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A calculated look at capital gains distributions

When winter winds finally give way to warmer breezes, you know that a new season is once again upon us—tax season. And with this new season, you may find the arrival of a Statement of Capital Gains Distributions from your mutual fund company.

"Many mutual fund investors are uncertain about capital gains distributions and how they should be reported for tax purposes," says Myron Knodel, CA and Director, Tax & Estate Planning, Advanced Financial Planning Support at Investors Group. "Simply put, mutual funds buy and sell securities. Mutual fund investments may generate investment income and gains if sold for more than the purchase price. The fund is not taxable on income and gains distributed to its investors. Distributions are generally done in December and are taxed in the hands of the recipient at his or her marginal tax rate."

Here are some answers to the most commonly asked questions that may help you get a better understanding of capital gains distributions:

Q: Are fund returns and fund distributions the same thing?

A: No. Fund returns are a measure of how the fund has performed over time, including the distributions and change in its price per unit. Fund distributions are how much the fund has paid in cash and/or allocated out to the investor in the form of additional fund units.

Q: Under what circumstances am I liable for capital gains taxes on my mutual fund investments?

A: One, when you redeem fund units at a price higher than their Adjusted Cost Base. And two, when the fund distributes gains that have resulted from the fund selling holdings in its portfolio during the year at prices higher than their cost. These gains are reported on the T3 Supplementary slip.

Q: Why does a mutual fund trigger capital gains?

A: A mutual fund buys and sells stocks, bonds, T-bills and other assets. If a security is sold for more than its purchase price, which is the objective, a capital gain will result. If a fund manager is of the opinion that a security sale is in the best interests of the unit holders, a sale will be carried out even if a capital gain is triggered.

Q: Why does a mutual fund distribute capital gains?

A: If over the course of the year, the funds' realized capital gains exceed its capital losses, it will have to pay tax on those gains (at the highest tax rate of about 50 per cent) to the extent that they are not allocated to unit holders. To avoid paying these taxes at these high marginal tax rates, a mutual fund distributes capital gains to its investors prior to its taxation year end. Generally the distribution is reinvested in additional fund units, however, it is possible to receive cash distributions from income and balanced funds.

Q: Why is the actual distribution amount not known until year-end?

A: The formula for determining the amount of the capital gains distribution is based on information that is not known until the taxation year end of the fund. This information includes income, expenses, net realized and unrealized gains, net assets and redemptions.

Q: Does reinvesting in a mutual fund reduce my tax bite?

A: No. You'll receive the same distribution and the same tax bill if you've held the fund for ten years or ten days.

Q: Does the length of time I held my investment affect distribution and tax position?

A: You'll receive the same distribution and the same tax bill if you've held the fund for ten years or ten days.

Q: Must I include capital gains income on my current tax return?

A: Yes. You'll receive a tax slip (T3 supplementary) from the fund reporting income and capital gains distributed to you. This tax slip does not include any gains you received when you redeemed any fund units, only the gains distributed by the fund. You need to review your year-end statements to report any gains or losses on redemptions during the year. These amounts must be included with your annual tax return.

Q: Are all my mutual fund investments subject to capital gains tax?

A: Not necessarily. You pay capital gains taxes on any non-registered investments, but not on funds held in registered plans (RRSP, RRIF, TFSA). When you withdraw money from your RRSP or RRIF, it is taxed as ordinary income. Alternatively, if your mutual funds are held within a TFSA, all income and capital gains are tax free.

Q: Can I do anything to reduce the amount of tax I pay?

A: There are a variety of strategies to reduce capital gains exposure, including using losses to offset gains and changing the type of mutual funds you invest in. Taxes are only one consideration of investing.

Most importantly, your strategies should address your individual goals and risk tolerance. Contact an Investors Group Consultant today to discuss your overall financial plan.

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Written and published by Investors Group as a general source of information only. It is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax, legal or investment advice. Readers should seek advice on their specific circumstances from an Investors Group Consultant.