he owns is 11,111.11 after taking the $10,000 distribution to buy new units at $9 which when multiplied by $9/unit = $100,000. His average cost per share is $9.90 for calculating capital gains later upon disposition of units.

    @Pat: thank you for your eagle eye, I noticed the same thing. I’ll amend the post as well.

  • lxf

    Preet,

    Thanks for the calrification!! So does he need to pay tax on the $1,000 as soon as the distribution is made even if he choses to REINVEST? Does this mean he need to make up the tax charge (through additional funds out of his pockets) in order to purchase the 1,111.111 units at $9 each?

    Thanks a lot!

  • Preet

    @lxf: you are correct. The $1,000 capital gain distribution means the investor must pay his/her marginal tax rate on 50% (the capital gains inclusion rate) of the $1,000. Even if he/she reinvests. You are correct in that he/she will have to find the extra money out of pocket to pay this tax liability (or buy less units).

  • dj

    On crap,this is me!!! but it’s $6 per unit cap gain…anyone known a good CGA? My CFP said:”don’t worry about the tax,I’ll look after the profits”…I’m selling everything an going Formula Ford racing.

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