Empty Pockets

From Our Canadian Bureau: Tax Tips for Fund Investors - T3s are only the beginning

Empty Pockets

Now that the registered retirement savings plan (RRSP) frenzy is behind us, most of the T3 (see bottom for description of terms) and T5 slips from GICs, stocks, mutual funds, segregated funds, and other pooled investment products should have trickled in by now. (Actually, the deadline is the end of March for those slips.) However, for Canadian investors gathering their tax information, that's just the beginning.

For investors with mutual funds or other investments in taxable accounts, we must look beyond the standard tax slips to determine the ultimate tax bill or refund. Here are a few tips to make sure you get it all straight.

The dreaded adjusted cost base (ACB)
Whenever you sell units of a fund, or shares of a stock, there is some tax consequence - usually a gain or a loss. To figure out any gain or loss, the ACB must first be calculated. ACB is the same as book value, which is the average cost of an investment and is usually expressed per unit or share of the investment in question.

Very basically, ACB per unit is calculated by taking the total of all purchases (including any buying commissions), and dividing that sum by the total units or shares purchased. Use units or shares purchased. Technically ACB per unit is calculated as: (total purchases acquisition costs reinvested distributions) ÷ (units purchased) Only units "purchased" should be used here, not unit "balance." Why? ACB is the average acquisition cost, so only purchases impact your per unit ACB.

Let's look at an example. Suppose you make the following transactions in a mutual fund: BUY 117.6471 units @ $8.50 per unit for a total purchase price of $1,000 BUY 210.5263 units @ $9.50 per unit for a total purchase price of $2,000 SELL 150.0000 units @ $10.00 per unit for total proceeds of $1,500 Total purchases are $3,000 ($2,000 $1,000), which bought a total of 328.1734 (117.6471 210.5263). From there, we calculate the ACB per unit as $9.14 ($3,000 ÷ 328.1734). The capital gain or loss is then calculated as: (selling price per unit - selling costs - ACB per unit) x (number of units sold) Selling costs can be any costs incurred to sell your investments, such as brokerage fees, redemption charges, or any other transaction related fee. In our example, the capital gain is $129 ( [10.00 - 0.00 - 9.14] x 150 ). If the next transaction in that series is another "sell" transaction, the ACB per unit will still be $9.14. It can't be stressed enough that the $9.14 will only change when additional purchases are made.

For 2001 and subsequent years, only half of capital gains will be taxable. However, for the 2000 tax year, I won't even begin to try to explain the taxable amount (i.e. inclusion rate). Two federal budgets resulted in three different inclusion rates, so pay a visit to myBC.com where you'll find a summary of the tax changes for the 2000 tax year.

Those are the basics, but there are a couple of other points to mention depending on the specific investments you hold. Non-taxable distributions and cash distributions Mutual fund investors who receive distributions in cash - i.e. not reinvested - should not include such cash distributions in the above calculation. Only reinvested distributions are added. Further, there are some mutual funds that pay out distribution that are greater than the actual income generated in the fund. The result: the fund dips into the original capital to pay out the distribution. When a fund does this, that part of the capital paid out is called a "return of capital." Since it's a return of capital, it isn't taxable.

There are two things to know about return of capital distributions. If you receive any "return of capital" distributions and it's not reinvested, your ACB per unit for that fund is reduced by the amount of "return of capital" per unit. How do you know if you've received a return of capital? Look at your T3 and annual mutual fund statement side-by-side. If the total of "distributions" listed on your statement for the year exceeds the amount of income shown on your T3, you've got a return of capital. If, on the other hand, this return of capital distribution is reinvested, the net effect is nil. In other words, the fact that a fund returns original capital reduces the ACB, but the fact that it's reinvested bumps it back up. Check this out for any fund with fixed distributions. Funds notorious for paying out capital include Mackenzie's Industrial Income, Mackenzie Industrial Dividend Growth, and Clarington Canadian Income. Segregated Funds The tax implications of segregated funds are pretty much the same as for mutual funds with one primary difference. When a mutual fund manager was unsuccessful in her stock trading and realizes a net capital loss for the year, the loss cannot be passed on to investors - only gains are flowed through to investors. The loss is kept in the fund to offset any future gains from the fund's stock selling. However, segregated funds do flow losses through to investors. That allows you to claim that loss immediately against any other gains you may have, rather than waiting for the fund manager to generate future gains. Further, when calculating your ACB of a segregated fund, the capital loss that is flowed through to you also reduces your ACB.

Labour sponsored investment funds (LSIFs)
This year, many LSIFs became eligible for redemption without the tax credit clawback. If this was done in a taxable account, there are special rules of which to be aware. Any tax credits received by an investor on the original purchase of the LSIF has no effect on the ACB. However, if you sold your LSIF units at a loss, the original tax credits will reduce your capital loss.

Exempt gains balance (EGB)
Did you realize gains for the general capital gains exemption on your 1994 tax return? Do you still hold units of funds for which you crystallized gains? If so, make sure you don't forget to benefit from this time-limited tax shelter. When gains were crystallized for mutual, segregated, or any type of pooled investment fund (known as flow-through entities), the ACB of these units didn't get bumped up like they did for stocks. Rather, a "pool" of exempt capital gains was created for each fund for which gains were crystallized. You could use a fund's exempt gains balance to offset only capital gains (either from distributions or from selling units) of that same fund. But investors were given only ten years during which to use up that pool, which means you must "use it or lose it" by the year 2004.

Hopefully, these tips will better help you prepare your taxes or at least help you get more organized when you deliver your pile of papers to your tax preparer. It's also worth noting that although I've tried to highlight the important points on mutual fund taxation (and ensure their accuracy), there may be things I've overlooked that apply to some of you. Hence, it's always a good idea to seek the advice of a real professional when it comes to taxation.

Explanation of Terms:
T3 - tax information slip detailing taxable income from a trust (including mutual fund trusts)
T5 - tax information slip detailing taxable income from GICs, mutual fund corporations, etc.
GIC - Guaranteed Investment Certificate (aka - a term deposit usually sold by banks, trust companies, or life insurers)

Dan Hallett, B.Comm., CFP is Senior Investment Analyst with Sterling Mutuals Inc. Sterling Mutuals is registered as a mutual fund dealer in Ontario, British Columbia, and Manitoba.