Mutual funds allow investors to purchase and hold a basket of securities in a convenient single security form. To deliver this streamlined structure, however, there are some fairly complex activities operating in the background.
One very important event when these activities come to the foreground is in the annual distribution of income generated on the securities held in a mutual fund. These distributions occur at year-end, and can be particularly confusing for an investor who has seen a decline in the net asset value (NAV) of the fund.
Why distributions?
Whether in the form of a trust or corporation, a mutual fund is a taxable entity, and a highly taxed one at that. Income earned in the fund is taxable, though the fund is entitled to apply expenses against that income. Those expenses are the management expense ratios (MERs) charged to the fund by the investment management company.
Any remaining income will be subject to tax rates in the same range as the top-bracket tax rates an investor would face personally. Of course a significant proportion of investors will not be in the top bracket – or won’t be currently taxable at all in the case of registered investment accounts. Rather than subject all the investors to a high tax rate, the mutual fund will distribute excess income to investors. In turn, the recipients will be taxed on the income at their respective marginal tax rates, or, in the case of registered accounts, be entitled to deferred taxation.
A distribution of income means that the assets held by the mutual fund decline. We can illustrate this with the following example, with the assumption that there are 1,000 mutual fund units.
Mutual fund Pre-distribution Post-distribution
Fair market value of securities $10,000 $10,000
Cash from realized income $400 $0
Total fair market value $10,400 $10,000
Net asset value per unit $10.40 $10.00
(1,000 units)
At first glance, an investor might think that something has been lost, but we need to look further at the investor side of the arrangement. Assuming an investor held 100 of these mutual fund units, here is that other side:
Investor Pre-distribution Post-distribution
Fair market value of mutual fund $1,040 $1,000
Cash in hand $0 $40
Total $1,040 $1,040
Net asset value per unit $10.40 $10.00
(100 units)
Cash versus reinvested units
Quite often, an investor will have chosen to have distributions reinvested in the mutual fund. In that case, the $40 distribution would purchase 0.4 more units. The investor would own 100.4 units x $10.00 = $1,040. Accordingly, whether the distribution is paid in cash or reinvested, the net position of the investor is the same.
In the case of a registered account, there would be no taxable event to prompt the investor’s attention, and so this may go effectively unnoticed.
With a non-registered account, the form may appear to matter, but that is just an illusion arising from focusing on the mutual fund value alone. A cash distribution will be subject to tax, leading to a net-of-tax amount in the hands of the investor. Comparatively, a reinvested distribution does not provide cash to the investor, but tax still has to be paid on the distributed income. The investor will need to pay that tax out of other assets, netting to the same position as the taxable cash payment.
Form of an income distribution
The key area where there is a divergence between registered and non-registered accounts is in the type of income that is distributed.
For a registered account, the type of income is irrelevant. Only withdrawals are taxable from a registered account, not the interim activities within it. And when those withdrawals occur, they are fully taxable, irrespective of the types of income that had contributed to the growth of the account.
On the other hand, the type of income matters a great deal for fund distributions to a non-registered account. Interest and foreign income are fully taxable, Canadian dividends are entitled to a gross up and tax credit, and only half of capital gains is taxable. Consequently, while net wealth is the same whether under a cash distribution or reinvestment, the net-of-tax result of the distribution will depend on the type of income at issue.
Distributions in a time of decline
In years where the NAV of a fund has fallen, it may appear that there has been a breakdown in the logic and accounting of distributions. What is important to keep in mind is that it is possible that the capital value of the assets declined during the year, despite that income was earned and paid from the securities.
Furthermore, for tax purposes, the reduced paper value of the investment should not be confused to have been an actual loss. An actual capital loss or gain will only come about on a disposition (actual or deemed), and will be calculated based on the change from the investor’s adjusted cost base, not simply based on an interim calendar-year value.