Limited partnerships and trusts offer tax advantages and return of capital is one of those advantages.
The return of capital portion of a partnership or income trust distribution can be made out to be a very complicated thing, but it need not be. So let’s keep it simple.
If an income trust makes $0.50 from its operations, but it happens to pay out $0.60, the extra $0.10 is termed a ‘return of capital’. That’s all it is. Return of capital is nothing more than the amount by which distributions exceed income.
Why do they call it that?
It’s important not to read too much into the term itself: ‘return of capital’ is a term that was created by the Canada Revenue Agency, and it’s not very descriptive. They might better have named it ‘portion of distribution not from operating income’ or something similar, buy they didn’t. The fact that they chose to call it ‘return of capital’ is unfortunate in that some investors conclude that this is their own invested capital being returned to them.
That’s not the case at all. Return of capital most often results from the income trust being allowed more depreciation (or amortization or depletion) expense than they need to spend to keep the assets of the company in good shape. Consequently, the trust ends up with more cash available for distribution than they have taxable income.
Take, for example, limited partnership Brookfield Renewable Partners (TSX—BEP.UN), which had US$30.7 billion in property, plant and equipment at the end of 2019. The depreciation on these items far exceeded what the partnership paid to keep its assets in good order. Hence they had a return of capital in 2019 (see below). From this example you can readily see how the term ‘return of capital’ is not the best description of how this cash flow arises.
The tax implication of a return of capital is that it’s deducted from the adjusted cost base of the investor’s units. Thus, return of capital is only taxed when the units are sold, and then only at the capital gains rate, so there is both a tax reduction and a tax deferral aspect at work with it.
At some point, the total return of capital received by a unit-holder could eventually accumulate to be equal to the purchase price of the units they hold. If that’s the case, their adjusted cost base would be zero, any return of capital received by the investor beyond that amount becomes taxable (at the capital gains rate) in the year it is received, and so from that point on there is no more deferral.
Brookfield’s return of capital
The limited partnership units of Brookfield Renewable paid out a return of capital that amounted to 45 per cent of its total distribution in 2019.
Limited partnerships are generally not subject to federal or provincial income tax. Instead, the partnership flows all of its income through to its partners. Then it’s up to the partners to pay tax on the portion they received, at their individual tax rates.
Brookfield Renewable Partners is just such a limited partnership. The partners in Brookfield Renewable are called unit-holders. These partners/unit-holders share in the partnership’s cash distributions in proportion to the number of units they own.
Each distribution received by a unit-holder can consist of a combination of business income, Canadian interest income, Canadian dividend income, foreign income, capital gains and sundry deductions or credits. These are all reported by the unit-holders on their individual tax returns as though the unit-holder had incurred them directly. The T5013 tax form received by each unit-holder prior to tax time helps greatly in sorting out the correct amounts.
Only part of each distribution is taxable income. In Brookfield Renewable’s case, in 2019, the total distribution per unit was C$2.71306, but only $1.49716 of that was taxable income, or about 55 per cent of the total. The other 45 per cent was a return of capital.
Brookfield’s unit-holders, then, received a return of capital amounting to $1.21590 a unit in 2019. Unit-holders, therefore, were obliged to reduce the adjusted cost base (ACB) of their units by this amount. Assuming an ACB of $21.40191 at the beginning of 2019, then, the year-end ACB would be $20.18601 ($21.40191 – $1.21590).
In this way, the return of capital is treated as a tax-deferred capital gain. Only when you sell your units will you have to pay taxes on your return of capital.
This is an edited version of an article that was originally published for subscribers in the November 13, 2020, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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