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Jul 2, 2019

What Is Return Of Capital (ROC)?

by Moez Mahrez

Moez MahrezInvestors normally care about three main forms of investment income: capital gains, interest income and dividends. When it comes to Exchange Traded Funds (ETFs) and mutual funds, there is a false perception among investors that distributions are purely dividends for equity funds and interest for bond funds, when in fact, most fund providers will state: “Cash distributions consist primarily of income but may, at the Manager’s discretion, include capital gains and/or return of capital.” That is a direct quote from a Vanguard prospectus. That last item mentioned—Return of Capital (ROC)—is often overlooked or not as understood by many investors.

Return Of Capital (ROC) Definition

ROC is the portion of the fund’s distribution that is not capital gains, dividends or interest. It is not actual income generated from investments, rather it is cash that is distributed from the cash portion of the fund. It may appear as though the fund is basically giving investors their money back, but ROC is not necessarily a bad thing. If the fund is performing well, this will result in the unit value of the fund remaining steady or increasing over time. This can offset some or all of the negative effect of returning capital to investors. For investors who rely heavily on a consistent income, ROC is used to maintain that consistent stream in months or quarters where the fund does not perform as well. ROC becomes more of a concern if the fund does not perform well over time and when its portion of the distribution is consistently high. On that note, just because a fund mentions in its prospectus that its distributions may include return of capital, does not mean it will. By default, if a fund has enough dividends, interest and capital gains, it should use those to fulfill the distribution.

ROC And Taxes

ROC does not get taxed right away like most sources of income. Instead, it decreases your Adjusted Cost Base (ACB) which is the average price at which you purchased the units of your fund. This results in a higher capital gain and consequently a higher capital gains tax.

It is easier to understand with an example. Let’s say the distribution per unit received was $1 and the ROC portion of that distribution was $0.10. Your ACB would then be reduced by $0.10. So, if you originally bought units at $25.00, your new ACB would be $24.90. When you sell your shares at, say $40, your capital gain would be slightly higher per share than if you did not receive ROC. The degree to which ROC affects your capital gains tax will vary based on the percentage of ROC it contains. Sometimes, you need to adjust the ACB yourself by subtracting your ROC received for the year, which is reported on your T3. If you have an accountant, they should do this for you. The tax implications of ROC distributions are more of a concern for investors who use a non-registered account since registered accounts do not pay taxes when capital gains are realized anyway. Despite the unwanted reduction of ACB by most investors, ROC is quite tax-efficient as it converts that cash into a capital gain, which can be deferred. Where this advantage is lost, however, is through foreign ROC income, which is fully taxed as regular income immediately.

How To Think About ROC?

One simple way to offset some of the negative effects of ROC (higher capital gains) is by reinvesting the distributions you receive. This is a good practice with investing in general. Even if you rely on fund distributions for income, you can choose to re-invest just the ROC portion to “even things out”. However, trying to perfectly reverse the reduction in your ACB may end up being quite the tedious task and not a path we would suggest. For example, if your original ACB was $25 at 10 units and as a result of a $0.10 ROC your ACB became $24.90, you would have to purchase 10 units at $25.10 to bring your ACB back up to $25.00. This practice is not recommended, for reasons related to potentially holding cash for too long unnecessarily and in a sense, timing the markets. In the end, it is likely not worth the hassle for most investors when getting down to how much you actually save on taxes by implementing this tactic. We would instead prefer a strategy of consistent dollar-cost averaging of reinvesting cash (on a monthly or quarterly basis). We would even prefer reinvesting distributions at a lower price, which does lower your ACB, but this would be, after all, the equivalent to tactically buying on weakness. The main idea is to avoid as much as possible having your cash handed back to you via the fund by essentially sending it back to be put to work for you.

Big Picture

In the grand scheme of things, most ETFs that hold common equities pay out only a minuscule portion of their distributions as ROC and should not be a cause for concern for most investors. As mentioned earlier, funds pay their distributions from their cash holdings and many have mandates to hold a certain amount of cash. It’s important not to forget that this cash is often a combination of realized returns from the past as well as new money from investors. So, if a fund receives a surge of new money it may pay out a higher portion of ROC at first, but that is usually on a temporary basis until that new cash is invested and the cash portion of the fund eventually turns into accumulated income. In the end, what we think should largely be the focus for investors is the fund’s ability to grow its net asset value (NAV) over time.

 

Moez Mahrez, CFA , Investment Analyst at 5i Research Inc., Waterloo