Take note of these tax-efficient funds

This is the time of year when many investors think about how they can get more bang for their investment dollar. One of the ways to achieve this is to seek out tax-efficient mutual funds. However, you need to decide in your own mind exactly what is important to you in this regard.

The industry considers tax-efficient funds to be those that trade infrequently and therefore make few capital gains distributions that attract tax if units are held in a non-registered portfolio. But if you are an income-oriented investor, that is not a form of tax efficiency that appeals to you.

Instead, you want funds that offer steady distributions combined with tax deferrals or low-tax payments like dividends. We just completed a survey that identified several funds that fit the bill.

These funds pay most of their distributions in the form of “return of capital” (which is tax-deferred), dividends (eligible for the dividend tax credit), and capital gains (only half of which are taxable).

Two funds achieved 100 per cent tax deferral in calendar 2003: Clarington Canadian Dividend Fund and Talvest Dividend Fund.

Return of capital payments are common from inme trusts funds but are relatively rare from dividend funds. Clarington Canadian Dividend Fund is able to achieve this unusual result because the manager, Seamark Asset Management, uses a buy-and-hold approach with a very low portfolio turnover (under 5 per cent annually in recent years). This minimizes taxable capital gains. Dividend income from the portfolio of blue-chip stocks goes mainly to cover expenses. The 8c per unit monthly distribution is paid from the fund’s cash holdings, which are deliberately kept on the high side for this purpose (currently 6.1 per cent). Since many investors don’t actually take cash but reinvest the payments in new units instead, the system has worked so far.

It’s important to understand exactly what tax deferral means in these cases. You will not pay any tax on the distributions in the year they are received. However, you must subtract the “return of capital” portion of the distribution in 2003 from your cost to calculate an adjusted cost base (ACB) for tax purposes.

For example, suppose you purchased units in the Clarington fund at the beginning of January 2003 at a net asset value of $8.57. Your ACB at the start of 2004 is $7.61 ($8.57 minus a 96c distribution). This is the amount you would have to use in calculating your taxable capital gain if you were to sell now. The process of calculating a revised ACB is repeated annually.

Over several years, the ACB will decline to zero if the fund maintains the current payment policy. When that happens, you will lose the return of capital tax deferral and all future payments would be considered to be taxable capital gains.

Here are the most tax-effective funds for 2003 among those in our survey. In this table, the first column shows the amount of the total distribution in 2003 in cents. So .960 for Clarington Canadian Dividend is 96c. Tax-advantaged income is made up of dividends and capital gains. Fully taxable income gets no tax benefits. Tax-deferred income is not taxable in the year received.

Total Tax-advantaged
Clarington Canadian Dividend .960 0 0 100
Talvest Dividend .697 0 0 100
R Monthly Income Balanced .840 8 0 92.2
Clarington Canadian Income .720 7.6 4.2 88.8
Standard Life Monthly Income .960 15.1 3.3 82
AIM Canada Income .360 20 0 80
RBC Tax Managed Return Fund .880 19.3 8.5 72.2
BMO Monthly Income .720 16.1 17.9 65.8
CIBC Monthly Income .720 20.6 17.6 53.9

This article originally appeared in Mutual Funds Update, a monthly electronic newsletter of common sense mutual fund advice edited by Gordon Pape. For subscription information, go to www.buildingwealth.ca