AdjustedCostBase.ca now offers a streamlined method for importing phantom distribution and return of capital transactions for many exchange traded funds (ETF’s), publicly traded mutual funds, income trusts and real estate investment trusts (REITs). Learn more about this feature.
Return of capital is a distribution from an investment that is not considered income. It’s common for a fund or trust to pay out a distribution in excess of its income earned. In this case the excess is considered to be return of capital.
The return of capital portion of a distribution is not considered taxable income for the current tax year. However, the adjusted cost base of the security must be reduced by the amount of the return of capital. As a result, the capital gain is greater when the investment is eventually sold. Avoiding or forgetting to factor in return of capital distributions when calculating ACB will result in an capital gain value that’s too low and therefore would be considered tax evasion.
It’s worth noting that return of capital is usually the most tax efficient type of distribution. In most provinces and most income tax brackets in Canada, the marginal tax on capital gains is comparable to that of eligible dividends. However, the capital gain (and thus the tax on the capital gain) does not occur until the investment is sold. Therefore tax is deferred on return of capital distributions.
Return of capital can occur for a variety of reasons. For example, a mutual fund may decide to distribute more than it has earned, in order to maintain a constant distribution even when income falls. In the case of a Real Estate Investment Trust (REIT), income for tax purposes is often less than net cash flow due to capital cost allowance for depreciation on its properties. As a result, if the REIT distributes its entire net cash flow to unit holders, the distribution will exceed net income and a portion of it will be considered return of capital.
For Canadians holding foreign investments, any income that’s considered to be return of capital by the foreign country will be immediately taxable as income. In other words, a return of capital distribution from a foreign fund does not provide the benefit of deferred taxes, and is taxed as income as opposed to a capital gain (and has no effect on ACB).
Return of capital is reported on box 42 on a T3 slip. However, a T3 slip you receive from your brokerage may aggregate the amount for multiple securities, and ACB must be calculated separately for each security. See Tax Breakdown Service for ETF’s and Trusts from CDSInnovations.ca for further details on this matter.
As an example, let’s assume you purchase 1,000 units of REF-UN.TO at a price of $45.00 per unit with a commission of $10.00. The initial ACB becomes:
(1,000 units x $45.00/unit) + $10.00 = $45,010.00
Then assume you receive a $1.00 per unit distribution that’s composed of 60% income ($0.60 per unit) and 40% return of capital ($0.40 per unit). The ACB must be reduced to the following:
$45,010.00 — (1,000 x $0.40/unit) = $45,010.00 — $400.00 = $44,610.00
As a result, the capital gain when the units are sold will be $400.00 greater than it would have been if the return of capital distribution did not occur.
AdjustedCostBase.ca supports calculations for return of capital distributions. For the example above, the following “Return of Capital” transaction would be used:
The ACB would be calculated as follows:
The tool will not allow return of capital to be reduced below zero. If the return of capital amount should exceed the ACB, the ACB will be reduced to zero and the difference will be displayed as an immediate capital gain.