Return of Capital and How it Affects Adjusted Cost Base

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.

Note that return of capital cannot reduce ACB below zero.

AdjustedCostBase.ca supports calculations for return of capital distributions.  For the example above, the following “Return of Capital” transaction would be used:

REF-UN.TO Return of Capital Transaction

The ACB would be calculated as follows:

Transactions for REF-UN.TO

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.

31 thoughts on “Return of Capital and How it Affects Adjusted Cost Base

  1. Lucy

    When you subtract the amount of return of capital from your ACB must you then subtract the units owned from your total using the price at time of distribution? I think not but please confirm.

    Question:Does the return of capital method mirror the distribution additions but in reverse?

    Thank you for your website and information. I understand adjusted cost base much better but still dislike return of capital. The fund is returning my invested money back to me increasing my ACB. If I fully reinvest the return of capital to buy more units should it not be revenue neutral therefore not subtracting the ROC.

    The fund returns my money ROC which is subtracted from my account. My capital is returned to me. I never get to see it in cash or reinvested. It disappears into thin air or is kept by the fund.

    I give you $100.00. You return the money by handing me a piece of paper saying you returned the $100.00 to me. I now have $100.00 less in my account.

    Sounds like smoke and mirrors accounting to me.

  2. AdjustedCostBase.ca

    Lucy,

    ROC involves a cash distribution only and the number of units you own does not change. What do you mean by “distribution additions”?

    In some cases, ROC can be a bad sign – for example a fund distributing more cash than it’s taking in to maintain the illusion of a high dividend yield.

    But it other cases ROC can be viewed as a good thing. For example, REIT’s commonly have large non-cash expenses such as depreciation on real estate, and as a result cash flow can exceed net income for tax purposes. If the REIT distributes an amount that exceeds its net income, then the difference could be considered ROC. And if the depreciation for tax purposes is larger than the true depreciation of the property, then the distributions may be sustainable. This is beneficial for investors in terms of taxation since ROC will defer taxes into the future as opposed to dividends which are taxable immediately.

    If you’re reinvesting an ROC distribution this will be equivalent to not having been paid ROC, all else being equal.

  3. Lucy

    By ,” distribution additions”, I meant the interest, capital gains and dividends distributed to the fund. They are added to your ACB plus the units they buy are also added.

    In my previous post I wondered if the return of capital subtraction also required the subtraction of units they had bought. You kindly answered my question by saying no,” the number of units you own do not change”.

    You stated,”If you’re reinvesting an ROC distribution this will be equivalent to not having been paid ROC, all else being equal.”
    Question#1: To clarify, are you saying that ROC is not subtracted from the ACB if you are reinvesting the distributions?

    While researching ROC online I came across this from CRA – “Tax Treatment of Mutual Funds For Individuals” which is new information to me. Now I am really confused!

    “If you receive a T3 slip with an amount in box 42 – Amount
    resulting in cost base adjustment, the ACB of that mutual
    fund trust identified on the slip will change. If box 42
    contains a negative amount, add this amount to the ACB of
    the units of the trust. If box 42 contains a positive amount,
    subtract this amount from the ACB of the units of the trust.”

    Question #2. How can the ROC be negative and why is it added?
    One step forward and two steps back.
    (Under the mattress seems so much simpler)

    Thank you for taking time to respond to my questions.
    Your knowledge is much appreciated.

  4. AdjustedCostBase.ca

    I think it’s best to look at the return of capital and the reinvestment of the distribution as two separate events, since as you’ve mentioned the distribution can contain other components in addition to ROC.

    Let’s say that you receive a distribution for $1.00 that’s 25% ROC and 75% income, and the entire distribution is reinvested for additional units. The ROC of $0.25 will decrease total ACB by $0.25. Then the reinvestment of the distribution will increase total ACB by $1.00. So the net increase in ACB is $0.75 resulting from both the ROC and subsequent reinvestment.

    The ROC does not affect the number of units, but the reinvestment does increase the number of units. If the entire distribution is ROC and is entirely reinvested, the net affect on ACB will be zero. But if the distribution is not entirely ROC (and is still full reinvested) ACB will increase.

    I’m not sure under what circumstances ROC would be negative (I don’t think I’ve encountered this before) but it would make sense that it should be added to ACB since a positive value is subtracted from ACB.

  5. lastminutetaxdoer

    Quick question: I understand that ROC reduces the ACB of the held securities, but what happens when you dispose of ALL of your shares in the year and then receive a ROC at the end of the year (per your T3 slip)? I’m assuming that you still subtract the ROC from the ACB at the time of the sale(s), (or from what you report) so that it reflects on your capital gain/loss? Or is there another way to do this? Many Thanks!

  6. AdjustedCostBase.ca

    lastminutetaxdoer,

    ROC can occur in distributions that happen any time of the year. Most likely you received ROC distributions before you sold the shares and that’s why it’s listed on your T3 slip. You should include it when calculating ACB (before the shares are sold).

  7. lastminutetaxdoer

    Of course, that makes obvious sense! And I went through my T3 Summary of Trust Income and that made it easier to find and enter the ROCs, rather than go through all of my securities transactions. Luckily the calculations turned out to be the same as if I subtracted it at the end of the year but I will make sure to enter them as they are distributed throughout the year. Thanks:)

  8. Tony M

    In your article you said:
    “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).”

    Is this something new? I am looking at my $US account for 2011 and see a ROC distribution. The $amount of the ROC is not included in the total income on the companion T5 form, therefore was not taxed as income. If it is not to be used to reduce the $UC cost base, then is it really a tax-free distribution? Or have I missed something?

  9. Sol Jakubowicz

    I am getting a return of capital adjustment figure on year end statements and on the T3 box 42,but not receiving any actual money. This roc adj. is used to decrease my adjusted cost base and therefore increase my capital gains if I were to sell the shares. Since I’m not receiving any actual $ what purpose does this serve?

  10. AdjustedCostBase.ca

    Sol,

    It’s possible the return of capital was reinvested into the fund and not distributed. If this was the case then the return of capital would decrease the ACB, but the reinvestment would increase the ACB by the same amount, and they would effectively cancel each other out.

    Unfortunately, reinvested amounts are not reported on T-slips. To see if there was a reinvested distribution for your fund you can follow the instructions here:

    http://www.adjustedcostbase.ca/blog/tax-breakdown-service-for-etfs-and-trusts-from-cdsinnovations-ca/

    and look for any “Total Non Cash Distribution” amount.

  11. Mame Bate

    Hi, I’m new to mutual funds this year, but learning fast. One of the T3’s that I received this year had an amount in Box 42. I have not disposed of the funds in the T3, so can I just ignore the amount in Box 42 this tax year until the year that I sell the fund and then use it to get an adjusted cost base?

  12. potatoman

    @Mame Bate

    Probably OK for this year, but after several years its possible for the RoC you receive on your investment to exceed the amount you initially paid for your investment. If the cumulative return of capital exceeds the amount you actually paid to acquire fund units, then your ACB could go negative. Negative ACB in a trust unit results in a capital gain that must be reported in that year. You should be tracking return of capital you receive on a fund by fund basis when you hold your funds in taxable accounts.

  13. oradba.ca

    Hi,

    I own a company and have investments, one of which is an REIT stock. I am wondering how to account for ROC in my books of account, or even IF the ROC should be reflected in my books. (I enter the monthly dividends into my books.)

    I keep a separate spreadsheet of purchases/sales and monthly dividends, and it is easy to apply the ROC there to reflect the ACB. Should I also be making a (credit) journal entry to the book value (asset) account to reduce the book value in my books of account (to accurately reflect company assets)? And if so, what is the contra account I should debit? It isn’t income for the current tax year. I didn’t receive any cash in hand. It isn’t dividends. How do I account for it?

    Thanks!

  14. AdjustedCostBase.ca

    oradba.ca,

    Normally for ROC, you can account for it in your books by crediting/decreasing the REIT and debiting/increasing cash. That seems unusual that you didn’t receive the distribution in cash, so you may want to double check that (unless the distribution was reinvested, in which case you would debit/increase the REIT, effectively negating the ROC).

  15. oradba.ca

    Thank you, I think have it now. The confusion comes by my monthly investment statement wherein the total distribution is listed simply as dividends. It isn’t until I get the T3 details that I can see this single value broken down into ROC (box 42 – amount resulting in cost based adjustment), Capital Gains (box 21, but listed on my statement as “Capital Gain Div”), and Other Income (box 26).

    I have been accounting monthly in my books as 100% dividends, and then when the T3 details arrive I remove the money from dividends and adjust the cost base in my book value account. Since I only report annually, this works for me for the most part. My year end is July and I get the T3 details for the previous calendar year. I’ll have to see if I can get these details on demand.

    Your article and reading through the comments have been very helpful.

    Thanks!

  16. Vern

    I receive T3 slips with box 42 ROC details. I would like to post the information on Quicken Home & Business 2016 program. There is a transaction on Quicken named Return of Capital & Transfer but what do I enter for Transfer Account?

  17. Ian

    For a Canadian REIT, is the amount reported in box 21 of the T3 slip as a capital gain added to the adjusted cumulative cost base?

  18. AdjustedCostBase.ca

    Ian,

    Capital gains distributions do not affect ACB, unless they are reinvested (via a DRIP or a phantom distribution). Capital gains that appear on your T-slips are reportable and taxable for the current tax year.

  19. laa

    hello,

    Is tax info on T5008/RL-18 usually correct for income tax purposes?
    Do I still need to verify ACB as per box 42 for all years?
    I don’t have any records when I stopped receiving cash dividends and started reinvesting.
    Also, on the statement I received from the Trust, I can see that amount is reported in the box 42 of T3 was used for shares acquisition. Confused. It says in the post that ROC is not used to buy shares. Should I then increase ACB by that amount or decrease?
    Please advise and clarify.
    Thanks

  20. AdjustedCostBase.ca

    laa,

    A report on ACB and capital gains from a mutual fund directly is more likely to be correct than that from a brokerage. See the following for more information about this:

    https://www.adjustedcostbase.ca/blog/can-you-rely-on-your-brokerage-for-calculating-adjusted-cost-base-and-capital-gains/

    If a return of capital distribution is reinvested, then the two actions effectively cancel each other out, resulting in no change in ACB. However, if the distribution is not entirely composed of ROC and/or the distribution is not entirely reinvested, then there will likely be a net change in ACB.

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  22. lastminutetaxdoer

    How do you deal with the ROC reported on Box 113 of T5013 (Partnership Income)? I believe it is still used to reduce the ACB of the limited partnership. How do make an entry of this in the transactions? Btw, I’m using your premium service and I really love it so far! Thanks:)

  23. AdjustedCostBase.ca

    lastminutetaxdoer,

    I believe ROC reduces your ACB for a limited partnership in the same way as other types of units. This can be inputted into AdjustedCostBase.ca as a “Return of Capital” transaction as described above. Just make sure that the total return of capital amount is correct when adding the transaction.

    Thanks for your feedback!

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  25. MungoDM

    Hello,

    My broker on an annual basis reduces my ACB by the amount of ROC on my T3 slip saving me the headache of doing the calculations myself unless I sell before the adjustments are processed. For most of my securities the amount reduced matched Box 42 on my T3 with the exception of Chartwell REIT. This REIT had a non-reportable component to the distribution that seems to have thrown the calculation out of whack. Does a non-reportable component affect the amount of the book value adjustment I should have on my ROC?

  26. AdjustedCostBase.ca

    MungoDM,

    According to Chartwell’s 2016 Management Discussion & Analysis:

    “In 2016, 36.7% of our distributions were classified as return of capital, 58.2% as non-taxable capital dividend and 5.1% as non-eligible dividend.”

    The non-taxable capital dividend portion does not affect ACB (and of course is not taxable). Only the return of capital portion affects ACB.

  27. A.S.

    Thank you greatly for sharing this valuable website and information. I have found it to be tremendously helpful to figure out how to calculate and track the adjusted cost base. For the Return of Capital ACB calculations, you have provided an example using the ROC percentages. Could you kindly offer an example on how you calculate the ROC when the CDS tax break down service reports ROC RATE instead of PERCENT values, using 2016 Horizons Active Emerging Markets Dividend ETF – Class E units (HAJ) for instance. I would like to know either how to calculate either the ROC ACB using the RATE value, or how to convert the RATE to PERCENT so I may apply it to your original example. Thanks again.

  28. AdjustedCostBase.ca

    AS,

    When the ROC amount is provided to you as a dollar amount, no further calculation is necessary. Adding a new “Return of Capital” transaction in AdjustedCostBase.ca you can input this dollar amount as a per share value. For example, the ROC amount for HAJ distribution with a record date of January 29, 2016 distribution would be $0.00466 per share.

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