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How Return OF Capital Works





The topic of Return OF Capital has been discussed at nauseum in the comments, but I thought that I should bring it to the front page as the same questions keep coming up.

What is ROC?

Return of Capital is when a publicly traded company distributes money collected from their share holders back to the share holders themselves. The resultant distribution is non taxable but decreases the adjusted cost base of the original purchase (tax deferral). When it comes time to sell in the future, providing that there is a profit, the capital gains tax will be paid on the new adjusted cost base minus the selling price.

An Example

Purchase XYZ income trust for $10, it distributes an annual ROC of $1. Sell 1 year later for $20. The capital gain is: $20 – ($10-1) = $11

Who distributes ROC?

Income trusts and some corporate mutual funds. The biggest indicator of ROC is if the distribution is extremely high relative to the yields of the strong dividend stocks.

What about ROC and Leveraged Investing?

For leveraged investing, it is not preferred to buy anything that has a return of capital component in their distribution as ROC reduces the tax deductibility of the investment as it is received.

One way around this is to use the ROC distribution to pay down the investment loan and re-invest if desired. Technically though, this should be the same as leaving the ROC distribution within the investment account. However, this assumption needs to be confirmed with CRA or an accountant.

Receiving ROC in a leveraged investment account can also be an accounting nightmare if dividends/interest/ROC are mixed together in a distribution, and regular withdrawals from the leveraged account are needed (like with my version of the Smith Manoeuvre).

Please see the article “Key Considerations of an Investment Loan” for more details.

I would be grateful if tax experts/accountants would chime in!

Disclaimer: Information provided in this article are for entertainment purposes only and if used, it is at your own risk. Please consult a tax expert before implementing anything you read here





31 Comments, Comment or Ping

  1. Most of the income trusts achieve their high yields because their distributions include return of capital. Thus, when I invest I usually buy stocks which I understand how they make money and are able to pay dividends. Also dividend payout ratios should be checked for reasonableness – if over 100% I am not getting in..

  2. For T-class funds, when your ACB reaches zero, every distribution becomes taxed as a capital gain (less actual interest and dividend income). Basically the portion of the distribution that was ROC and was not subject to tax, is now completely subject to tax at 50% x MTR.

    Also a clarification: a fund doesn’t necessarily need to be set up as a mutual fund corporation to distribute ROC. Funds that distribute ROC are usually classified at T-class funds, which may be structured as either unit trusts or corporations.

    The advantage of the corporations is that you can start with the non-ROC fund and then when it comes time for cashflow, you can switch a portion of the funds into the T-class version to get the tax-efficient cashflow. The goal is to defer taxes as long as possible.

    Preet

  3. Thanks for the clarification Preet! What is your opinion on ROC funds? Are there any that have consistently outperformed the market?

  4. There might be a few, but the same argument applies as for mutual funds in general versus indexation. Indexing products have low turnover and are pretty tax efficient compared to actively managed portfolios with high turnovers. Many broad mandate funds don’t beat their benchmarks, however I see that the real benefit of ROC fund structures is as mentioned before, when you have the non ROC version (in a corporate class structure) while accumulating, and then switching to ROC versions later when you need the income. You can delay massive amounts of taxation until much later.

    However, with the new TFSA accounts – this will negate both the ROC and corporate class structures for the new generation of investors who will be building up room faster than they can use it.

    The TFSA has wide ranging implications!

    But for those who have windfalls (sales of businesses for example), they may do well to examine the tax savings of investing the lump sum in a corporate class, ROC structure for tax efficient cashflow. Fidelity and CI and Franklin Templeton are three of the big providers and all have large fund selections. The savings can be quite good especially if there is a lot of tax inefficient income (i.e. a higher proportion of fixed income in the portfolios). But best to compare all alternatives. Some find they are happy to save on fees used indexed products or purchase a diversified portfolio of higher yielding securities.

  5. In an incorporated mutual fund structure, an ROC class of shares can be used to provide a fixed monthly return of capital distribution to higher income investors looking for tax efficient cash flow. At NexGen Financial, the Return of Capital Class can be utilized in any one of 15 of the 16 funds at a distribution of 7.5% per annum. This creates tax efficiency since the investor is not taxed on the original principal returned. The ACB is lowered as distributions paid. As mentioned above this is ideal for high income investors looking for tax efficient cash flow, investors looking to defer capital gain liabilities, investors looking to manage “clawback” concerns on old age security payments, tax free transition from growth to income, and tax efficient charitable giving.

    http://www.nexgenfinancial.ca

  6. 6. WealthManager

    One question I’ve been trying to get clarification on regarding ROC is how to handle ROC when it’s reported annually and there are mid-year partial dispositions? How does one allocate a yearly amount to calculate average unit cost just prior to sale (and thus capital gains calculation)?

    Using CRA’s example:
    http://www.cra-arc.gc.ca/E/pub/tg/rc4169/README.html

    It would appear you just ignore the annual ROC and apply to the remaining units. In a situation where 90% of the security was sold, nearly all of the ROC amount would be used against the remaining 10% in the given year, thus not accurately representing the correct proportions.

    Is there something else that could/should be done here? This assumes of course that you can’t get a more detailed breakdown (e.g. monthly, quarterly) which is more common with trusts vs. mutual funds.

    Cheers!

  7. 7. Jineshwar singh

    Is it true to say that corporate class mutual funds levy more in management expense ratio (MER) than non corporate class funds?
    From a tax stand-point, is it better (financially) to invest in corporate mutual funds for a retired person paying 30% income tax? Is the extra payment in MER worth for receiving ROC (Return on Capital)?

    Many thanks

  8. 8. lee

    quote from article:
    “Receiving ROC in a leveraged investment account can also be an accounting nightmare if dividends/interest/ROC are mixed together in a distribution”

    I don’t believe that’s the case, all investment growth (interest or dividend or cap gain) will end up as 50% capital gain in the ROC fund after all principal has been withdrawn.

  9. 9. Vern

    @FT – How does ROC affect using iShares XDV or Claymore’s CDZ for the Smith maneuver? Would this mean that annually I would need to pay off the HELOC for the ROC portion of above ETFs’ distributions, than reborrow to buy more shares to keep the HELOC’s interest tax deductible?

    Will ROC distributions change into eligible dividend distributions when income trusts change into corporations in 2011?

  10. @ Vern – That’s the reason why I don’t hold XDV or CDZ in my SM portfolio due to the ROC. You should consult with an accountant, but it looks like to keep everything clean, you may want to do as you suggested. Withdraw the ROC, pay down the investment loan and reborrow if you wish.

    With regards to income trusts becoming corporations, I could be wrong but I don’t see ROC distributions continuing as most dividend paying companies do not pay out ROC.

  11. 11. Vern

    @FT – That’s excellent news, even though it would be a little hassle to shuffle the money around. I just finished looking back at some of Ed Remple’s comments and he made the same point as you. Either use the ROC portion of the distributions to pay down the investment loan then reborrow it to buy more shares, or simply use the ROC portion directly within the investment account to buy more shares (thus keeping the capital invested) and withdraw the dividend portion.

    If income trusts become dividend paying corporations than using an ETF like XDV or CDZ could become viable choice for the SM. You could setup your HELOC for regular transfers to your investment account, set the investment account to buy just one ETF, after paying the taxes annually withdrawn the dividends to drop on the non-deductible mortgage and repeat. I guess the only consideration than is reduce the Canadian content of the rest of your portfolio (RRSP & TFSA) to maintain your diversification.

    I really hope that XDV and CDZ will become 100% eligible dividend payers. Than I can setup my dream portfolio (the percentages are of my contributed money):
    RRSP:
    25% VIG – US Dividends
    12.5% VEA – Europe & Asia
    12.5% VWO – Emerging Markets

    TFSA:
    18.75% CLF – Corporate Bond Ladder
    18.75% CBO – Canadian Bond Ladder
    12.5% XRE – REIT

    Non-Registered (100% HELOC leveraged): CDZ – Canadian Dividends

    Basically, my savings would go towards topping up the RRSP and TFSA accounts while the leverage funds would purchase the Canadian content. I hope this portfolio would maximize tax savings, keep the MER low and let indexes select the stocks instead of me.

    What are your thoughts FT?

  12. @ Vern, as you know, I’m not a qualified financial advisor. But if you want an opinion, it looks like a pretty darn good portfolio to me! If you don’t mind me asking, how old are you?

  13. 13. Vern

    @FT – (laughing) I know you’re not an advisor and that I “should consult a professional before making investment decisions”. Thanks for your personal opinion on a hypothetical portfolio.

    I’m 27, married with a baby due soon. I’m in the education sector with a growing pension fund. I’m saving towards buying a triplex home with my in-laws (1/2 the mortgage + free daycare + rental income for mortgage lump sums/ future income stream). I hope to use the SM to pay off the non-deductible mortgage before my in-laws retire. After that I plan to retire in my 50′s.

  14. 14. K

    Hi Everyone,

    Does anyone know how I can draw off CDZ taxable distributions and leave ROC invested?

    CDZ has monthly distributions, but the tax breakdown isn’t reported until AFTER year end.

    Can I estimate the distribution breakdown and reconcile after year end?

    Any ideas or suggestions would be helpful.

    Thanks,

    K

  15. 15. K

    Hi,

    Just wanted to clarify my last post.

    I’m planning to invest in CDZ with a modified smith maneuver.

    I want to accelerate the debt conversion by drawing off the taxable distributions to pay down the mortgage and then reborrow from the credit line to reinvest.

    The ROC component is very small, but I need to separate it from the rest.

    I don’t know how to do this when the tax breakdowns aren’t reported until year end.

    Thanks,

    K

  16. 16. M

    I have the same question.

    I’m torn between FT’s dividend strategy and Ed Rempel’s corporate class fund strategy. The downside of FT’s is the research time and tax drag. The downside of Ed’s is return of capital and very high MERs. I was thinking about a corporate class ETF (Purpose Core Dividend Fund) which avoids the very high MER. At 0.55%, its on par with CDZ (0.66%). It has half the fund in US dividends while avoiding the foreign income tax rate. So its about the same cost, but better diversified and more tax efficient.

    Then I would have to figure out how to deal with ROC. But I would need to figure that out regardless if I choose Ed’s funds, PDF, CDZ, or XIC. The details of how to deal with ROC is the $64000 question at the moment.

    Given that XIC’s proportion of ROC has ranged from almost nil to 16% of total distributions, the best I can think of is to withdraw say 80% of the distributions as they arrive (to put against non-ded and reborrow), leave 20% of the distribution in the investment account, and reconcile at year end by reinvesting the confirmed amount of ROC and withdrawing the remainder. I will probably need to engage an accountant on that question if Google comes up short.

  17. @M, have you looked at Vanguards dividend ETF VDY? It has a MER of 0.34% and hasn’t distributed ROC in the last two years. However, that’s not to say that it won’t distribute ROC in the future.

  18. 19. M

    Thanks FT, I checked out VDY.

    I had a good chuckle when I read Ed’s critique of most mutual funds as being “closet indexers.” I accuse VDY of being a closet indexer. Is that possible for an ETF? Looking at VDY’s top ten holdings, I see the TSX. Sure enough, VDY’s distribution yield is 2.68%. XIC’s yield is almost identical at 2.66%. Why pay 0.34% for the TSX via VDY when I can get it for 0.05% with XIC? The hassle of dealing with ROC would have to be significant for me to forego 30 years of an extra 0.29% (assuming that VDY somehow manages to avoid paying any ROC, ever). I calculate that as a 9% difference in my final portfolio value.

    I ran XIC, VDY, PDF, and IVV’s stats through a spreadsheet to compare MER and tax efficiency at an income level of $100,000. I controlled for differences in the distribution yields. For example, XIC’s distribution over the last five years averaged 89% eligible dividends, 5% other income, 5% return of capital, and 1% capital gains (low turnover in the TSX 60 obviously). VDY was also mainly eligible dividends, while IVV was 100% foreign income, and PDF was 44% Canadian dividends, 45% capital gains, and 11% return of capital. I thought PDF would do well, but XIC came out the winner. XIC and PDF were equal in after-tax, after-MER take-home yield at 2.1%, but only because PDF had a higher distribution yield to start with. After controlling for yield, XIC was the most efficient, followed by VDY and PDF. IVV came in last because it was all foreign income (IVV also fared the worst in raw take-home because the S&P only yields 1.81%).

    There is more work to do in the hunt for a low MER, tax efficient, geographically diversified SM couch potato portfolio.

  19. @M, good to see some quantitative analysis! Can you keep posting updates on what you find for tax efficient ETFs ideal for SM? I may get a post together on the topic.

  20. 21. M

    FT: You were right about MER being a deal breaker. If PDF’s MER was the same as XIC, PDF would match XIC in tax efficiency, MER efficiency, win in take home yield, and win handily in geographical diversity.

  21. @M, for Canadian exposure, tax efficiency, and LOW MER, have you looked at HXT? 0.09% MER and no distribution. It covers the TSX 60.

    http://www.horizonsetfs.com/pub/en/etfs/?etf=HXT&tab=overview

  22. 23. M

    I think the site ate my reply.

    HXT is a good idea for efficiency. Add HXS for US exposure, and Europe has plenty of swap ETFs. I wonder about the lifetime returns, and how big the tax bill would be when it finally came?

    Downside is that no distribution means a slower debt conversion. There’s also counterparty risk and regulatory risk. Are we absolutely sure that capital gains will be taxed as favourably in 30 years as they are now?

    That could be your article. Swap ETFs for SM.

  23. 24. M

    Do swap ETFs qualify for interest deductibility? Their reason for being is to defer distributions until redeemed, so, can one argue that there is potential for income?

    Page 22 of the HXT prospectus says “The ETFs will not make regular distributions.”

    Page 32 says “each ETF has the authority to distribute, allocate and designate any income or capital gains of such ETF to a Unitholder of such ETF who has redeemed Units of the ETF during a year in an amount equal to the Unitholder’s share, at the time of redemption, of the ETF’s income and capital gains for the year or such other amount that is determined by the ETF to be reasonable,” and “provided a Unitholder does not redeem their units of an ETF that uses a Swap as its sole investment strategy, the Unitholder is not expected to receive any distributions of income for purposes of the Tax Act in a taxation year throughout which the Swap is in effect.”

    It seems to me that arguments could be made for either side? Surely this question has already been answered, given the popularity of swap ETFs.

  24. 25. M

    My gut tells me that swap ETFs must be investment loan deductible.

    Ed recommends corporate class mutual funds which he describes as “100% tax efficient,” which I interpret to mean that the funds pay no distributions. So swap ETFs must also be deductible. But why?

  25. 26. Ed Rempel

    Hi M,

    Why not look for “negative MER”? Instead of accepting below index returns, why not put your brain to work to figure out how to beat the indexes?

    Here is my question – What is the “cost” of a fund with an MER of 2.5% that has beaten its index by 3%/year compounded for the last decade resulting from stock picking skill?

    I get a kick out of reading about the debate of how much lower a return than which index everyone wants. For myself personally – I can tell you that I have never and will never own any passive ETF or index-type investment of any type. I have no interest in index-lagging returns.

    There are a variety of strategies proven to beat indexes in the long run. We do it by studying All Star Fund Managers – finding top stock pickers. I can tell you there are fund managers that have outperformed their index by wide margins over the long term and over their career – often with lower risk. Our core Canadian fund manager has had triple the growth of the TSX in the last 15 years with 20% lower volatility.

    Other strategies proven to beat indexes are value investing, high “Active Share”, small caps, buying less liquid stocks, and having focused portfolios. I’m sure there are more.

    Dividend investing would also be included as an index-beating strategy, but only if you can invest at lower P/Es than the index and without restricting yourself to Canada.

    The mind is a powerful thing. Once you start focusing on how to most reliably beat the index long term, you may be surprised what you find.

    Ed

  26. 27. M

    Thanks for the reply Ed.

    I respect your posts a lot. It is clear that your accounting/financial planning dual background is perfectly suited to SM expertise, so much so that I am considering becoming a client.

    You will understand that I am very skeptical when it comes to claims of beating the index, risk adjusted, over the long term. Not that it can’t be done, and not that it wouldn’t be worth paying high MERs for. I think it is a rare skill, and it is risky for the common investor to try to find that manager. That you receive commissions from these funds, in my opinion, lessens the likelihood that your claim is true. Judging from the quality of your posts it is possible that you have found such people, yet I remain skeptical. Further, that you call ETFs “index lagging returns,” when they trail the indexes by only minuscule MERs and tracking errors, misleads someone who may confuse lagging the index by 0.1% to lagging the index by many times that amount. I disagree that ETFs are “index-lagging” unless you are really splitting hairs.

    When it comes to the idea of “negative MER,” using the example you give of beating the index by 0.5% after MER over the long term, is that a sufficient reward for the risk I have taken by trying to find that rare manager? If I know that I can passively obtain a fractionally below-the-index return at no extra risk, and I know that 90% or more of fund managers fail to beat the index over the long term (before MER!), how is that extra 0.5% of return worth the risk I assume by trying to find the diamond in the rough? I would definitely have to see it to believe it.

    Any thoughts on the original question of whether swap ETFs qualify for deductibility? Are your funds able to maintain deductibility without distributions simply because they are not explicitly prevented from making distributions?

  27. 28. Brandon

    How can you tell if a fund distributes return of capital? ive just started the SM and id like to do it using ETF. Do index ETF distribute ROC?

    Thanks!

  28. Best bet is to go to the ETF homepage (google the ETF), then click on their distributions/taxation tab. They generally will break down the distribution over the past few years.

  29. 30. Brandon

    what if you use the dividend distribution to just buy more of the ETF with a DRIP. Will the interest on the loan still be tax deductable?

  30. 31. ken

    Hi Brandon,

    I looked into this recently before I started the SM.

    Yes, your loan remains tax deductible. If you re-invest all distributions you will be fine.

    There would be problems only if you take distributions out of the investment account. For example if you take distributions out to pay down the mortgage or put into a TFSA. This would create serious accounting difficulties.

    Ken

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