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
7 Comments, Comment or Ping
1. Dividend Growth Investor
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..
May 15th, 2008 @ 1:19 pm
2. WhereDoesAllMyMoneyGo.com
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
May 15th, 2008 @ 1:37 pm
3. FrugalTrader
Thanks for the clarification Preet! What is your opinion on ROC funds? Are there any that have consistently outperformed the market?
May 15th, 2008 @ 4:42 pm
4. WhereDoesAllMyMoneyGo.com
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.
May 15th, 2008 @ 5:28 pm
5. Philip Baron
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
Jun 11th, 2008 @ 1:27 pm
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!
Jul 29th, 2008 @ 3:11 pm
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
Nov 13th, 2008 @ 2:11 pm
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