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Taxation - Mutual Fund Distributions

Any income earned during the year by mutual funds must be paid out to its investors or the fund risks paying tax on this income. Only those investors holding units of the funds at December 31st will receive a distribution.

Mutual funds earn interest income, dividends, foreign-source income and capital gains. The various types of income earned by the mutual fund retain their "character" when distributed to the investors.

The following summarizes the various types of income distributed by a mutual fund;

Income Type

Instruments

Tax Reporting

Tax Rate

Interest T-bills & bonds T3 - Other Income Highest
Dividends-CDN Stocks
CDN Corporations
T3 - Dividends CDN Lowest
Capital Gains Stocks, bonds etc. T3 - Capital Gains 50% of gain is taxable
Foreign-source Stock, bonds etc. Same rate of tax as interest income. Income is reported in CDN dollars gross of any foreign taxes paid. Highest
(foreign taxes paid may be claimed as a tax credit)

As long as units are owned on December 31, even if they were purchased the day before, the investor will receive a distribution. This taxable consequence is only relevant for those investments held outside a RRSP.

If a fund distributes more than the income and capital gains earned in the year, the excess is considered to be a return of capital. This return of capital is not taxable, although it reduces the adjusted cost base (ACB) of the investors’ units. By reducing the ACB, the investors capital gain will be larger if they sell their units.

The ACB is important for two (2) reasons:

  1. it is used when calculating the capital gain or loss resulting upon the sale of units.
  2. the foreign content (currently up to 100% eligibility) of RRSP’s and RRIF’s is determined with reference to the ACB of the units.

At death RRSPs & RRIFs are converted to income and taxed at the higher marginal tax rate. This could be as high as 46.2%.

E.&O.E.