Income taxes and the mutual fund investor

When you invest in mutual funds outside a registered plan, you face some income tax considerations foreign to those who invest directly in stocks.

Once again, it’s that time of year to consider especially carefully any decision to invest in mutual funds before the end of December. That’s because of the income-tax treatment of mutual funds. You could end up being forced to give the government of Canada what is, in effect, an interest-free loan for as long as you own your investment. And it could be large.

A mutual fund must, by law, either pay income taxes as an economic entity or pass the income-tax consequences of its activities to its investors, pro rata, at least once each year. Most do the latter. They do so by passing all realized taxable gains—capital gains net of capital losses, interest and dividends—to investors in the form of a cash distribution.

Most funds do, however, automatically reinvest these cash distributions back into units of the fund immediately after the distributions. You can ask your fund to send you the cash instead of reinvesting it. But you’d forgo the benefits of compounding on your realized gains in the fund.

Income tax ramifications

In most cases, funds make distributions only once each year (exceptions occur among funds designed to produce regular income). And the distribution includes all investment capital gains realized during the preceding 12 months. But the tax consequences of the investment gains go to investors of record at the time of distribution, not to those at the time the fund realized its investment gains.

What’s more, if your fund realized capital gains or received interest or dividends, it will pass these on to investors regardless of the net asset value of the fund’s units. So even if the fund’s net asset value per unit declines, realized gains must be recognized and tax liability dealt with—i.e. taxes paid.

Suppose, for example, you invested $1,000 in Fund A right now, buying 100 units at $10 each. Further suppose the fund declares a distribution of capital gains in the amount of $1.00 a unit on December 31, 2021. You’ll receive a T3 or T5 slip next March for a capital gain of $100. And yes, the Canada Revenue Agency will receive a copy. That means you’ll have an additional $50 in taxable income (50 per cent of capital gains are taxable). If you’re in the 50-per-cent tax bracket, you’ll pay income tax of $25 next April.

Your investment remains unchanged

Meanwhile, the fund’s unit value will, of course, fall by $1.00 a unit as cash leaves the fund. And you’ll buy an additional $100 worth of the fund at $9 a unit, or 11.111 units. You’ll then hold 111.111 units with a net asset value per unit of $9.00, for a total investment of $1,000. So your investment stays the same. But you’ve sent $25 off to Ottawa.

Since your units of Fund A have been reduced in value by $1.00 each, you have an embedded capital loss of $100. So when you finally sell out of the fund, you’ll get a tax reduction equal to the tax liability you received now. In other words, there’s no double tax.

But there is the matter of the $25 you sent to Ottawa, in effect, prepaying income taxes, at least from your point of view. We call this an interest-free loan from you to the federal government for as long as you own the investment.

This is an edited version of an article that was originally published for subscribers in the November 12, 2021 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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