Return of capital is a difficult concept to understand, both in terms of what it means and how it is treated for tax purposes.Getty Images/iStockphoto
In last week's column, I mentioned a fund that distributes large amounts of return of capital (ROC). Because some readers wrote in with questions, today I'll look at ROC in more detail.
Return of Capital is a difficult concept for many investors to understand, both in terms of what it means and how it is treated for tax purposes. So let's make it really simple: ROC is the portion of a distribution that does not consist of interest, dividends or realized capital gains.
For example, if your mutual fund or exchange-traded fund distributed $1 per unit in 2014, but only 75 cents consisted of interest, dividends or capital gains from assets it sold during the year, then 25 cents of the distribution will be classified as ROC.
One nice thing about ROC is that it is not taxed immediately. Instead, ROC is deducted from the investor's adjusted cost base (ACB). This gives rise to a larger capital gain (or smaller capital loss) when the units are ultimately sold. Continuing with the example, if you paid $10 for your unit, that 25 cents of ROC would reduce your ACB to $9.75.
Now, say you sold your unit a year later, also for $10. Even though the fund's market price hasn't changed, you would report a capital gain of 25 cents (the $10 sale proceeds minus the $9.75 ACB). The idea here is that, if the unit price remained at $10, the capital in the fund must have grown by 25 cents to offset the 25 cents that went out the door as ROC. So that growth is effectively taxed as a capital gain.
Now let's look at a slightly different example. Consider a fund that has a $10 unit price but holds nothing but cash. It generates no interest, dividends or capital gains (realized or unrealized). But the fund decides to pay a 25-cent distribution anyway. This amount would be classified as ROC and deducted from the investor's purchase price of $10, for an ACB of $9.75. But because the fund generates no growth or income, the unit price would have to fall to $9.75 to reflect that 25-cent distribution.
In this case, if you sold the shares you would not report a capital gain, because the sale price and the ACB would be identical – $9.75. ROC is sometimes defined as "getting your own money back" and in cases such as this where there are no unrealized capital gains to back up the ROC, that would be true.
Often, ROC amounts are small and inconsequential. In the case of some fast-growing exchange-traded funds (ETFs), for example, part of the distribution may be classified as ROC to account for new cash coming into the fund. However, when ROC makes up a large portion of a fund's distribution, investors need to probe a little deeper.
In extreme cases, a fund can be distributing so much ROC that its net asset value will erode over time if the ROC isn't backed up by sufficient unrealized capital gains. So it's important for investors to identify how much ROC they're receiving. (If you're reinvesting your distributions, then ROC won't deplete your capital as it would if you took the distributions in cash).
You'll find the amount of ROC – also known as a "cost base adjustment" – listed in box 42 of the T3 slip issued by your broker or fund company and also on your year-end statements. With ETFs, ROC is also broken out separately as part of detailed tax information posted on their websites. Investors need to keep track of ROC every year so they can adjust their ACB accordingly. Another thing to keep in mind: If your ACB drops below zero, any further ROC distributions will be taxed in the current year as capital gains.
Mutual funds and ETFs aren't the only sources of ROC. Many real estate investment trusts (REITs) also distribute ROC, and while it's treated the same way for tax purposes, it arises for a different reason. For accounting purposes, REITs depreciate their assets, which reduces net income. But because depreciation is a non-cash charge (and may not reflect the actual change in value of a REIT's property portfolio), the REIT's cash flow is usually higher than its taxable income. The difference is classified as ROC and is included in the distribution to unitholders.
Now that you understand return of capital, you can ROC on with your investments.
John Heinzl