Once again, mutual funds have calculated their year-end distributions and are paying them out.

In some cases, these payouts produce unintended results that can push investors into a higher tax bracket than expected. This is because mutual fund companies are required to distribute all interest, dividends, other income and net capital gains to their unit holders at least once every year at their fiscal year-end.

For most mutual fund trusts, the fiscal year ends December 31. Money will be distributed to you even if you buy into a fund late in the year. So you may want to hold off investing until the New Year.

Fiscal years for mutual fund corporations, on the other hand, may end on dates other than the calendar year-end. That means distributions could occur at any time in the year. Your best bet may be to invest shortly after the distributions are made to avoid the tax.

The Liberal Government has introduced a new tax rule that makes switching between classes in a mutual fund corporation taxable after December 31, 2016. The exchange of shares of one class for another will be considered a disposition for tax purposes for proceeds equal to the fair market value of the exchanged shares.

The rule contains exemptions, however. A switch between series of the same class will continue to be tax deferred. In addition, share exchanges taking place in the course of a reorganization or amalgamation will continue to be eligible for rollover treatment.

Start a Review

As a result, it may be a good idea to review risk tolerance and investment objectives, as this change will speed up the taxes that would otherwise be deferred until disposition. In light of these changes, consult with your RSW advisor about whether you can better manage tax outcomes by re-balancing your investment portfolio before the year-end.

In most situations, income from mutual funds is taxed in two ways:

  • On the distributions that are flowed out to you while you own the shares or units. If you own units of a mutual fund trust, you will receive a T3 slip, Statement of Trust Income Allocation and Designations. If you own shares of a mutual fund corporation, you will get a T5 slip, Statement of Investment Income. The income can be capital gains, capital gains dividends, dividends, foreign income, interest, other income, return of capital, or a combination of these amounts.
  • On the capital gain, if any, when you redeem (or cash in) your units or shares. Your mutual fund investment is considered the capital property for tax purposes. You will receive a T5008 slip, Statement of Securities Transactions, or an account statement from the mutual fund.

The paradox with mutual funds is that even if they show thousands of dollars of losses in a bear market, you may still owe capital gains taxes. This is because the fund trust may have to sell holdings to finance redemptions if too many investors sell fund units. If the trust had held the stocks for many years, the sale could generate substantial capital gains. Those gains are passed on to you — along with dividends and interest earned — as taxable distributions.

Taxation Categories

Taxable earnings fall into four broad categories, each taxed at a different rate:

  1. Interest income on Treasury bills, bonds and similar instruments is taxed at the highest rate and receives no preferential tax treatment.
  2. Dividends from Canadian corporations are subject to a gross-up percentage and tax credit mechanism that results in preferred federal and provincial tax treatments. These distributions receive preferential tax treatment for individuals though the dividend tax credit.
  3. Foreign income, which includes both interest and dividends from outside Canada, is taxed at the same rate as interest income, but you may claim a credit for foreign taxes paid. This income is reported in Canadian dollars, gross of any foreign taxes paid.
  4. Capital gains, which will be taxed on what's left after adding front-end loads and other such expenses to the purchase price and subtracting redemption fees and similar costs from the sale price. Preferential tax treatment of only 50% of a capital gain is taxable.

If your paper gain is likely to be smaller than the expected distribution, you may want to drop out of the fund before the distribution and buy back into it after the payout. That would keep you out of the fund for about a week.

If you're looking at capital losses, you must first use them to reduce any capital gains you may have. After that, you can:

  • Carry back losses three years to offset earlier capital gains, which could generate a full or partial refund of capital gains taxes you already paid; or
  • Carry forward losses indefinitely to apply against future capital gains.

If you have tax losses available, you may want to invest in a mutual fund in December, apply the losses to the fund's taxable distribution and potentially end up with no tax liability on the payout.

Be Wary of the Superficial Loss Rule

The Income Tax Act bans selling investments to trigger a capital loss to reduce taxes and then repurchasing the same or an identical investment within 30 calendar days. This is called the superficial loss rule. It applies when you sell the asset to an affiliated person or if an affiliated person repurchases the same or identical asset within those 30 days.

The rules are complex, but generally a loss is deemed superficial and you can't claim it if you, your spouse or common-law partner — or a company either of you controls — purchases an asset identical to one you sold within 30 days before or after the original disposition. The denied loss can usually be added to the adjusted cost base (ACB) of the investment (see box below).

Moreover, you also can't sell property held in a non-registered account and reacquire it within an RRSP or Registered Retirement Income Fund (RRIF).

Additional Strategies

Staying out of the market to avoid a superficial loss generally means you can't take advantage of potential price gains in the fund's underlying securities. But the following tactics may let you remain invested and still realize a capital loss:

  1. Transfer fund units to a child or parent at fair market value — the superficial loss rules won't apply.
  2. Invest in another fund in the same family. You may realize the loss incurred by a Canadian equity fund trust by switching to another equity fund trust in the same family. Your ability to claim the loss will hinge on whether the trusts are considered identical.
  3. Transfer the loss to a spouse or common-law partner who has a capital gain to deal with. Sell the shares with a promissory note at Canada Revenue Agency's (CRA) prescribed interest rate. That triggers a superficial loss that's denied and added to your spouse's ACB. Your spouse must hold the investment for 30 days after the disposition.

Before making investment decisions, talk with your advisor to avoid making choices that might cost you money.

Calculating ACB and Capital Gains When Selling a Fund

If you hold mutual funds in a non-registered account, you must keep track of your adjusted cost base (ACB) for each mutual fund.
Most mutual fund companies provide information on how to calculate this.

The ACB of your investment in one mutual fund will be the total of:

  1. Amount you paid for the units, including commissions
  2. Plus the amount of all reinvested distributions or dividends
  3. Minus the return of capital component of any distributions
  4. Minus the ACB of any previously sold units.

When you sell some or all of your units, your capital gain or loss is:

  1. Net proceeds, after commissions or fees
  2. Minus the ACB of the units sold.