Return of capital investments best route for tax efficiency

Traditionally, investors wanting investment income have fulfilled this objective through interest and/or dividend income, both of which are taxable in the year received.  Capital gains can also be a source of cash flow that is taxable in the year realized.  Becoming more popular is a cash flow stream commonly referred to as return of capital or ROC.

As an investor it is always important to factor in the tax consequences of your investments.  After all, the amount that ends up in your pocket is the gross income less any taxes.  The following illustrates the tax consequences of a top tax bracket individual (43.7 per cent marginal tax rate) who resides in British Columbia, and receives $1,000 through interest income, dividend income, capital gains and return of capital in year one.

return1

What type of cash flow stream results in putting more in your pocket?  After Year 1, an investor with a ROC cash flow streams ends up with more in their pocket.  Let’s look in depth at how the ROC cash flow stream is deferred over time.

ROC Illustration 

An investor purchases 1,000 shares at $25 (total purchase price is $25,000).  Let’s assume the shares pay a fixed cumulative distribution every quarter of $0.25 per share (or $1.00 per annum).  The distributions are tax efficient and considered 100 per cent return of capital.

return2

At the end of Year 3 you decide to sell the shares and the market value is $25 per share.  The proceeds would be $25,000 less the Adjusted Cost Base $22,000 creating a Capital Gain of $3,000 and a Taxable Capital Gain of $ 1,500.  In principal the ROC structure should create a capital gain.  The main difference between a Capital Gain and ROC is that the later provides the ability to defer income.  It is possible to set up an account that has a cash flow stream with no immediate tax consequences.  In many ways this is similar to the benefits of an RRSP without the deduction.

Tax Slips

Investors filing their own tax returns over the last two years may be curious to see box 42 on their T3 slips. Box 42 is “information only” and represents the “return of capital” amount that you received in the year.  Return of capital is not considered income when it is received.  The amounts in Box 42 reduce the cost of your original investment.  You are essentially receiving a portion of your own money back.  This information is relevant when you ultimately dispose of the position as you must manually factor in the total ROC amounts when calculating the adjusted cost base of the investment on schedule three of your income tax return.

Five Questions to Consider

  1. Do you have capital losses available (see your latest Notice of Assessment)?
  2. Do you have non-registered investments?  If so, would you like to increase the yield within your portfolio by using a tax efficient strategy?
  3. Is deferring tax important to you?
  4. Are you paying too much tax on your investment income (i.e. GICs and Bonds)?
  5. Would you like a tax efficient income stream?

Three Key Benefits of ROC

  1. Reduce your taxable income – in the above example, the investor had no investment income for Years 1 through 3 as the distribution is considered Return of Capital.
  2. Ability to utilize your capital losses – investors that have capital losses available are able to carry those losses forward to offset against future capital gains. Many ROC investments have low risk ratings that allow investors to utilize those past losses even when they are reluctant to invest in common shares.
  3. Pay less tax on your investments – if the above distributions were interest income (i.e. GICs and Bonds), a high tax bracket investor would have approximately $462 ($1,075 x 43%) in taxes to pay each year.  The combined tax for 3 years is estimated at $1,386 for “interest income” versus $693 ($1,613 x 43%) for the return of capital structure which generated a capital gain and only half the amount of tax!

Investors who benefit most from return of capital investments are those that are in high tax brackets, aged 65 and older who are concerned about the claw back of government benefits, investors with capital loss carry forwards, and/or investors who are simply interested in putting more investment income in their pocket.

Before implementing any strategies discussed in our columns we recommend that you speak with your financial and tax advisors.