Return of capital and your ETF cost base

Return of capital is the distribution that feels like income, is not taxed like income, and quietly raises the tax bill you pay years later.

It is common in REITs and in a number of ETFs, it is easy to miss because nothing unusual appears in your account, and it is one of the two most frequent reasons a brokerage's cost base and your real one part company.

What it is

Most distributions are income: interest, dividends, or your share of the fund's realised capital gains. You pay tax on them in the year you receive them.

Return of capital is different. The fund is handing back part of your own investment. So it is not taxed on receipt, and instead it comes off your adjusted cost base.

Lower cost base, same eventual sale price, larger capital gain. The tax was not avoided. It was deferred to the year you sell, which is usually a year you have forgotten this ever happened.

The fund category where this shows up most is the one built around a large fixed monthly distribution. See covered call ETFs, where a payout set above what the fund earns is returning capital by construction.

Where it shows up: box 42

It arrives on a T3 slip, in box 42. CRA labels it amount resulting in cost base adjustment, which is a more honest name than "return of capital", because the box runs in both directions:

• a positive amount in box 42 is subtracted from the ACB of those units;
• a negative amount in box 42 is added to it.

The second case surprises people who have only ever been told that box 42 reduces cost base. Most of the time it does. It is not a rule that only points one way.

The slip usually arrives in the spring, after the statements it should have adjusted. That timing is a large part of why the adjustment gets skipped.

When the cost base runs out

Because return of capital keeps reducing the pool, a long-held position that distributes it steadily can drive its own cost base to zero.

CRA handles that explicitly. If the adjusted cost base of the units is reduced below zero during the year, the negative amount is deemed to be a capital gain from a disposition of the property at that time, the ACB is deemed to be zero, and the gain is reported on line 13200 of Schedule 3.

So the gain becomes payable in that year, without you having sold anything at all. That is not an edge case for someone who has held a distributing REIT for a very long time.

Why the number you are given may not carry it

A brokerage's book value is "adjusted for reinvested distributions, returns of capital and corporate reorganizations" when it is prepared well. CRA's own description of what belongs in T5008 box 20. Whether it has been applied to yours is another question, and CRA says plainly that the box "may or may not reflect the investor's ACB". T5008 box 20 is not your adjusted cost base covers that in full.

The reliable move is the boring one: read box 42 on every T3 each spring, and apply it in the year it happens.

What Luum does with it

Luum applies return of capital automatically. It reduces the cost base, and once the pool reaches zero the excess is reported as a deemed capital gain in the year received, which is the treatment above. Reinvested (phantom) distributions raise the pool in the same pass. Both are applied across your accounts, because the pool is per taxpayer rather than per account.

How Luum tracks adjusted cost base lists what is applied automatically and what is not, spin-off allocations and the superficial loss rule are yours. To run one security's pool through the arithmetic by hand, including a return-of-capital step, the adjusted cost base calculator does it in your browser.

This is educational information about how the adjustment works, not tax advice. Verify with the CRA or a qualified tax professional before you file.

Common questions

Is return of capital taxed when I receive it?

No. Return of capital is not included in income in the year you receive it. It reduces your adjusted cost base instead, which raises the capital gain you eventually report when you sell. The tax is deferred rather than avoided.

Where do I find the return of capital for my ETF?

On the T3 slip for the fund, in the box reporting return of capital, and in the annual tax characteristics the fund publishes. Funds also post per-unit distribution breakdowns after year end, which is what you need if you held units for part of the year only.

What happens if return of capital pushes my cost base to zero?

Once the cost base reaches zero, further return of capital is generally treated as a capital gain in the year it is received rather than continuing to reduce the base below zero. This is uncommon over short holding periods and much less so for a high-distribution fund held for many years.