April 2002

Another Tax-Efficient
Mutual Fund Option

© Talbot Stevens

Investors now have another tax-efficient way of investing outside of RRSPs. A relatively new and popular type of mutual fund can promise very attractive fixed yields of around 8 to 10%, but these funds are not like regular mutual funds and are easily misunderstood.

"Return of capital" funds, as we might call them, generally pay out a regular monthly distribution, making them appealing to those who are perhaps retired and requiring income from their investments. However, while the annual distribution might be in the 8 to 10% range, investors should be clear that this payout is not guaranteed, and more importantly, it is not a "return on investment", which is the yardstick for most investments. In many cases, the majority of the income received is treated as a "return of investment", or a return of capital.

Like an unregistered annuity, these funds result in less tax payable on the income received because some of the payout is considered to be a return of your own money, which has already been taxed.

As long as everyone understands what they're getting, these "return of capital" funds are more tax-efficient than annuities and even Systematic Withdrawal Plans (SWPs) set up with regular mutual funds.

The danger for investors who only have a superficial view of these products is that they may think they have a fixed-income investment producing 8 to 10% guaranteed annual returns - obviously appealing when short-term GIC returns are 2% or less.

Income trusts have been around for a long time, and generate an income stream from mature businesses like real estate (REITs: Real Estate Investment Trusts) and energy. With energy trusts, the trusts' reserves and thus assets generally are depleted over time, unless new reserves are found. These funds, which might be called royalty trusts, generally do not target a fixed payout.

The newer approach that results in similar tax treatment is for fund companies to take their income or balanced funds and pay investors regular distributions, with a portion of the payout non-taxable as a return of capital.

Technically, what happens is the "return of capital" distribution lowers the Adjusted Cost Base, or ACB. When any non-registered investment is sold, capital gains taxes are payable on the difference between the amount the investment was sold for and the ACB. Until the ACB declines to zero, the majority of the monthly income is received tax-free, resulting in tax deferral. With an annual 8% distribution, it would take about 12 years for the ACB to reach zero, when you would face tax on the entire monthly distribution.

If you are seeking tax-efficient income from your non-registered funds, already have a Systematic Withdrawal Plan, or want another way to save in a tax-deferred way, talk to your advisor about these "return of capital" funds.

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