The whole story on half of the returns

Mutual funds provide a streamlined way to make a single purchase of a portfolio of securities. By pooling with others, an investor has a cost-effective way to participate in a chosen investment mandate that would be challenging to assemble and maintain individually.

When holding individual securities, an investor’s total return is a combination of the income earned by that security for a given period and the change in its price over that same period.

The same holds true when securities are pooled in a mutual fund. The netting of the ups and downs of individual prices is reflected in the change in the fund’s net asset value (NAV), while the sum of all the securities’ incomes becomes the fund’s periodic distribution to investors.

Why distribute a mutual fund’s income?

In Canada, an investment manager may create a mutual fund in one of two legal structures: trust or corporation. By both number of funds and assets under management, the trust form is significantly more common. Except where noted otherwise, this article deals with mutual fund trusts.

Once a mutual fund is created, the manager will make it available for investor deposits, charging the fund for its administration and investment management services. Such charges are calculated and expressed as a percentage of the fund’s investment assets, known as the management expense ratio (MER).

A mutual fund is taxable on the income from its investment holdings, though it is allowed to deduct the expenses it incurs in earning that income, which is mainly that MER. Regardless which of the two legal forms it takes, a mutual fund is subject to very high tax rates, roughly the same as what a top tax bracket individual would pay.

If a mutual fund had to pay tax itself, that would be costly for the overwhelming majority of its investors—who are not at top bracket—and exceedingly so when held in a registered plan that does not pay tax while earning income. This includes a Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), Registered Education Savings Plan (RESP), Registered Disability Savings Plan (RDSP), or Tax-Free Savings Account (TFSA).

Limiting tax on investment income

Rather than impose its high tax rate on investors, a mutual fund will absorb sufficient income to deduct the full MER charged by the investment manager. It will then distribute the remaining income to investors according to their proportion of ownership, to be taxed to each at their respective income brackets—or in the case of RRSPs and other registered accounts, with zero tax applying on those distributions.

Facilitating more invested capital

Distributions can also indirectly increase the capital a mutual fund has available to invest. As discussed further on, investors can receive distributions in the form of cash, or allow that amount to be reinvested on their behalf in more units of the fund.

For investors with current spending needs, for example those in their retirement years, a cash distribution will allow them to pay the associated tax and spend the net income on their living expenses.

If the automated reinvestment route is chosen—which is the default choice for most mutual funds, with investors entitled to opt out—the fund will have both the original capital and that year’s income for continuing investment. Or, if an investor takes the cash distribution, part of that could be used to pay the tax, with the difference available for the investor to reinvest in the fund. In the former case the gross amount is reinvested, and in the latter, it is the net amount. Either way the use of the investors’ lower tax rates assures the lowest tax and highest reinvestment.

Form of income distribution

In addition to being taxable to investors rather than the fund, distributions retain their tax character when received by investors. Still, one must distinguish whether the mutual fund is in a registered or non-registered account.

Registered accounts

Income type is irrelevant in registered accounts, as no tax is charged on income or growth while in such plans. On money coming out of the plan, taxable withdrawals are treated as regular income up through the recipient’s graduated tax brackets, regardless of the original income type when received. The notable exception is a TFSA, for which there is no tax on either internal income or growth, or withdrawals.

Non-registered accounts

For non-registered accounts, the investor is taxed in the year of receipt, according to income type:

Interest – Fully taxable, according to the investor’s graduated bracket rate.

Foreign dividends – Fully taxable, according to the investor’s graduated bracket rate. Usually, the issuing corporation is obligated to withhold tax in the foreign jurisdiction before paying the net amount to the mutual fund. When this is distributed to the investor, the mutual fund typically is able to report the details of what was withheld, allowing the investor to claim a foreign tax credit when calculating (reducing) their Canadian tax obligation.

Canadian dividends – A two-stage gross-up and tax credit process applies to Canadian dividends received by a Canadian resident investor, whether received directly or via mutual fund distribution. Mutual fund distributions are most often eligible dividends, being those originating from publicly traded Canadian corporations, though on occasion there may be non-eligible dividends sourced from a Canadian-controlled private corporation. Either way, the two-step procedure results in a preferred tax rate for the investor, which is roughly the difference between the investor’s marginal tax rate and the amount of Canadian tax the originating corporation has already paid.

Net capital gains – The mutual fund tallies all its capital gains and losses on trading transactions over the course of its taxation year, and reports the net capital gain to investors. Under current rules, half of the capital gain is taxable. If the mutual fund is in a net capital loss position, that loss cannot be distributed to investors, but can be carried forward to reduce the fund’s future capital gains.

Return of capital (ROC) – Rather than being income, this is a return of the investor’s own capital. There is no tax on such capital, but, as discussed in greater detail elsewhere in this article, it reduces the investor’s adjusted cost base (ACB) in the mutual fund. When the investor has a future disposition of part or all of the mutual fund, this reduced ACB contributes to an increase in the capital gain—or a decrease in the capital loss—on that transaction.

Effect on mutual fund’s NAV

A mutual fund’s assets are a total of the securities it owns and the cash it holds when income is paid from those securities. When that cash is distributed to investors, there is a corresponding reduction in the fund’s assets.

To illustrate, assume a mutual fund trust with 1,000 outstanding units is holding securities with a combined fair market value (FMV) of $10,000, and $600 of distributable income after deduction of the MER. To isolate the effect of the distribution on NAV, the example assumes no change in market value.

On the left, Table 1A shows the mutual fund before and after the distribution, and viewed in isolation may give the impression that $600 has been lost on the total assets line. But in Table 1B on the right, consider the investor who initially had 100 units worth $1,060, who now has $1,000 value in the mutual fund plus $60 of distributed cash.

Project those 100 units up to the 1,000 units held by all investors to arrive at the $10,000 of remaining mutual fund value, to which can be added the $600 in investors’ hands collectively. Total assets remain intact at $10,600.

Effect on investor’s ACB

Most often, an investor’s adjusted cost base (ACB) is simply acquisition cost. That said, there may be some adjustments. For example, it may be increased by purchase costs such as commissions.

Fund distributions interact with the investor’s ACB as follows:

• • A cash distribution of income from a mutual fund has no effect on an investor’s ACB.
  • Distribution by reinvestment in units of the fund increases the investor’s ACB. The investor must still pay tax on that reinvested amount, but as the fund did not distribute any cash to the investor, another source must be used to pay the associated tax.
  • ROC distributions reduce an investor’s ACB, though that reduction will be restored to the extent that an investor reinvests some or all of the distribution. If the fund’s ACB is zero or negative, ROC distributions are treated as capital gains.

In the case of registered accounts, the concept of ACB does not apply. However, such accounts are subject to maximum contribution limits and may have minimum withdrawal requirements. A distribution from a mutual fund into a registered account has no effect on the calculation of either contributions or withdrawals.

Cash distribution or reinvested units

An investor may receive a distribution in cash or may instead accept the mutual fund’s offer to reinvest the otherwise distributable income. Whether taken in cash as shown in Tables 1A & 1B above or as a reinvestment in units of the fund, the tax result for the investor is the same.

To show this as a continuation of the foregoing example, we’ll assume the $60 distribution is interest and that the investor is at a 50% marginal tax rate, resulting in $30 tax due. We’ll further assume that $800 was originally invested, using that as the ACB to arrive at the investor’s final financial position after disposing of the mutual fund.

The second stage disposition illustrates how the investor is in the same tax position by either of the two routes. To be clear though, that is true whether or not the disposition happens at that time. In reality, the investor will likely continue to own the fund over many years, with more contributions, income distributions and withdrawals along the way—while the effect of the reinvestment remains baked-in, just as if it had been a cash distribution.

Timing of distributions

Distributions may vary based on a fund’s performance or may be at a fixed rate. Common scheduled intervals are monthly, quarterly, semi-annual or annual, with interest and dividend income usually distributed during the year, and net capital gains distributed at year-end. Distributions are paid to unitholders as of a set record date, generally the business day prior to the respective distribution date.

Funds with a fixed rate distribution calculate their coming year’s projected distributions based on the NAV per unit as of the preceding calendar year-end, using the formula:

For example, a fund on a monthly distribution schedule with a $12.00 NAV at December 31 of the preceding year and a 4% fixed distribution rate would have a per-unit distribution of $0.04 [$12.00 x 4% ÷ 12]. An investor with 10,000 units would expect to receive $400 each month.

Distributions and rate of return

While distributions are designed to allocate a fund’s income to investors, this should not be confused with rate of return. A fixed distribution rate is a commitment to periodically distribute a certain dollar value out of a fund’s assets—and may be premised on expected returns—but is not a guarantee of a fund’s rate of return.

Similarly, there may be an expectation of the income types making up that distribution based on the fund’s investment parameters, but the actual composition of distributions cannot be known until the fund does its
year-end accounting. Only then can distributions be reconciled with the type and amount of income earned.

If distributions exceed income, the excess is a return of the investor’s own capital (ROC). The income is part of the investment return calculation, while ROC is not. Details will be reported on the investor’s T3 tax slip.

T-series distributions

Some mutual funds allow investors to choose a distribution rate that is intentionally higher than the income the fund expects to realize in the year. “T-series” is the common term investment managers use to describe these arrangements, with the “T” highlighting the tax effect of this type of distribution.

The result is that most or all of the distributions will be non-taxable ROC, which can be appealing to someone presently at a high tax bracket who anticipates being at a lower bracket in future. Another candidate may be an Old Age Security pensioner, or other recipient of income-tested benefits, who wishes to stay below an income threshold beyond which such benefits would be reduced or clawed back.

Though this approach may be effective in addressing near-term goals, investors should bear in mind that a high T-series rate (historically, 8% or more has been available) will deplete the value of holdings over time if it consistently exceeds the fund’s rate of return.

As well, successive ROC distributions grind down the investor’s ACB, increasing the eventual capital gain on future withdrawals. This can be especially costly on a deemed disposition at death if there is no spouse to whom the investment can be rolled over to, as the entire gain will be taxable in a single year, likely at higher tax bracket rates than if it had been drawn down over multiple years.

Distributions in a year when fund value has declined

Investors may be surprised to receive reported income on their annual T3 slip from a mutual fund in a year when the fund’s value has fallen. As noted earlier, distributions and rate of return are different concepts. To explain what’s going on here, one can look back to the two components of a mutual fund’s total return: price change and income earned.

Over multiple years, investors generally expect to see a combination of a net increase in the price of securities owned, and income being generated from those securities. However, in any one year, it is possible for income to be earned and paid out to investors, while the fund’s price declines. Depending on the investment mandate, and how actively securities have been traded in a year, it may even be possible to have net capital gain distributions even if the value of the fund is down from the previous year-end.

While receiving a distribution in a down year is not a happy occasion, the positive to be taken out of it is that the income components of the fund have continued to play their role, despite the downward price pressure. In addition to softening the fall by contributing income to counter the price drop, that income is being deployed opportunistically. Assuming the fund’s mandate still fits the investor’s longer-term goals, reinvested distributions will be acquiring fund units at a bargain cost, positioning the investor to participate in the price rebound.

A final caution: Purchases near year-end

Over the course of a year, an investment manager buys and sells securities as appropriate to fulfill the fund’s investment mandate. As noted earlier, the capital gains and losses on those trades are tallied so that the net capital gain can be reported to investors. Just as interim income distributions are reported to unitholders as of a record date, the same applies to the year-end distribution. Depending on the fund, that date is generally mid to late December – and this is where the danger arises with non-registered mutual fund purchases late in the year.

An investor who purchases a mutual fund shortly before the record date is buying an appreciated asset, to their detriment. Adapting the example in Table 1A & 1B above to be shortly before the year-end record date:

• • The $10,600 ‘before’ value can be viewed as including a $600 net capital gain waiting to be distributed.
  • Just before the record date, an investor buys 100 units for $1,060, being both the ACB and FMV.
  • The fund distributes by a reinvestment of units, causing the investor to pay tax on a $60 capital gain.
  • The reinvestment increases the investor’s ACB by $60 to $1,120, while the FMV remains $1,060.

Having only bought into the fund for a day or two, the investor is paying tax on a full year’s worth of activity. This could have been avoided by waiting just a few days. Some solace can be taken that there is now a built-in $60 capital loss on the investment that will reduce future capital gains…eventually!

Importantly, as distributions into registered accounts are not taxable, this is not a problem there.

Strategies to defer and reduce tax on capital gains

Mutual funds provide a streamlined way to make a single purchase into a portfolio of securities. By pooling with others, an investor has a cost-effective way to participate in a chosen investment mandate that would be difficult to assemble individually.

Over time though, changes in the investment landscape, securities regulations and tax rules may prompt an investment manager to merge funds. This happens for a variety of reasons, usually designed to reduce overlapping mandates, simplify product offerings and achieve better economies of scale.

From an investment perspective, all investors should inform themselves of the mandate and strategies of the continuing fund.

From a tax point of view, it is those in non-registered accounts who may be most affected, with the prospect of capital gains being triggered either by the investor selling prior to the merger, or upon the investment manager completing the fund merger.

1.    Capital gains generally

Mutual funds offer investors the potential for both income and capital gains. Income is what is earned from the invested capital, generally distributed annually in the form of interest and dividends. A capital gain is an appreciation in the value of the invested capital itself.

An increase in price is an unrealized capital gain, with no tax applying to such a price movement. However, once there is a sale or disposition, capital gains become realized and taxable. Since 2000, 1/2 of a capital gain has been included in income. In the 2024 Federal Budget, the inclusion rate was increased to 2/3, but the 1/2 rate remains available for individuals on the first $250,000 of capital gains in any year. For trusts and corporations, the 2/3 rate applies to all capital gains.

A mutual fund investor can experience capital gains in a few ways:

1. 1. If the investor sells some or all of a mutual fund that has appreciated in value (owing to the appreciation of its underlying holdings), the investor will realize a capital gain directly.
   2. Within the mutual fund, the buying and selling of securities can result in net capital gains for the fund, which are then distributed proportionately to investors.
   3. In the case of a fund merger, a capital gain may arise from the combined effect of dispositions within the merging fund and the investor disposition of that fund in the course of moving to the continuing fund.

The investment manager’s management information circular will give general guidance on expected tax effects of a fund merger. The investor may then consider the following strategies to reduce or eliminate any resulting tax liability.

2.    Applying capital losses

Just as an appreciation in the price of a security is a capital gain, a decrease in price is a capital loss. As with capital gains, capital losses are unrealized until there is a taxable event.

Capital losses realized in a year must be used against capital gains that same year, with the investor then having discretion to apply any unused excess against capital gains in any of the three preceding tax years, or to carry forward for future use.

a.     Use your capital loss carryover

If you have unused capital losses from past years, you may apply them against capital gains in the current year. You can find your carryover balance on your latest Notice of Assessment, or by logging into your My Account on the Canada Revenue Agency website, and viewing “Carryover amounts” under the “Tax returns” tab.

b.     Review current holdings for loss positions

Look at your current non-registered account holdings to see if you have any securities in a loss position. You can sell a portion of those to realize sufficient capital losses to offset some or all of the capital gains arising out of a fund merger. To be clear, the tax impact contributes into your decision, but should not dictate your actions.

In fact, a common concern in this situation is the possibility of missing out on a price recovery of those disposed securities. While it may be tempting to immediately re-establish the position after triggering a loss, tax must again be borne in mind, due to the risk of being caught by the superficial loss rules in the Income Tax Act (ITA).

Superficial loss rules

These rules apply if the same security is purchased in the 30 days before or 30 days after the loss transaction. This extends beyond you as the purchaser to affiliated persons, including your spouse and registered plans belonging to either of you, such as RRSPs and TFSAs. The capital loss is denied on the sale transaction, but an equivalent amount is added to the adjusted cost base (ACB) of the new holding on the purchase side. Thus, the capital loss remains available for the holder to use in future, but cannot be used against capital gains arising out of the fund merger presently. An important exception is that if the purchase transaction occurs in a tax-sheltered account where ACB is not applicable (eg., RRSP, TFSA, etc.), the capital loss is forever forfeited.

c.     Import losses of a spouse

There is a way to use the superficial loss rules to your benefit if you do not have any securities in a loss position, but your spouse does.

• • Your spouse sells and realizes a capital loss, and you purchase the same security in the +30/-30 day window.
  • Your ACB will be higher than your purchase price by the amount of the added loss denied to your spouse.
  • After waiting at least 30 days following your spouse’s settlement date (which is 1 day after the transaction date), you can sell and realize your loss so you can use it against the capital gain from the fund merger.

Of course, the price of your new security could rise during your holding period, reducing your expected loss. But that means you receive more money when you sell, so there’s not much to complain about under that scenario.

d.     Accessing losses of an owned corporation

An investor who is the owner/shareholder of a corporation could transfer the appreciated mutual fund holding to that corporation. Unlike an arm’s length transaction, this transfer can happen on a tax-deferred basis by electing a rollover under ITA section 85. If the transfer occurs prior to the fund merger, the corporation will be the investor that is taxed on any deemed capital gains, against which it may apply any existing capital losses. Depending on the corporation’s year-end, any excess gain may be realized in either the current or next calendar year.

Consult qualified business and tax professionals to review how this may affect and be influenced by relative personal and corporate tax rates, the corporation’s small business threshold and the tax on split income (TOSI).

e.     Trust distributions, rollouts and other interactions

If the investor is a trust, a closer look at its tax attributes and those of its beneficiaries may reveal planning options. Most trusts are taxed at the top marginal tax bracket, but some are entitled to graduated bracket treatment. Trust income is generally distributable to income beneficiaries, and capital property may be rolled over to capital beneficiaries at ACB. While capital losses may not be distributed from a trust to beneficiaries, if one or more beneficiaries have existing capital losses or securities in a loss position, this could inform their combined planning.

3.    Sell to family to spread the tax up to 5 years

If you sell capital property but do not receive all the proceeds immediately, you can claim a capital gains reserve that allows you to recognize the gain over as many as 5 taxation years. In fact, there is a way that you may be able to do this with a spouse or other family member.

Your family member purchases your current holding prior to the merger, giving you 1/5 of the price plus a promissory note at the prescribed interest rate applicable to spousal/non-arm’s length loans. The prescribed rate is adjusted quarterly according to economic conditions, standing at 5% for the third and fourth quarters of 2024. As owner of record at time of the merger, the family member would be taxed on the capital gain arising at that time. As the loan is retired over the next four years, you recognize a proportionate gain each year.

This must be a sale directly to the other person, not a redemption of the fund by you and a purchase of the fund from the investment manager by the other person. As well, this assumes that the purchaser has his/her own resources to fulfill the transaction; if not, this is not a viable option.

Consult qualified tax and investment professionals to make sure that all necessary steps are taken, that they are in the right order and that everything is adequately documented.

4.    Defer other income sources

If you have some control and flexibility with your income sources, you could defer or otherwise adjust them:

• • Owner/shareholders of business corporations may reduce salary or dividends, or adjust the mix of them.
  • RRIF withdrawals could be limited to mandatory minimums.
  • Those on the verge of commencing their CPP retirement pension or OAS pension may consider deferring to the next or later year.
  • Sale of a cottage or investment property with its own unrealized capital gain might be deferred to the next or later year. Alternatively, the transaction could be structured so that payments are spread over multiple years, whether with family or a willing arm’s length purchaser, to take advantage of the capital gains reserve rules.
  • At tax filing time, recipients of eligible pension income can choose to split the appropriate amount with a spouse (subject to the 50% maximum) that will minimize the tax bill for the couple.

Bear in mind that while a fund merger may trigger a capital gain, there will not generally be a cash distribution. This may limit how much these deferrals may be used if there is insufficient cash for living expenses. As a complement to the deferral of these taxable sources above, one might consider a larger than usual TFSA drawdown for the current year.

5.    Charitable donations in-kind

The tax system provides generous assistance for those who donate to charity. Beyond the first $200 of annual donations, the tax credit rate is around 50%, varying by province. In effect, about half of the value of the donated property comes back to the donor/taxpayer in the form of reduced tax on other income.

Cash is common for small donations, but the tax benefits are accentuated when other forms of donation are used. In particular, when appreciated securities are donated in-kind, there is no tax to the donor on as-yet unrealized capital gains. A donation prior to the fund merger can take advantage of this rule, but first confirm that the charity’s bylaws allow it to accept securities and that it has a brokerage account ready to receive them.

6.    Create deductions

If an investor has available room and cash for the purpose, contributions into an RRSP will allow for a deduction against income in the current year.

For investors who have the investment knowledge, qualified risk tolerance and financial capacity, an investment loan could be arranged. Interest can be deductible if the loan proceeds are directed toward producing income in a non-registered account. Interest can also be deductible on loans taken out for business purposes. In either case, consultation with qualified business, tax and investment professionals is highly recommended.

7.    Consult your tax professional

This article provides information about potential tax issues arising out of mutual fund mergers, and strategies an investor may take in response. This is neither advice nor a recommendation for an investor to take any action and no member of the Aviso Wealth group is capable of providing tax advice in any circumstances. Readers are advised to consult a qualified tax professional to provide advice based on individual circumstances.