How Return OF Capital Works

The topic of Return OF Capital has been discussed at nauseum in the comments, but I thought that I should bring it to the front page as the same questions keep coming up.

What is ROC?

Return of Capital is when a publicly traded company distributes money collected from their share holders back to the share holders themselves. The resultant distribution is non taxable but decreases the adjusted cost base of the original purchase (tax deferral). When it comes time to sell in the future, providing that there is a profit, the capital gains tax will be paid on the new adjusted cost base minus the selling price.

An Example

Purchase XYZ income trust for $10, it distributes an annual ROC of $1. Sell 1 year later for $20. The capital gain is: $20 – ($10-1) = $11

Who distributes ROC?

Income trusts and some corporate mutual funds. The biggest indicator of ROC is if the distribution is extremely high relative to the yields of the strong dividend stocks.

What about ROC and Leveraged Investing?

For leveraged investing, it is not preferred to buy anything that has a return of capital component in their distribution as ROC reduces the tax deductibility of the investment as it is received.

One way around this is to use the ROC distribution to pay down the investment loan and re-invest if desired. Technically though, this should be the same as leaving the ROC distribution within the investment account. However, this assumption needs to be confirmed with CRA or an accountant.

Receiving ROC in a leveraged investment account can also be an accounting nightmare if dividends/interest/ROC are mixed together in a distribution, and regular withdrawals from the leveraged account are needed (like with my version of the Smith Manoeuvre).

Please see the article “Key Considerations of an Investment Loan” for more details.

I would be grateful if tax experts/accountants would chime in!

Disclaimer: Information provided in this article are for entertainment purposes only and if used, it is at your own risk. Please consult a tax expert before implementing anything you read here

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FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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Ash
4 years ago

Hello,
For ROC, you mentionned we can draw it and repay the LOC and then reinvest it.

But if I invest in CDZ or XDV how will I know which part of the distribution is dividend and which part ROC.

Thanks

Best regards
Ash

John R
3 years ago
Reply to  Ash

I understand this is an old thread & I would appreciate if someone in the know could please answer my question below.

Thanks

Similar to the OP, in 2008 a purchase XYZ income trust for $10, paying $1/yr ROC.

The investor collecting distributions of $1/yr, holds the shares for 10 years at which time the ACB is zero.

Its now 2018, the investor has to make a decision by mid-2018 …. should they;

a) sell the shares that are at currently around the $10 purchase price even though they fluctuated over the 10 years?

b) let the shares sit to keep on collecting the $1 distribution, which will now become capital gain income & report that accordingly?

ken
7 years ago

Hi Brandon,

I looked into this recently before I started the SM.

Yes, your loan remains tax deductible. If you re-invest all distributions you will be fine.

There would be problems only if you take distributions out of the investment account. For example if you take distributions out to pay down the mortgage or put into a TFSA. This would create serious accounting difficulties.

Ken

Brandon
7 years ago

what if you use the dividend distribution to just buy more of the ETF with a DRIP. Will the interest on the loan still be tax deductable?

FrugalTrader
7 years ago

Best bet is to go to the ETF homepage (google the ETF), then click on their distributions/taxation tab. They generally will break down the distribution over the past few years.

Brandon
7 years ago

How can you tell if a fund distributes return of capital? ive just started the SM and id like to do it using ETF. Do index ETF distribute ROC?

Thanks!

M
7 years ago

Thanks for the reply Ed.

I respect your posts a lot. It is clear that your accounting/financial planning dual background is perfectly suited to SM expertise, so much so that I am considering becoming a client.

You will understand that I am very skeptical when it comes to claims of beating the index, risk adjusted, over the long term. Not that it can’t be done, and not that it wouldn’t be worth paying high MERs for. I think it is a rare skill, and it is risky for the common investor to try to find that manager. That you receive commissions from these funds, in my opinion, lessens the likelihood that your claim is true. Judging from the quality of your posts it is possible that you have found such people, yet I remain skeptical. Further, that you call ETFs “index lagging returns,” when they trail the indexes by only minuscule MERs and tracking errors, misleads someone who may confuse lagging the index by 0.1% to lagging the index by many times that amount. I disagree that ETFs are “index-lagging” unless you are really splitting hairs.

When it comes to the idea of “negative MER,” using the example you give of beating the index by 0.5% after MER over the long term, is that a sufficient reward for the risk I have taken by trying to find that rare manager? If I know that I can passively obtain a fractionally below-the-index return at no extra risk, and I know that 90% or more of fund managers fail to beat the index over the long term (before MER!), how is that extra 0.5% of return worth the risk I assume by trying to find the diamond in the rough? I would definitely have to see it to believe it.

Any thoughts on the original question of whether swap ETFs qualify for deductibility? Are your funds able to maintain deductibility without distributions simply because they are not explicitly prevented from making distributions?

Ed Rempel
7 years ago

Hi M,

Why not look for “negative MER”? Instead of accepting below index returns, why not put your brain to work to figure out how to beat the indexes?

Here is my question – What is the “cost” of a fund with an MER of 2.5% that has beaten its index by 3%/year compounded for the last decade resulting from stock picking skill?

I get a kick out of reading about the debate of how much lower a return than which index everyone wants. For myself personally – I can tell you that I have never and will never own any passive ETF or index-type investment of any type. I have no interest in index-lagging returns.

There are a variety of strategies proven to beat indexes in the long run. We do it by studying All Star Fund Managers – finding top stock pickers. I can tell you there are fund managers that have outperformed their index by wide margins over the long term and over their career – often with lower risk. Our core Canadian fund manager has had triple the growth of the TSX in the last 15 years with 20% lower volatility.

Other strategies proven to beat indexes are value investing, high “Active Share”, small caps, buying less liquid stocks, and having focused portfolios. I’m sure there are more.

Dividend investing would also be included as an index-beating strategy, but only if you can invest at lower P/Es than the index and without restricting yourself to Canada.

The mind is a powerful thing. Once you start focusing on how to most reliably beat the index long term, you may be surprised what you find.

Ed

M
7 years ago

My gut tells me that swap ETFs must be investment loan deductible.

Ed recommends corporate class mutual funds which he describes as “100% tax efficient,” which I interpret to mean that the funds pay no distributions. So swap ETFs must also be deductible. But why?

M
7 years ago

Do swap ETFs qualify for interest deductibility? Their reason for being is to defer distributions until redeemed, so, can one argue that there is potential for income?

Page 22 of the HXT prospectus says “The ETFs will not make regular distributions.”

Page 32 says “each ETF has the authority to distribute, allocate and designate any income or capital gains of such ETF to a Unitholder of such ETF who has redeemed Units of the ETF during a year in an amount equal to the Unitholder’s share, at the time of redemption, of the ETF’s income and capital gains for the year or such other amount that is determined by the ETF to be reasonable,” and “provided a Unitholder does not redeem their units of an ETF that uses a Swap as its sole investment strategy, the Unitholder is not expected to receive any distributions of income for purposes of the Tax Act in a taxation year throughout which the Swap is in effect.”

It seems to me that arguments could be made for either side? Surely this question has already been answered, given the popularity of swap ETFs.

M
7 years ago

I think the site ate my reply.

HXT is a good idea for efficiency. Add HXS for US exposure, and Europe has plenty of swap ETFs. I wonder about the lifetime returns, and how big the tax bill would be when it finally came?

Downside is that no distribution means a slower debt conversion. There’s also counterparty risk and regulatory risk. Are we absolutely sure that capital gains will be taxed as favourably in 30 years as they are now?

That could be your article. Swap ETFs for SM.