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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







13 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.

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