Invest some time to understand taxation of mutual funds

CIBC's Jamie Golombek offers tips to help Canadians

TORONTO, April 29 /CNW/ - "While Canadian investors are generally well-versed on the tax rules for mutual funds, many are confused by the need to report not just amounts on the T3 slip, but also any capital gains on redemptions during the year, which do not appear on the slip. In addition, Box 42 of the T3 slip remains a mystery for many," says CIBC's tax and estate planning expert, Jamie Golombek in the fourth of a series of tax tips this month.

His latest report, Mutual obligations: Tax tips for mutual fund investors, stresses the importance of reporting not only capital gains that appear on your T3 slip, but also any gain from the redemption of the mutual fund units. Investors should be aware that these are also reported directly to the Canada Revenue Agency, which can match them up against redemptions you report.

Mr. Golombek reminds investors that when computing their capital gain (or loss) on redemption, any costs to acquire the mutual fund units (such as front-end commissions) should be added to the adjusted cost base (ACB) of the units, and any costs to sell the units (such as deferred sales charges) should be subtracted from the proceeds of disposition. He adds that, in addition, any distributions you received and reinvested during the period of ownership should be added to the ACB of the units or you "risk paying tax twice" on these amounts.

The report cites a tax case which demonstrates the risks of not properly reporting all taxable dispositions. "Two obvious lessons can be gleaned from this case," says Mr. Golombek. "First, be sure to report all taxable dispositions on your tax returns or you risk being subject to gross negligence penalties on top of the tax and arrears interest that you will owe. Second, be sure to keep meticulous records of your ACB, so if the CRA ever asks you to justify the ACB reported on your return, you have clear, documentary evidence to substantiate the reported amounts."

The other mistake mutual fund investors often make is ignoring the amount reported in Box 42 of their T3 tax slip. Mr. Golombek says that investors regularly ask him what they are supposed to do with it, given that the number does not go on their tax return.

The amount indicated in Box 42 reflects a "return of capital" received during the year. A return of capital is simply an amount received from your mutual fund that is neither income nor capital gain, and thus isn't taxable. For example, if you invested in the T-series of a mutual fund, you will likely have received a return of capital, which is designed to produce a tax-effective cash flow.

"Box 42 was added in 2004 by the federal government out of concern that investors were receiving large amounts of non-taxable distributions which constituted a return of capital," advises Mr. Golombek. "Under tax law, these amounts, while not currently taxable, reduce your ACB. So it's important to track the amounts as you must take them into account when you redeem the mutual fund units, at which time you are required to report the resulting capital gain or loss."

In the report, Mr. Golombek also reminds investors that "for tax purposes, mutual funds are considered to be flow-through entities, meaning that the taxable income earned inside the fund may be flowed through to the investor, as if earned directly by the investor." He states that, "for example, if your fund distributed Canadian dividends, you can claim the related federal and provincial/territorial dividend tax credits on such amounts. Similarly, capital gains earned by the fund manager, when stocks or bonds are sold at a profit, also maintain their tax characteristic when distributed and thus are only 50 per cent taxable."

He explains that income or capital gains from mutual funds are taxed in two ways:

    <<
    -  The first being annually on any fund distributions that are flowed out
       to you while you own the mutual fund. In this case, you should receive
       a T3 slip, "Statement of Trust Income Allocations and Designations"
       which will show the amount of capital gains, dividends, foreign
       income, other income or return of capital you received during the
       prior year.

    -  The second being on the capital gain, if any, when you redeem or sell
       the mutual fund units. In this scenario, you should receive either a
       formal T5008 slip, "Statement of Securities Transactions", or an
       account statement from the mutual fund company which reports the sale.
    >>

"While tax reporting for mutual funds is generally straightforward and is made easier by the tax slips and record-keeping by fund companies, it's important to keep in mind the two most-often missed tips: report all dispositions and reduce your fund's ACB by any ROC received," advises Mr. Golombek.

Mutual fund investors can review the full report by Mr. Golombek by visiting Tips to reduce your 2010 taxes on cibc.com.

CIBC is a leading North American financial institution with nearly 11 million personal banking and business clients. CIBC offers a full range of products and services through its comprehensive electronic banking network, branches and offices across Canada, in the United States and around the world. You can find other news releases and information about CIBC in our Press Centre on our corporate website at cibc.com.

SOURCE CIBC

For further information: Kevin Dove, Senior Director, Communications and Public Affairs, 416-980-8835 or Kevin.dove@cibc.com


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