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The Companion Advisor: Taxes & Estates
Mutual Funds - Year end distributions tax tips

A Companion Advisor Article Prepared by:
Sal Tino, C.A. and Suzanne Grimble, C.A
Clarington Mutual Funds

December 31 is an important date for mutual fund investors, as this is the day most mutual funds make their distributions to investors. Here are some frequently asked questions about how mutual funds distributions are taxed and how this impacts your clients and our answers to these questions.

Article Index
	Why year-end distributions?
	How are distributions taxed?
	Does it matter how long I hold my mutual fund units?
	What is a return of capital?
	Consequences of receiving a distribution in the form of units
	Why is ACB relevant?
	How did they avoid attribution?

Why do we have year-end distributions?

Any income earned during the year by mutual funds must be paid out to its investors or the fund risks paying tax on this income. This is consistent with the idea that economic consequences pass from the mutual fund to investors. Only those investors holding units of the funds at December 31st will receive a distribution.

How are distributions taxed?

Mutual funds primarily earn interest income, dividends, foreign-sourced income and capital gains. Each of these types of income is taxed differently. The various types of income earned by the mutual fund retain their cc character" when distributed to the investors - interest income in the fund is interest income in the hands of the investor. The fact that the income was received from a mutual fund has no bearing on its tax treatment.

The following summarizes the various types of income generally distributed from a mutual fund:

-Interest income is the income earned on instruments such as T-bills and bonds. It is categorized as "other income" on T3 slips. This type of income attracts the highest rate of tax.

-Dividends from Canadian corporations are subject to the 25% gross-up and tax credit mechanism. Canadian dividends attract the lowest rate of tax.

-Foreign-sourced income includes both interest and dividends from outside Canada. This income is reported in Canadian dollars, gross of any foreign taxes paid. It is subject to the same rate of tax as interest income, although foreign taxes paid may be claimed as a tax credit.

-Capital gains are generated upon the sale of securities by the mutual fund. Unrealized gains are not taxable. The fund will distribute the entire capital gain, although only 75% is reported as income by investors.

Does it matter how long I hold my mutual fund units?

The answer is no. As long as the units are owned on December 31, even if they were purchased the day before, the investor will receive a distribution. This, of course, is only relevant to those people who hold investments outside their registered plans.

There has been a lot of discussion recently about the potential tax cost associated with buying mutual funds towards the end of the year. This tax cost may not exist in all cases. For example, if a client has tax losses available, the client can invest in a mutual fund that is going to pay a distribution. The losses can then be applied against the income received and there may be no resulting tax liability.

It is also important to look at the mutual funds themselves. Some funds do not have large distributions at year-end because they pay distributions throughout the year. Also, some funds do not have a lot of income to distribute. The performance of many growth equity funds, for example, is attributable to unrealized £rains on investments, which are not taxable.

What is a return of capital?

If a fund distributes more than the income and capital gains earned in the year, the excess is considered to be a return of capital. This return of capital is not taxable, although it reduces the adjusted cost base of the investors' units. By reducing the cost base, the investors capital gain will be larger if they sell their units.

What are the consequences of receiving a distribution in the form of units?

The income distributed is taxable whether it is paid in cash or reinvested in the fund. A distribution in the form of units will encourage compound returns; however, it does not provide cash to pay the resulting tax liability. In addition, the cost base of your client's investment will be increased by the value of the units received.

Why is 'adjusted cost base" relevant?

The adjusted cost base of the units is important for two reasons. Firstly, it is used when calculating the capital gain or loss resulting upon the sale of units. Secondly, the foreign content of RRSPs and RRIFs is determined with reference to the adjusted cost base of the units. These types of plans may hold 20% of the assets in the plan in foreign securities, measured at cost. It is therefore necessary to keep track of these adjustments to the cost base to avoid incurring penalties.

Now that we are approaching the end of the year, it is important to closely monitor the foreign content of your client's registered plans. The foreign content of these plans could exceed the 20% limit as a result of a reinvested distribution from a foreign fund. For plans that are close to the 20% limit you may wish to request cash distributions. Alternatively, you may wish to purchase more Canadian investments.

The comments in this Tax Tip are not intended, nor should they be relied upon, to replace specific professional advice.

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