Invesco Canada blog

Insights, commentary and investing expertise

Invesco Tax & Estate team | October 5, 2021

Tax and estate planning: How do fund distributions affect ACB?

Most investors who hold funds (e.g., mutual funds and exchange-traded funds) in non-registered accounts are familiar with how purchases and redemptions affect their adjusted cost base (ACB). However, many are not aware of how distributions affect their ACB. Distributions can impact an investor’s ACB depending  on the income characterization of those distributions and whether they are reinvested or paid out in cash.

Generally, an investor’s ACB (sometimes referred to as the “tax cost”) is the sum of all the purchases in the fund and any expenses incurred for those purchases, such as commissions or sales charges1, adjusted for certain corporate actions.

It is critical to know the ACB to calculate the capital gain or loss when the fund is disposed of or deemed to have been disposed of. When calculating capital gains and/or losses, it is important to track the distributions’ effect on the investor’s ACB to ensure the figure is up-to-date and accurate.

Return of capital distributions

A return of capital (ROC) distribution is not taxable in the year received, which distinguishes it from the following investment distribution categories: interest income, Canadian dividends (eligible and ineligible), foreign non-business income and capital gains. The distribution’s effect on an investor’s ACB will depend on whether the investor decides to receive the distribution in cash or reinvest the distribution in the fund.

ROC distributions taken in cash reduce the investor’s ACB by the amount of the distribution. ROC distributions that are reinvested also first reduce the ACB by the amount of the ROC distribution, but then increase the ACB by the amount of the reinvestment. The result is no impact on the total ACB; however, more units or shares of the fund are purchased.

When a ROC distribution taken in cash results in a negative ACB, the negative part of the ACB is immediately taxable as a capital gain in the year this occurs. The taxable portion is subsequently added back to bring the ACB up to nil (zero) to avoid any double taxation on future dispositions.

Income distributions

An income distribution is included in the investor’s income in the year received, regardless of whether the distribution is taken in cash or reinvested. Income distributions can be composed of interest income, Canadian dividends, foreign non-business income and/or capital gains. Annually, the fund will indicate the income characterization and the total sum of the fund’s distributions on the tax slip issued to the investor.

Income distributions are taxed according to their respective income categorization, following Canadian tax rules. For instance, Canadian eligible dividends are grossed-up and given a dividend tax credit, whereas interest income is fully included as income.

Since income distributions are taxable to the investor in the year they are paid, reinvested income distributions are not taxed twice because they increase the investor’s ACB. On the other hand, income distributions paid in cash will not affect the ACB.

For investors who hold ETFs, special attention should be paid to year-end reinvested distributions. These year-end distributions are commonly referred to as “phantom distributions” because the investor does not actually receive any cash or physically see any additional units.

Instead, the investor receives a notional distribution of new units that are immediately consolidated so the net asset value (NAV) and number of units are the same as they were before the distribution. Although the investor does not receive any cash or any actual new units, the phantom distribution is taxable to the investor in the year assigned and it is reported on the tax slip.

To avoid double taxation, the investor should therefore adjust the ACB by the amount of the income portion of the phantom distribution reported on the tax slip. We will discuss “phantom distributions” in more details in our next blog post of this series.

Why the NAV decreases after a distribution

Income and capital gains earned by a fund are added to the fund’s total assets throughout the year and reflected daily in the fund’s NAV. At the end of the year, or on an earlier distribution date, some or all of the income received, and the capital gains realized throughout the year (or in the period since the last distribution) are distributed to investors from the fund’s assets. The distribution of amounts from the fund’s assets generally lowers the NAV by the amount of the distribution to account for the decrease in the fund’s assets.

Example of the impact of fund distributions on ACB

Let’s assume a unitholder purchases two units of Fund A at $4 per unit for a total of $8. The $8 becomes the unitholder’s ACB, with an average cost per unit of $4 ($8 divided by 2 units). Then the unitholder receives a distribution of $0.03 per unit, comprising $0.01 ROC and $0.02 income. The total distribution received is $0.06.

Scenario 1: The entire distribution is taken in cash

  • The $0.02 per unit income distribution has no effect on the ACB
  • The $0.01 per unit ROC distribution reduces the ACB by that amount
     

No new units are purchased, since the distribution was taken in cash, so the new total ACB for the initial two units is $7.98. The new average cost per unit after the distribution is $3.99 (the initial total ACB ($8) less the total ROC distribution ($0.01 x 2) divided by the total units (2)). Alternatively, it can be calculated by taking the new total ACB ($7.98) and dividing it by the total number of units (2).

Scenario 2: The distribution is reinvested

  • The $0.02 per unit income distribution increases the ACB by that amount and more units are acquired
  • The $0.01 per unit ROC distribution reduces the ACB by that amount and then, once reinvested, increases the ACB by the same amount; the impact is no change to the total ACB, but more units have been acquired 

The number of new units acquired depends on the NAV of the fund on the day of the distribution. If the NAV falls to $3.97, the investor will receive 0.01511 in new units ($0.06 divided by $3.97). The total number of units after the distribution will be 2.01511 units.

The new total ACB after the distribution is $8.04, calculated as the pre-distribution total ACB of $8 less $0.02 because of the ROC distribution plus $0.06 to account for the reinvestment of the entire distribution (ROC distribution and income distribution). With the receipt of 0.01511 in new units (based on a reinvestment price of $3.97 per unit), the new average cost per unit is $8.04 divided by the number of units (2.01511), which is $3.99. The total ACBs are different in the two scenarios since the unitholder does not receive new units in the first scenario, but receives 0.01511 new units in the second scenario. The average cost per unit will change depending on the amount of the reinvestment and the NAV per unit when the reinvestment is made. In the example given, we assumed no market fluctuation in the underlying investments and because the reinvested amounts are relatively small, the impact to the average cost per unit is negligible.

Summary – Impact of fund distributions on ACB
Distribution typeReinvestedCash
ROCACB decreases by the amount of the ROC distribution, then increases by the amount of the reinvested ROC distribution. No effect overall ACB decreases by the amount of the ROC distribution
IncomeACB increases by the amount of the income distributionNo effect

[1] Expenses such as commissions incurred on dispositions do not technically form part of the ACB, though they are valid outlays that may be deducted from the proceeds of disposition. This has the effect of reducing the capital gain or increasing the capital loss for income tax purposes. Also, the ACB is not to be confused with the security’s “book value” or position cost. The former may simply be the total of all cumulative purchases in the fund without regard for any reinvested distributions, corporate actions or adjustments to the ACB (such as for returns of capital). To be sure, investors should contact the institution providing the figure to determine the variables used to calculate the book value figure. The latter on the other hand, is a regulated figure specific to each security (or position) to give investors an idea of how the security has performed (in total dollar terms) relative to its market value.

More from Invesco Tax & Estate team

Year-end tax tips for 2021
November 24, 2021

Tax and estate planning: How do fund distributions affect ACB?
October 5, 2021

Tax and estate planning: What you need to know about gifting to family members (Part three)
August 12, 2021

Tax and estate planning: What you need to know about gifting to family members (Part two)
June 24, 2021

Tax and estate planning: What you need to know about gifting to family members
June 10, 2021

Federal Budget 2021: Sales and Excise Tax Measures
April 28, 2021

Federal Budget: Business Income Tax Measures
April 27, 2021

Federal Budget 2021: Personal Income Tax Measures
April 23, 2021

Foreign withholding taxes on ETF and mutual fund investments
March 30, 2021

Resulting trusts and registered plan beneficiary designations
February 18, 2021

Canada Revenue Agency makes it simpler to claim home office expenses due to COVID-19
January 18, 2021

Year-end tax tips for 2020
December 1, 2020

Transitioning from CERB to EI benefits or the new CRB
November 25, 2020

Power of attorney arrangements and beneficiary designations on registered plans
October 21, 2020

RESP withdrawals: basic rules and strategic considerations
September 24, 2020

Locked-in plans: Beneficiary entitlements and creditor protection
August 25, 2020

Locked-in plans: Types of plans and unlocking options
July 22, 2020

Locked-in plans: understanding the basics
June 23, 2020

An overview of COVID-19 government support programs
May 26, 2020

Planning strategies for Registered Retirement Income Funds
April 15, 2020

Subscribe to the blog


Do you want to subscribe in French?

Subscribe to receive e-mails from Invesco Canada Ltd. about this blog. To unsubscribe, please e-mail blog@invesco.ca or contact us.

NA8929

Important information

Image: Klaus Vedfelt / Getty Images

For more information about this topic, call us at 1.800.874.6275.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from your advisor or from Invesco Canada Ltd.

The information provided is general in nature and may not be relied upon nor considered to be the rendering of tax, legal, accounting or professional advice. Readers should consult with their own accountants, lawyers and/or other professionals for advice on their specific circumstances before taking any action. The information contained herein is from sources believed to be reliable, but accuracy cannot be guaranteed.