Return of Capital 2006-10-01 FORUM Magazine Understanding the differences between the good and the bad By Jamie Golombek When it comes to reviewing the hierarchy of tax-efficient investment income with clients, advisors are generally comfortable extolling the tax advantages of earning capital gains, which are only 50 per cent taxable. Advisors are also getting pretty comfortable praising the benefits of buying Canadian stocks or funds that pay out Canadian dividends, in light of the recent federal budget increasing the dividend tax credit for eligible dividends received in 2006, thus putting dividends on pretty much equal footing with capital gains as the lowest taxed form of income in most provinces. By contrast, when it comes to articulating exactly what is meant by a "return of capital (ROC)" and whether or not this type of cash flow, often associated with income trust and mutual fund distributions, is tax advantageous to clients, advisors often stumble. The confusion likely stems from a lack of understanding as to whether the client is getting a return on their capital, which we'll call "good ROC" as opposed to a return of their own capital, which we'll deem "bad ROC". Before attempting to explain the difference, a brief summary of the taxation of ROC is in order. Taxation of ROC A return of capital (either good ROC or bad ROC) is not generally taxable immediately, but rather reduces the adjusted cost base (ACB) of the units or shares held, thus increasing the amount of capital gain that will be realized when the shares or units are sold or redeemed. Beginning in 2004, the amount of any return of capital is required to be shown in Box 42 of the T3 information slip, sent annually to income trust and mutual fund investors. If the total amounts received as a return of capital ever exceed the investor's ACB of the units acquired (increased, naturally, for any reinvested distributions), the Income Tax Act deems that excess (the "negative ACB") to be a capital gain, which must be included in the investor's income for the year in which the excess arose. Now, let's examine the difference between good ROC and bad ROC. Good ROC There are really two sources of "good ROC". The first one is the distribution of amounts that are non-taxable due to various tax deductions, such as depreciation, amortization of financing fees, etc., that are claimed by the income trust and are essentially flowed through to the investor. Let's take the example of an investor who purchases units of a real estate investment trust (REIT). In a particular year, the REIT may receive $100 of rental income, which is cash paid by its real estate tenants. The REIT may have various expenses, including deductible mortgage interest, maintenance fees, insurance, property taxes, etc., that reduce the $100 of cash received by, say $60, to a net distributable cash flow of $40. Because the REIT owns depreciable property (i.e., buildings), it may be able to reduce its taxable income by claiming, say, $20 of capital cost allowance (CCA) or tax depreciation. This CCA is a non-cash outlay, but reduces the taxable portion of the net distribution. To summarize: the REIT receives $100 cash in rents, pays $60 of cash expenses and thus can distribute $40 in cash distributions to its investors. But because it can claim CCA of $20, the investor will receive a cheque for $40, of which half will be fully taxable as ordinary income and the other half will be deemed to be a return of capital, which is not immediately taxable but, instead, reduces that investor's ACB of his REIT units. The second type of "good ROC" is when a fund distributes its unrealized gains to investors at the end of the year. Let's take an equity mutual fund that begins the year with a net asset value of $1,000. During the year, the fund nets, after fees and expenses, $30 in dividends, $20 in realized capital gains and pays out $100 of cash at the end of the year. At first glance, this looks like "bad ROC" (see below) because the fund only earned $50, yet is distributing $100, which seems to represent the return of your own capital. But what if the fund's net asset value at the end of the year (before distributions) had increased to $1,100? Then the balance of the $100 being distributed (other than the $30 of dividends and $20 of realized capital gains) or $50, is non-taxable ROC, which essentially represents the unrealized gains in the fund that particular year. Again, this amount reduces the investor's ACB of his or her units. Bad ROC As alluded to above, "bad ROC" is essentially when an investor receives a non-taxable amount from a fund, ostensibly described as a "tax-efficient yield" but which is really nothing more than a return of the investor's own money. Continuing from the example immediately above, if the fund's net asset value at the end of the year was only $1,050 and the fund chose to distribute $100, of which only $50 constituted realized dividends and gains, the other $50 essentially represents a return of the client's own money, often disguised as "tax-efficient yield". Advisors can add significant value by ensuring clients understand the difference between good and bad ROC - and avoid the latter, where possible.