What is return of capital and how does it affect tax?

• A. Return of capital reduces the adjusted cost base of the investment and is not taxed as income when received; taxes arise later when the investment is sold.
• B. It is taxed as interest income in the year received.
• C. It increases the adjusted cost base and is immediately taxed as capital gains.
• D. It has no effect on cost base or taxes.

Answer: (A)

Return of capital is a distribution that comes back to you of part of your original investment rather than earnings from the fund. Because it represents a return of your money, it isn’t taxed as income in the year you receive it.

Instead, it reduces the adjusted cost base (ACB) of your investment. The ACB is your basis for calculating future gains or losses, so when you receive a ROC payment, you lower that basis. This means that when you eventually sell the investment, the gain is calculated using the lower ACB, which typically results in a larger capital gain at that time—and taxes are then due on that gain.

Example: if you paid $10,000 for units and receive $1,000 as ROC, your new ACB becomes $9,000. Later, if you sell for $12,000, the capital gain is $12,000 minus $9,000 = $3,000, which is taxable (at the capital gains inclusion rate). The tax is deferred until the sale, not when ROC is received.

In short, ROC is not taxed as income when received, but it reduces the cost base, affecting taxes at the eventual disposition.