6. Mutual Fund Tax Liability
-- Tax Planning - Investment Taxes --
Investment Taxes 6. Mutual Fund Tax
Wednesday 29 October 2003
Investors purchasing mutual funds or pooled funds close to year-end should be aware of an unexpected capital gains tax liability.
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6. Mutual Fund Tax Liability
Investors purchasing mutual funds or pooled funds close to year-end should be aware of a situation
whereby they might unknowingly ‘buy' a capital gains liability as part of their purchase. An issue
arises in the event the investor may have just recently purchased his fund units. If the fund distributes
its capital gains at year-end they will receive their prorata (i.e. up to the date of their purchase)
portion of the total capital gains recognized during the year. A capital gain distribution is most likely to
occur with the purchase of equity funds, since these funds typically generate the largest capital
gains. The problem is less of a concern with bond and balanced funds since the size of their
distributions is likely to be smaller. Most mutual funds have a December year-end and distribute
capital gains on December 15th; other funds will schedule their distributions earlier in the year. The
concern is with mutual funds with a December year-end, and only with funds purchased outside of a
Mutual funds accumulate the income received from the investments it holds until the fund's next
scheduled distribution date. The interest and dividends received by the fund as well as the growth in
the fund's underlying investments (i.e. capital gains) is reflected in a corresponding increase its Net
Asset Value (NAV) and therefore the value of each unit. Equity funds usually schedule their
distributions once a year. When the accumulated income is distributed the net asset value declines
by an amount equal to the distribution.
As previously stated, the Net Asset Value of a fund is also affected by the increase or decrease in
the value of the underlying investments (i.e. accrued capital gains/losses). When a fund manager
sells an investment to trigger a capital gain or loss, this recognized gain or loss is generally retained
within the fund until its fiscal yearend. Accumulated capital gains can represent a significant portion
of the fund's NAV, especially in equity funds.
In the case where an investor purchases a mutual fund just prior to a capital gains distribution, the
distribution they receive is actually a portion of their investment capital (i.e. the purchase price of the
fund units, since the accumulated capital gain was reflected in the fund NAV) returned to them as a
taxable capital gain. This capital gain distribution represents the capital gains accumulated since the
last distribution - in the case of most equity funds, the entire year. Depending upon the time of
purchase, most if not all of this distribution was recognized prior to the investor's purchase.
Once the distribution is made, the Net Asset Value of the fund is reduced by the amount of the
distribution. The investor has realized no increase in the value of his or her fund holding; they will
simply hold additional units with a lower unit price, assuming reinvestment of the distribution.
Consider the following example:
An investor purchases 100 units of a mutual fund at a price of $15 per unit on December 1, 2000.
The purchase price of $1,500 includes recognized gains of $2/unit that will be distributed on
December 15, 2000.
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6. Mutual Fund Tax Liability
The investor will have to pay a tax liability of up to $70 on the $200 capital gain distribution. The
distribution is reinvested in additional units at the new NAV of $13 per unit and continues to hold the
investment with a total value of $1,500. Ultimately, the investor will not be double-taxed since the
adjusted cost base on the units will be recalculated because of the reinvested distribution, but the
investor has paid tax prematurely.
The purchase of a common stock or closed end mutual fund does not necessarily result in the same
problem as the purchase of a mutual fund. When a stock or closed-end fund distributes its income,
the underlying unit price does not necessarily decline by exactly the same amount as the distribution.
Therefore, the investor is better off since the total value of the investment has increased (i.e.
ex-dividend value plus after-tax income is generally greater than the purchase price).
These solutions are specific to situations were you are considering purchasing or have recently
purchased a mutual fund with an expected capital gain distribution.
Wait Until January
The most obvious method of avoiding the receipt of unearned capital gains in a cash account would
be to simply wait and purchase the fund after the distribution date. This would likely require the
investor to wait until January before purchasing the fund. Again, this remedy assumes a December
distribution date; the solution is to purchase after the distribution, whenever it occurs. For example,
certain AGF funds have a September capital gains distribution date.
Sell before distribution date
If the investor has already purchased the fund, they could sell the fund prior to the distribution date to
avoid receipt of the distribution. Alternatively, they could swap the mutual funds into their RSP. This
would likely result in little or no tax liability since the cost base will likely be close to the sale price.
The potential capital gain should be determined prior to implementing this strategy. Be mindful of
redemption fees that may exceed the tax liability of the distribution.
Switch within the same fund family
One final option, if the investor has already purchased the investment, is to transfer out of the fund
into a money market fund within the same fund family. This option will avoid receipt of the distribution
but will trigger any unrealized capital gains that have accumulated since the investor made their
investment. This option would avoid the triggering of redemption fees on a mutual fund. Funds can
usually be switched within the same family at a minimal cost to the investor.
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