Return of Capital to Fund Investors

Demystifying Return of Capital

Return of Capital to Fund Investors
February 28, 2014

Return of Capital (ROC) is a difficult concept for fund investors to grasp. It can make your hair hurt – or whatever hair is left after you've torn out the rest. Hopefully, we can explain ROC without making you reach for a hat or an aspirin.

ROC is a portion of a distribution that doesn’t come from earnings (dividends, interest or realized capital gains), but is instead a portion of your capital being returned to you. In essence, with ROC a fund is paying out more than it earned. A fund may do this if it pays a regular distribution amount but didn't earn enough in a specific time period to cover the expenses.

For context, consider some background information and terms.

  • Capital Definition – Most people think of capital as the initial investment, but your actual capital in a fund can change over time – it can rise or fall as the funds gain or lose value, you can reinvest distributions into the fund, or you can sell some of the funds. The ROC is a method of returning some portion of this collective remaining capital to you. That's why it's not correct to say ROC is just the return of your original investment.

  • Taxes – Of the above changes in capital, the only one taxed immediately would be any capital gain realized when you sell shares in the fund. The other changes are taxed whenever the gain or loss is realized, and these gains or losses would be reported by the mutual fund the following February on Form 1099-DIV.

  • Adjusted Cost Base (ACB) – The current book value of your assets – in other words, how much of your capital value is left if it has lost value, or what the total is if it has gained value. This determines your eventual capital gains taxes.

The easiest way to wrap your head (and remaining hair) around ROC is with a simplified example. Let's say you invest $10,000 in a fund and hold it for ten years, taking cash distributions and never reinvesting into the fund. The current market value dropped to $8,000. Your original investment lost $2,000 compared to current market value.

However, the collective cash distributions you received over ten years add up to $7,000, representing all incoming cash sources – interest, dividends, capital gains, and ROC. In ten years, you made $5,000 ($7,000 cash received, minus a $2,000 decrease in current market value of your investment ).

Let's further assume that of the $7,000 you received, $4,000 was ROC and $3,000 came from earnings sources.

Your ACB is your cumulative capital ($10,000) minus the amount of ROC you received over ten years ($4,000), or $6,000. This represents the amount of capital you have left. (If we had reinvested distributions during those ten years, that would have been added to the $10,000 capital total.)

If you sell the fund shares at the end of ten years, you receive market value $8,000, but you only have $6,000 in capital "left" (represented by the ACB). The difference in value is $2,000. Instead of reporting a $2,000 capital loss on the sale (because you sold the funds for $2,000 less than you started with), you would be paying tax on a $2,000 capital gain (because you're receiving $2,000 more than your remaining capital in the fund).

If your ACB goes to zero, then everything after that is immediately taxable (since none of your original investment is left).

In summary, ROC is a method of allowing funds to distribute more to their investors than the fund earned in a particular period of time – and for investors, it allows deferral of taxes on the ROC component until they sell, giving them control over cash flow.

If your hair hurts from reading this article, don’t worry too much. For when April 15 comes, simply report and pay taxes on the amount shown on Form 1099-DIV.

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