**If I invest in a mutual fund that pays return of capital (ROC), I have to deduct the ROC from my adjusted cost base (ACB). That much I get. But what happens the day after ROC distributions result in the ACB equal to zero? Since all of my original capital is back in my hands, do I still have all of my shares intact in the account? That doesn't seem right.**

Based on the e-mails I get, return of capital is one of the most difficult concepts for investors to wrap their heads around.

Let's start with a basic definition: Return of capital is the portion of a distribution that does not consist of dividends, interest or realized capital gains. For example, if a mutual fund pays $1 in distributions but only makes 90 cents in interest, dividends and capital gains on investments it sold during the year, the remaining 10 cents will be classified as ROC.

ROC is not immediately taxable. Instead, it is deducted from the investor's ACB, which gives rise to a larger capital gain – or smaller capital loss – when the investment is ultimately sold. So ROC has tax advantages.

Many people think of ROC as getting their original investment back, but that's not necessarily true. It's more accurate to say that ROC comes out of your original investment plus the growth of that investment, which together constitute your capital. In other words, ROC may also reflect
*unrealized* capital gains, or paper profits from securities that have risen in value.

Example: An investor buys a fund with a net asset value (NAV), or price, of $10. We'll assume the fund earns no interest or dividends, but over the course of a year the value of its holdings rises by 10 per cent, pushing the NAV up to $11.

In this case, we'll assume the fund does not sell any of its holdings, and therefore has no
*realized* capital gains. It does have $1 in paper profits, however. If it distributes that $1, the entire amount will be classified as ROC, but the investor hasn't eaten his original capital: He's got $1 in his pocket, and the fund's NAV is now back to $10 – or $11 minus $1 – the same as what he paid.

Bottom line: The fund's NAV will not fall as long as interest, dividend and capital gains – whether realized or unrealized – match or exceed the amount distributed over the long run. Only when distributions exceed the total return of the fund will the NAV erode.

Now, to your question about the ACB. Given enough ROC payments, it's theoretically possible for your ACB to fall all the way to zero. But as I've just explained, that doesn't mean the fund's NAV must also fall to zero. The NAV may fall, rise or stay the same – it all depends on whether the fund has been distributing more or less than its total return from all sources.

For tax purposes, the important thing to know is that if your ACB does fall to zero, any subsequent distributions of ROC would be treated as capital gains. In this case, you wouldn't deduct them from your ACB, but would pay tax for the year the distribution was received.

Why is ROC suddenly taxable in this situation? Well, think of it this way: If your ACB has fallen to zero, that means you have already gotten back an amount equal to your original investment. Any further distributions of ROC must therefore reflect unrealized capital gains, and the Canada Revenue Agency taxes them as realized capital gains when paid.

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