When securities held in mutual funds generate earnings, they must be passed on, or distributed, to unitholders. These distributions can take several different forms depending on the type of assets a fund invests in, such as interest, if the fund invests in bonds, and dividends, if the fund holds shares. Regardless of the asset class, mutual funds might also distribute capital gains to unitholders. Over the course of the year, the fund managers will buy and sell securities, with each sale resulting in either a profit (capital gain) or a loss (capital loss). Once the losses have been deducted from the gains, the remaining net capital gain (net of expenses) will be distributed to unitholders, usually at the end of the year. Unitholders either receive distributions in cash or have them automatically reinvested back into the fund.
Types of fund distributions
Why does a fund pay distributions?
Distributing the income earned by the mutual fund helps reduce taxes incurred by the fund. If it didn’t distribute income to unitholders, that income would be subject to tax at a rate equivalent to the highest personal tax rate within the fund. By making distributions to unitholders, who will typically be taxed at a lower marginal rate than the fund, less tax is paid, which in turn should mean higher returns for unitholders.
This means unitholders may be responsible for taxes resulting from distributions regardless of whether they’ve reinvested them or received them in cash. The good news is that the income retains its character, so for taxable accounts, the investor receives preferential tax treatment for capital gains and Canadian dividends. In the case of capital gains, only 50% of the amount is taxable. Canadian dividends get preferential tax treatment through the gross-up and dividend tax credit mechanism. The grossed-up amount is included on the investor’s tax return, but the tax owing is reduced by the dividend tax credit.
What happens if the fund posts a negative annual return?
Mutual funds might still pay out a distribution even if the fund’s value has fallen. This can happen for a number of reasons; a fund distribution in a down market is like owning a rental property. Even if the value of the property is going down, the tenants will still be paying you rent. Similarly, unitholders can receive distributions of interest, dividend, and foreign income earned by the fund even if its value has dropped.
Furthermore, any net capital gains that the fund earns are distributed to unitholders at the end of the year, regardless of whether the value of the fund has gone up or down. For example, the fund managers might decide to sell a share they bought several years ago that’s now trading for many times the price they paid for it, which could generate a considerable capital gain even though the fund’s value is down for the year. At the same time, the fund managers might choose to hold securities that are currently valued at far less than they paid because they believe they'll ultimately recover and prove profitable. Because the loss hasn't been realized, these assets could have a significant impact on the value of the fund.
The combination of these two factors results in a negative annual return and a taxable distribution.
Understanding the impact of distributions
Once a distribution is paid out, the fund’s net asset value (NAV) goes down, as it’s now holding fewer assets (the reduction in the NAV is the same as the amount of the distribution). The overall value of an investor’s portfolio, however, doesn’t change, regardless of whether you choose to take your distributions as cash or reinvest in additional units of the fund.
For example, an investor invests when the fund has a NAV of $9. The NAV per unit (NAVPU) increases to $10 just before the fund makes a 5% distribution.
If the taxable distribution is received as cash, the adjusted cost base is the original investment amount of $9,000. On the other hand, if the taxable distribution is reinvested in additional units, the adjusted cost base increases by the amount of reinvested distributions, to $9,500.
1 The unitholder also receives $500 paid cash as part of the distribution.
Making the right choice
Mutual funds offer unitholders a raft of advantages, including professional management, diversification, and liquidity. Understanding how and why mutual funds make distributions and the impact they can have on the fund and tax returns can help unitholders make an informed choice about how to select the right investments for their individual needs.
Please note: This article deals only with distributions from mutual fund trusts. Distributions from mutual fund corporations are treated differently and will yield different results. Also note that a number of simplifying assumptions have been made in the article for clarity.
Important disclosures
Important disclosures
This communication is published by Manulife Investment Management. Any commentaries and information contained in this communication are provided as a general source of information only and should not be considered personal investment, tax, accounting or legal advice and should not be relied upon in that regard. Professional advisors should be consulted prior to acting based on the information contained in this communication to ensure that any action taken with respect to this information is appropriate to their specific situation. Facts and data provided by Manulife Investment Management and other sources are believed to be reliable as at the date of publication.
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