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Tax Treatment of Income From Investments in Mutual Funds
This information is regarding mutual funds which are held outside of RRSPs or other registered accounts.
Distributions made by Canadian mutual funds to shareholders can consist of
The distributions that are declared may not necessarily be paid to shareholders. Part or all of the distribution may be reinvested, not paid in cash. The amount of the reinvested distribution is added by the shareholder to the adjusted cost base of the shares in the mutual fund.
If the total return of capital amounts eventually reduce the adjusted cost base of the investment to a negative amount, this negative amount is reported as a capital gain by the investor.
Management fee rebates are either included in income or used as a return of capital. See the Mackenzie Investments Understanding how management fee rebates are taxed for more information.
Distributions made by foreign mutual funds to Canadian shareholders are usually considered foreign dividends, 100% taxable. When distributions from US mutual funds are categorized as capital gains or return of capital for US taxpayers, they will still be considered fully taxable to Canadian taxpayers.
See the 2012 Tax Court Case Schmidt v. The Queen. In this case, the appellant tried to claim that ROC and capital gains that were part of the distributions from a US mutual fund were not fully taxable to him. He had attempted to convince his brokerage that the T3 showing the amounts as foreign income, instead of ROC and capital gains, were incorrect. When he got no response from the brokerage, he excluded these amounts from his foreign income, and claimed the capital gains portion as capital gains. The result of the case was that the ROC and capital gains were fully taxable. However, the Minister had mistakenly included the ROC and capital gain from the appellant's spouse in the appellant's income, so this amount was allowed in the appeal.
Mutual funds allocate their realized capital gains to unit holders. Thus, if they have sold some investments at a gain during the year, they are allocating capital gains to you, even if the value of the mutual fund units went down.
How do I calculate the adjusted cost base (ACB) and capital gain when I sell my Canadian mutual funds?
If you hold mutual funds in a non-registered account, you must keep track of your adjusted cost base (ACB) for each mutual fund. Most mutual fund companies provide information on how to calculate the ACB. The ACB of your investment in one mutual fund will be the total of:
When you sell some or all of your units, your capital gain or loss is:
There are online services available that can help you track the ACB of your investments. One such service is AdjustedCostBase.ca, another is ACBTracking.ca. We have not used these services, so cannot advise as to how well they work.
When mutual funds are purchased with borrowed funds, any return of capital should be used to pay down the debt or purchase other investments for which the interest would be tax deductible. If the funds from return of capital are used for personal purposes, the interest on this amount is no longer deductible. The return of capital is a reduction of adjusted cost base, which means that the investor no longer has as much money invested. When this happens, the Tax Court has ruled, in Van Steenis v. The Queen, 2018 TCC 78, that there is no longer a direct link between the borrowed funds and the investment in mutual funds. See our article on interest expense on funds used to purchase investments.
Canadian mutual funds can be in the legal form of a trust or a corporation. When they are in the form of a corporation (often called corporate class funds), sometimes investors are able to exchange shares of one class of the mutual fund corporation for another class, with no taxable transaction created by the switch. This does not happen for mutual funds in the form of a trust. The Federal 2016 Budget amended the Income Tax Act (s. 131(4.1)) so that an exchange of shares of a mutual fund corporation or investment corporation that results in the investor switching between funds would be considered a disposition at fair market value for tax purposes. Although originally planned to come into effect on October 1, 2016, this now applies to dispositions that occur on or after January 1, 2017.
The Federal 2017 Budget, in Bill C-63, Budget Implementation Act, 2017, No. 2, amended s. 132.2(1) of the Income Tax Act re a "qualifying exchange", so that one mutual fund corporation could be converted to one or more mutual fund trusts. This applies to transfers after March 21, 2017.
Tax Tip: Keep good records, and recalculate the ACB of your Canadian ETFs after receiving your T3 each year.
Canada Revenue Agency (CRA) Resources
Revised: March 27, 2022
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