Understanding Fund Distributions: Taxation & Adjusted Cost Base (ACB)

Overview

Fund distributions in non-registered accounts involve specific tax considerations, particularly regarding how they impact adjusted cost base (ACB). Different types of distributions (including interest, dividends, foreign income, capital gains, and return of capital) affect both tax liabilities and ACB tracking, which is essential for reporting accurate capital gains or losses when an investment is eventually sold.

This article breaks down how various fund distributions influence tax outcomes and why tracking ACB correctly is crucial. Since brokerages do not always maintain precise ACB records (especially when investments are spread across multiple accounts or transferred) investors should monitor their own ACB to avoid errors and potential double taxation.

Note that distributions received from funds held inside registered accounts (such as TFSAs, RRSPs, etc.) are generally not taxable and do not require ACB tracking.

For information on calculating capital gains and ACB when selling funds, refer to our article on calculating capital gains on stocks.

What Are Funds?

In the context of Canadian investing, "funds" refers to investment products that individuals can purchase to gain a share of a diversified portfolio of assets that are managed by professionals and/or designed to track specific goals. These include options like traditional mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), and mortgage investment corporations (MICs). Funds provide a practical way to invest in diverse opportunities—like a broad range of stocks, bonds, real estate, or mortgages—by combining resources and expertise, making it more efficient and affordable than buying the underlying assets individually.

Key Point: Funds are investment products that pool resources to invest in a diversified portfolio of assets. Common examples include mutual funds, ETFs, REITs, and MICs.

Taxation of Funds

The key taxation concept for funds is they are structured to "flow through" their taxable income to investors as distributions, such that the funds themselves are not subject to tax. Additionally, funds generally maintain special designations under the Canadian Income Tax Act (ITA) such as "mutual fund trusts"¹ or "mortgage investment corporations"² which provide tax benefits to investors as opposed to standard corporate taxation.

For example, the popular Vanguard ETFs traded on Canadian exchanges (such as the Toronto Stock Exchange) are structured so that each fund "distributes a sufficient amount of its net income and net realized capital gains to [investors] for each taxation year, ensuring that the Vanguard ETF itself will not be liable for ordinary income tax", as outlined in its prospectus. This is the "flow through" concept illustrated where the fund aims to distribute all taxable income. Additionally, each Vanguard ETF qualifies as a "mutual fund trust", where the prospectus describes the tax implications of the designation.

Key Point: Funds are structured to "flow through" all their taxable income to investors in the form of distributions.

What Are Fund Distributions?

Given that funds distribute all their taxable income to investors, these distributions are a key component of investing in funds. Distributions are typically made on a regular basis and can take various forms. Certain funds will have a fixed distribution schedule (such as monthly or quarterly) and/or target amounts, while others may have discretionary or variable distributions based on the fund's performance or income generation. For example, the RioCan REIT is a popular fund that has a monthly targeted distribution of 0.0925 cents per unit as of March, 2024, as outlined in its 2024 annual information form.

Table: Types of Distributions

Cash Distributions

Many funds generate cash from their holdings or trading activity then distribute the cash to their holders. For example, a fund may hold bolds and earn interest income, an equity focused fund may hold stocks and earn dividend income, or an index fund may trade stocks to track their targeted indices and generate capital gains as a result.

For investors, these cash distributions are taxed in the year received according to their income category (e.g. distributions of interest will be taxed as interest income for fund investors). Distributions will be outlined on issued T3 slips and included in the investor's taxable income for the year in which they are received. The cash distributions do not impact the adjusted cost base (ACB) of the investment (other than return of capital, discussed below).

As a practical note, funds prioritize generating interest or dividend income over triggering capital gains distributions (which is rarely a goal). Instead, capital gains distributions generally arise from portfolio adjustments. As the Vanguard ETF prospectus explains, "The likelihood of a capital gains distribution increases with a high portfolio turnover rate" driven by factors like index changes or strategic shifts.

Note: Capital gains distributions received as cash do not impact the ACB of the investment like other cash distributions. However, they are still taxable as capital gains when received.

Key Point: Cash distributions are taxed as income when received and do not impact the adjusted cost base of the investment (other than return of capital).

Return of Capital

Funds may occasionally make distributions as a return of capital (ROC), effectively returning part of an investor’s original investment. Unlike interest, dividends, or capital gains, ROC is not taxed when received because it is not income. Instead, it simply reduces the adjusted cost base (ACB) of the investment (which defers tax until the investment is sold). This makes sense, as the fund is returning invested capital rather than generating new taxable earnings. Generally, investors prefer return of capital distributions as they maximize current cash flow and defer tax liabilities.

ROC typically occurs when a fund’s distributions exceed its taxable income. This can result from objectives like maintaining steady cash payouts, funding redemptions, or utilizing tax deductions that lower taxable income. For instance, many REITs claim depreciation (capital cost allowances), reducing their taxable income. This allows classifying a portion of distributions as ROC to improve tax efficiency and meet payout targets.

ROCs will be shown on T3 slips like other distributions. Importantly, if an ROC reduces the investment's ACB to a negative amount, the negative portion is treated as a capital gain in the year it occurs.

Key Point: Return of capital distributions are not taxed when received but reduce the adjusted cost base of the investment.

Reinvested Distributions

Funds may also reinvest distributions rather than paying them out as cash to investors. Any type of distribution can be reinvested, including interest, dividends, capital gains, or return of capital (ROC).

Even though cash is not received by the investor, reinvested distributions are included on investors T3 slips and taxed in the year "received" according to their income category (like cash distributions). However, reinvested distributions increase the ACB of the investment (unlike cash distributions). This ensures that when the holdings are eventually sold, the reinvested distributions are not taxed again as capital gains (avoiding "double taxation").

Any portion of a reinvested distribution classified as ROC still reduces the ACB of the investment independently from increasing the ACB by the total reinvested distribution amount. Effectively, this "nets out" the ROC portion from changing the ACB as the investors capital is "returned" but then reinvested.

Key Point: Reinvested distributions are taxed as income when "received" and increase the adjusted cost base of the investment (other than return of capital).

Notional Distributions

When distributions are reinvested into additional shares or units, this is often referred to as a "notional distribution". Notional distributions can occur in different ways. For instance, mutual funds generally permit investors to receive notional distributions (i.e. elect to automatically reinvest distributions in the fund). Certain stocks and ETFs offer dividend reinvestment plans (DRIPs) where distributions are automatically reinvested instead of paid out as cash. In each case, additional shares or units are purchased with the distribution amount. As such, the total ACB of the investment increases by the reinvested distribution amount (although the ACB per share or unit may increase or decrease depending on their current market value).

Key Point: Notional distributions are reinvested distributions paid as additional shares or units (as opposed to in cash) and increase the adjusted cost base of the investment.

Phantom Distributions

Phantom distributions are a type of notional distribution specific to ETFs where a fund reinvests distributions but does not issue additional units. The "phantom" name refers to the fact that investors will not receive cash or additional units.

Phantom distributions generally occur at an ETF's year-end when an ETF has not yet distributed (or "flowed-through" conceptually) enough income to avoid taxation at the fund level (as discussed above in "Taxation of Funds"). If needed, an ETF will distribute a sufficient amount of income to unitholders to avoid this taxation at the fund level. This distribution will automatically be reinvested in additional units; however, all outstanding units of the fund will then be consolidated such that the total outstanding units remain the sam after the distribution. Effectively, this results in no additional units being issued as part of the distribution.

Despite the unitholder not receiving additional units (or cash), the phantom distribution is still taxable in the year "received" (again according to its income category) and the ACB of the investment must still be increased by the distribution amount. This again ensures that when the investment is eventually sold, the phantom distribution amounts are not taxed a second time as capital gains.

Key Point: Phantom distributions are reinvested distributions that do not result in additional units but still increase the adjusted cost base (ACB) of the investment.

Tax Summary of Distributions

The overall ACB tracking steps for fund distributions are as follows:

1. Cash Distribution: Only ROC impacts the ACB. Increase ACB by the ROC amount.
2. Reinvested Distribution:
   1. Decrease ACB by any ROC amount.

   2. Increase ACB by the total reinvested distribution amount (including ROC).

Particular care must be taken in tracking phantom distributions given that additional units are not received. Investors must ensure that the increase to the ACB is accounted for to avoid potential double taxation when the investment is sold.

Many brokerages now track the changes to ACB of funds from reinvested distributions accurately. However, certain brokerages (including discount brokerages) reportedly still have omissions or errors in ACB tracking. Investors should independently track the ACB of their investments to ensure their brokerages is accurately reflecting distributions.

Additionally, if an investor holds the same fund in non-registered accounts at multiple brokerages, they will need to track their ACB as a brokerage will not be aware of investment at another institution. Further, if an investor has transferred their holdings in-kind between brokerages, there may be discrepancies in the ACB that need to be tracked.

Key Point: Investors should independently track the adjusted cost base of their fund investments to ensure accuracy, particularly when holding the same fund at multiple brokerages or transferring holdings between brokerages.