In a non-registered account, the income from a dividend or distribution can be in the form of interest income, dividend income, foreign income, capital gains, or return of capital. With the exception of return of capital, this income is usually immediately taxable in the year of the distribution. Often mutual fund investors elect to have distributions automatically reinvested back into the fund. Similarly, stock owners can enroll in a Dividend ReInvestment Plan (DRIP).
When a distribution is reinvested in additional shares/units, it’s still immediately taxable in the exact same way as it would be if you had received cash. But additional care must be taken to ensure that the Adjusted Cost Base (ACB) is calculated correctly. If you neglect to factor the reinvestment into your ACB calculations, you’ll end up paying more than you need to in capital gains taxes when the shares are eventually sold.
When a reinvested distribution occurs, it’s best to think of it as 2 separate transactions:
- You receive a cash distribution
- You purchase additional shares/units using the cash
Although the cash may never physically pass through your hands or even get deposited into your account, a reinvested distribution is seen as two distinct transactions from a tax standpoint.
For calculating ACB, the reinvestment of the distribution is equivalent to a buy transaction. The total ACB increases by the amount reinvested as follows:
New ACB = (Previous ACB) + (Total Reinvestment) = (Previous ACB) + ((Additional Shares Received) x (Cost Per Share of Additional Shares Received))
A reinvested distribution typically doesn’t involve any brokerage commission or any other transactions costs. But if you do incur these costs they should be added into the ACB.
Example 1: Let’s assume that you own 1,060 units of XYZ Canadian Equity Fund with a total ACB of $22,684.00 and receive a distribution of $321.16, which is entirely reinvested in 12.95 additional units of the fund. The ACB would become:
New ACB = $22,684.00 + $321.16 = $23,005.16
Now, a total of (1,060.00 + 12.95 = 1072.95) units are owned.
It’s important to recognize that in addition to the ACB adjustment, the distribution is taxable in the year of the distribution. The taxation of the distribution will depend on whether it’s in the form of interest income, eligible dividend income, non-eligible dividend income, foreign income, capital gains, etc. The tax breakdown should be included on the annual T3 and T5 slips sent by your financial institution, or you can look up this information yourself. The ACB adjustment, however, will likely not be provided for you.
If all or a portion of the distribution is in the form of return of capital, an additional adjustment to ACB must be made. Suppose that 25% of the $321.16 distribution is return of capital. In this case, the ACB must be adjusted (decreased) based on this amount:
New ACB = $23,005.16 — ($321.16 x 25%) = $22,924.87
Note that if you’re using a value for return of capital per share, this amount should be multiplied by the number of shares owned before the reinvested distribution (1,060 shares).
Sometimes when you elect to have distributions reinvested, you only receive whole shares, and the remainder is distributed in cash. This is often the case with a synthetic DRIP at a brokerage. In this case, only the reinvested portion is added to find the new ACB.
Example 2: Let’s alter the above example such that the $321.16 distribution is reinvested in 12 additional units and you receive $23.56 in cash. The price per unit would therefore be (($321.16 — $23.56) / 12 = $24.80) and the reinvested amount would be ($321.16 — $23.56 = $297.60). In this case the ACB becomes:
New ACB = $22,684.00 + ($321.16 — $23.56) = $22,981.60
Let’s assume again that 25% of the $321.16 distribution is return of capital. In this case, the ACB must still be adjusted (decreased) based on the amount:
New ACB = $22,981.60 — ($321.16 x 25%) = $22,901.31
Note that the effect of the return of capital is the same regardless of whether the distribution is received as cash, fully reinvested, or partially reinvested.
When you’re enrolled in a dividend reinvestment plan, extra work is required to accurately track ACB. This can become a tedious chore, especially when distributions occur monthly. Many investors choose not to participate in DRIPs simply because of the headaches involved with the ACB calculations.
Using AdjustedCostBase.ca can alleviate the pain in tracking ACB caused by frequent and persistent reinvested distributions. AdjustedCostBase.ca is a free web application that allows you to enter transactions, and the ACB and capital gains are calculated for you. This saves a lot of time, and allows you to base your decision to enroll in a DRIP on your investing needs rather than your desire to avoid the extra work.
For Example 1 from above, you would add a new “Reinvested Dividend” transaction, setting the appropriate amounts for the reinvested amount and additional shares received:
You could also use a “Buy Transaction” type with a total amount of $321.16 for 12.95 shares and the effect will be exactly the same. Using a “Reinvested Dividend” transaction, however, makes it easy to see which transactions are related the DRIPs and which are normal purchases.
Next, you would need to create another transaction for the return of capital:
The transactions and resulting ACB after entering these transactions are shown below:
For Example 2 the transactions would be entered in much the same way, except the “Reinvested Dividend” transaction would be for only 12 shares with a total amount of $297.60.
You may notice the subtle detail that the transaction date for the “Return of Capital” transaction is set the 2014-Sep-02 while the date of the “Reinvsted Dividend” transaction is set to 2014-Sep-03. This is done to ensure that the return of capital is applied first. This will not be an issue if the return of capital amount is inputted as a “Total” amount, as opposed to a “Per Share” amount. But if a “Per Share” amount is used, the number of shares associated with the calculation of total return of capital is 1,060 (not 1,072.95). Moving the “Reinvested Dividend” transaction a day after the “Return of Capital” transactions ensures that the correct total return of capital will be calculated if you enter if as a “Per Share” amount. The total return of capital is equal to the return of capital per share multiplied by 1,060 shares. This also reflects the correct transaction order: first, a distribution occurs, and second, the distribution is reinvested.