Check mutual fund tax exposure

Most equity mutual funds will make their annual distributions before the end of December-some within the next week or so.

If you’re holding mutual fund units in a taxable account, now is the time to determine whether you are likely to be hit with a big bill for capital gains. This should be a top priority, as once the distribution has been made, you’re on the hook with Canada Customs and Revenue.

All distributions taxable
All distributions from mutual funds held in non-registered plans are taxable, whether they are
received as cash or additional units.

By law, a fund’s trustee must pay out all net capital gains, dividends, interest and other income realized within the portfolio at least once a year.

If the fund managers have done a lot of trading, this could mean very large distributions, perhaps
several dollars per share. Even if the net asset value (NAV) of your units has declined, you could end up having to pay tax even though you haven’t sold a single share.

Check, take action
Many fund companies have released preliminary estimates of their year-end distributions. Check
with your fund compa or ask your advisor to do so for you.

If you find that a fund you own is expected to make a large payment, you may wish to take appropriate action, if it makes sense to do so.

One possible alternative is to temporarily switch your assets in the fund that is making the distribution into a money market fund within the same company. Then you can switch back once the distribution has been paid.

Increase triggers tax
However, this tactic won’t work in all cases. The CCRA regards a switch as equivalent to a sale. So if your units have increased in value since you acquired them, you will trigger a capital gain and end up no further ahead.

But if the units have dropped in value since you bought them, this strategy should be seriously
considered. You will avoid the taxable distribution. And if you don’t switch back until at
least 30 days have elapsed, you will also qualify for a capital loss. This can be deducted from current year capital gains.

Next page: Carry back provision

Carry back provision
If you have no capital gains in 2001, you can carry back the loss for three tax years.

If you had any taxable capital gains in 1998, 1999, or 2000, this will work in your favour. The inclusion rate and the tax rates were higher in those years.

The formula for working out exactly how much you can claim is a bit complicated and you have to complete form T1A, called Request for Loss Carry-back.

It does not come with the general tax package, so you have to download it from the CCRA Web site. Or order a copy from your local tax office.

Impact of switch
Some people may be under the impression they’ll lose money by making a switch prior to a
distribution. This is not the case. The net asset value per unit will be reduced by the amount of
the distribution.

So suppose your units are worth $10 each and you switch to a money market fund the day before a $1 distribution is made. After that occurs, the net asset value (NAV) will drop to $9.

So the value of the distribution is already reflected in the asset value of the shares and you will realize it when you switch out. Of course, if you switch back, you’ll acquire the units at whatever the NAV happens to be at that time.

If the value has risen, you’ll lose a bit. But if it has declined, you’ll be even further ahead. That part is a bit of a gamble. But it may be a risk worth taking if you avoid a certain tax bill in the process.

Just be sure that the switches are done without incurring any sales commissions or switching

Remember, you must act quickly. Once the distribution has been declared, it’s too late.

Adapted from the December issue of Mutual Funds Update